Right now, there is probably no more frequently searched accounting topic by accounting and finance personnel in fintech than CECL. What is CECL, you ask? (pronounced SEE-sil) CECL (Current Expected Credit Loss) is a new accounting standard, ASC 326, that affects how companies account for credit losses. It requires companies to estimate the expected credit losses over the life of a loan or financial instrument at the time of origination or purchase and to reflect those losses in the financial statements.
While primarily introduced for banks and traditional financial institutions, fintech companies that offer loans or operate in the lending or factoring receivables space must comply with CECL and adjust their accounting practices accordingly. This means that fintech companies will need to use forward-looking models to estimate expected credit losses over the lifetime of a loan portfolio rather than relying on historical data.
CECL applies to financial assets, including trade receivables, leases and loans. Another fun acronym is ALLL (Allowance for Loan and Lease Losses) which is the result of applying the CECL methodology. The ALLL will become a contra asset on a company’s balance sheet, aka its reserve.
CECL is formalized by the Financial Authority Standards Board (“FASB”) in accounting standard codification (“ASC”) 326. Under ASC 326, entities are required to estimate and recognize expected credit losses on financial assets at the time of initial recognition and throughout the life of the asset. This is more complex than historical methods as companies may not have a long-standing history and may need to source data from non-traditional means. The standard requires entities to use:
- Historical information,
- Current information, and
- Reasonable and supportable forecasts.
The adoption of ASC 326 has significant implications for companies, as it requires them to make significant changes to their accounting practices and systems. It also requires entities to provide enhanced disclosures regarding their credit risk management practices. ASC 326 became effective for private companies on January 1, 2023.
Three-Step Process for Estimating Forecast Losses
Under ASC 326, estimating forecast losses involves a three-step process:
- Identify relevant factors: The first step is to identify the relevant factors that may impact the likelihood of a credit loss. This may include historical information, current economic conditions, and other factors that may affect the borrower's ability to repay.
- Develop models: The second step is to develop models that incorporate the identified factors to estimate expected credit losses. These models may be based on statistical analysis, historical data, and other factors that may be relevant to the borrower's credit risk (such as FICO score, debt ratios, delinquency rates, aging, etc.).
- Update models: The third step is to update the models as new information becomes available. Entities are required to use current information as well as reasonable and supportable forecasts to predict expected credit losses. Companies may only be formally issuing annual audited financial statements. However, companies should consider updating their models more frequently, such as quarterly or whenever a significant event occurs (i.e. economic downtown, significant change in consumer base, etc.)
The specific methods used to estimate forecast losses will depend on the nature of the financial asset and the information available. Entities are required to use judgment in developing their models and estimating expected credit losses, taking into account both quantitative and qualitative factors. Fintech’s may be at a disadvantage if they have experienced rapid growth, as it causes increased volatility in modeling and forecasting.
However, some fintech companies may have an advantage in implementing CECL, as they may have access to more diverse and extensive data sources than traditional financial institutions. Additionally, CECL may promote better risk management practices and transparency in financial reporting, which could benefit fintech companies in the long run.
It is important to note that estimating expected credit losses under ASC 326 can be a complex process and may require significant resources and expertise. Entities are encouraged to seek guidance from their auditors or other accounting professionals to ensure that their models are appropriate and comply with the requirements of the standard.
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For more information on current expected credit loss, please contact a member of Withum’s Fintech Services Team.
