The Allowance for Loan and Lease Losses (ALLL) is a calculated reserve established by financial institutions in connection to the expected credit risk within the institution's assets. It indicates the charge-offs that will most likely be incurred against an institution's operational income as of the end date of the financial statements. This decreases the book value of the institution's loans and leases to the amount that the institution expects to receive. The ALLL's objective was to indicate expected credit losses within a bank's loan and lease portfolio.
The 2007-2008 financial crises exposed the ALLL accounting standard's shortcomings, which included its inability to quantify credit losses depending on future events. It was based on losses that had been suffered but not realized. As a result, on June 16, 2016, the Financial Accounting Standards Board (FASB) issued the Current Expected Credit Losses (CECL) accounting model. The CECL standard is concerned with estimating predicted losses over the life of loans, whereas the existing standard is concerned with experienced losses. The method used to detect impairment losses on financial assets has long been regarded as a serious flaw, resulting in delayed identification and increasing scrutiny.
The CECL model's objectives are to:
· Reduce the complexity in US GAAP (Generally Accepted Accounting Principles) by reducing the number of credit impairment models that entities use to account for debt instruments
· Credit losses recognized in time with the use of an expected loss model instead of an incurred loss model
· Require an entity to set aside an allowance for predicted credit losses over time
· A specific method for entities not required to estimate expected credit losses
CECL standard applies to commonly held assets including:
· Certain debt instruments held to maturity
· Recognition of trade receivables and contract assets under ASC 606
· Lease receivables that are a result of sales-type or directing-financing leases
· Reinsurance receivables from insurance transactions
· Financial guarantee contracts
· Loan commitments
· The CECL model does not apply to available-for-sale debt securities
A financial crisis will not be averted by CECL. Rather, it seeks to correct flaws in the reporting of financial data, which is crucial during times of economic hardship. CECL also consolidates today's credit impairment regulations, which span many standards, into a single standard that applies to the vast majority of credit transactions.
The transition of accounting regulations to a current expected credit loss (CECL) framework is designed to improve financial system stability and liquidity across the economic cycle. Firms will begin preparing for possible losses when they first record loans under the new structure, rather than setting up reserves only when loan performance deteriorates.
Lenders must begin planning as soon as possible, and regulators must be prepared to respond to changing situations as the CECL deadline approaches. The current situation is excellent for lenders to prepare for the changeover, with the job market slowly strengthening and consumer credit losses near record lows. If the implementation of CECL coincides with deterioration in economic performance, the advantages of shifting will be minimized at best, and may even induce a recession at worst. All lenders should begin planning for CECL as soon as possible, for their advantage as well as the benefit of the financial system and the broader economy.
