“Times and conditions change so rapidly that we must keep our aim constantly focused on the future.”
~ Walt Disney
As many credit union executives have likely heard, the current expected credit loss model (“CECL”) is a new Financial Accounting Standards Board (“FASB”) accounting rule. CECL was scheduled to become effective on December 31, 2021, but in July of 2019, FASB extended the effective date for credit unions to January 2023. Regardless, in NCUA Letter No. 16-CU-13, the NCUA wrote, “…your credit union needs to take steps in advance to ensure effective implementation of the standard. The board of directors and senior management of your credit union should become familiar with the new accounting standard to assess how the new standard differs from the existing incurred loss model.” The standard changes how credit unions account for credit losses on their loans and on debt securities in their investment portfolios.
In a nutshell, the purpose of CECL is to address delays in the recognition of credit losses. In effect, CECL will require credit unions to record at the time of origination, credit losses that are expected during the life of loans and Held-to-Maturity securities. This is different than the “incurred loss” accounting methodology used today in which losses are recorded by credit unions when it’s probable that a loss already has occurred.
Much has been written about the effect of CECL on loans, but relatively little about its effect on credit unions’ investment securities. Currently, debt securities at purchase are designated as either Trading, Held-to-Maturity (“HTM”), or Available-for Sale (“AFS”). The accounting treatment is different for each designation, as are the applications of CECL and related FASB amendments. Changes may be coming, particularly in response to a growing concern about the chilling effect CECL may have on loans to low income borrowers, but here’s a quick summary of what we know so far in connection with CECL’s application to debt securities in credit union investment portfolios:
- Securities designated “Trading” are accounted for monthly on a mark to market basis and the adjustment in value is recorded to income. Credit losses are accounted for immediately. CECL does not impact securities designated “Trading.”
- HTM securities accounting is performed monthly on a book basis. Valuation changes are not recorded to income or equity. Currently, losses or Other Than Temporary Impairment (“OTTI”) are recorded to income when it is determined that a loss has or will soon occur. HTM is primarily used to reduce volatility to equity. HTM securities will be subject to CECL. CECL will require an allowance on these HTM debt securities for lifetime expected credit losses, determined by adjusting historical loss information for current conditions and reasonable and supportable forecasts. The forward-looking evaluation of lifetime expected losses will be performed on a pooled basis for bonds that share similar risk characteristics. These allowances for expected losses must be made by the holder of the HTM debt security when the security is purchased. So, when credit unions buy HTM securities, they will be required to look in the rear-view mirror and also squint down the road through the windshield to determine whether the new security will encounter trouble. If so, the expected trouble must accounted for at the time of purchase.
- AFS securities accounting is performed monthly on a book basis. Valuation change is not recorded to income but is recorded to equity in the form of Other Comprehensive Income (“OCI”). Currently, losses or OTTI are recorded to income when it is determined that a loss has or will occur. The income adjustment is recorded as a reduction in the security’s cost basis. Recovery of a previously recognized impairment is recorded in interest income prospectively over time. The FASB decided that CECL should not apply to AFS debt securities. Instead, targeted amendments were made to the existing AFS debt security model. Under the new guidance, an allowance will be recognized for credit losses rather than as a reduction in the cost basis of the security. Subsequent improvements in credit quality, or reductions in estimated credit losses, will be recognized immediately as a reversal of the previously recorded allowance, which aligns the income statement recognition of credit losses with the reporting period in which changes occur. Consequently, the guidance eliminates the theory of OTTI, and instead emphasizes determining whether an unrealized loss is credit-related, or due to other factors. Specifically, the length of time the security has been in an unrealized loss position will no longer be used to determine whether a credit loss exists. Impairment must be evaluated at the individual security level, at each reporting period, through a comparison of the present value of expected cash flows from the security with the amortized cost basis of the security.
- In addition to most existing disclosure requirements, disclosure of an allowance roll-forward, by major security type, for both HTM and AFS debt securities will be required. For HTM debt securities, by major security type, disclosure of credit quality information and allowance for credit losses and management’s estimation process will be required. Also, for AFS debt securities, disclosure of the accounting policy for recognizing write-offs will be required.
Stay tuned for more changes to CECL in the next few years – or maybe even months.
Although CECL may not inspire us to whistle while we work, we can take heart in the words of Disney’s Mary Poppins who sang, "In every job that must be done there is an element of fun.”
The author would like to thank Ken Jeffery of Heber Fuger Wendin for his contributions to this article.
Heber Fuger Wendin, established in 1934, is a fee-only, independent, fee-only SEC-registered fiduciary investment advisory firm (not a broker) to credit unions and other depository institutions. Mr. Barnes leads the Heber team in helping to manage $4 billion for over 100 clients. Mr. Barnes can be reached at dbarnes@hfw1.com or HeberInvestments.com