Many consumer industry companies extend credit or hold significant financial assets. If yours is one of them, it’s time to gear up for the current expected credit loss (CECL) accounting standard.
The new standard requires companies to measure estimated credit losses from receivables and loans, certain debt securities, as well as certain off-balance sheet obligations, and replaces existing impairment models for financial assets and off-balance sheet obligations. The CECL implementation timeline contemplates an effective date of Jan. 1, 2020 for calendar year-end public business entities that are SEC filers. That isn’t as far off as it may sound, especially if you have material portfolios in scope.
The good news? When all is said and done, the new CECL forecasting model offers compelling benefits to strategy-minded consumer industry companies. First, you’ll have to implement the model and obtain senior executive support to achieve effective cross-functional collaboration. Here’s an approach that’s worked for many of the early adopters we know.
Take stock of the relevant assets and off-balance sheet obligations
CECL applies to all companies holding financial assets not accounted for at fair value through net income and net investments in leases. For companies in the consumer industry, four types of financial instruments merit special attention:
Lending products: Transitioning to CECL will generally require credit loss reserves to be recorded sooner for companies that extend longer-term credit to customers, dealers, and other third parties.
Held-to-maturity securities: Different securities will have different requirements under CECL, with some requiring an evaluation along with expanded documentation.
Accounts receivable: Because CECL guidance is principles based, different methods can be used to estimate allowances. For short-term receivables, consumer companies will likely be able to leverage current processes (modified for expected loss versus incurred loss and for pooling of receivables with similar risk characteristics).
Loss-sharing arrangements: Arrangements with lending institutions to provide customers with product financing oftentimes involve loss-sharing arrangements, exposing companies to credit risk. Companies need to assess the applicability of CECL to these arrangements and adjust their current methodologies as needed.
Identify the data you’ll need
Estimating expected losses requires data that can reside in different parts of the company. Some of it might be with the product team. Other data might reside with IT, accounting, legal or other functions.
To complicate matters even further, these functions historically may have had limited interaction. That likely will have to change. CECL compliance requires visibility into the full economic cycle, which requires close integration across the affected groups.
On top of that is the likelihood of missing data. Economic cycles can extend beyond typical data retention guidelines, so it’s a good idea to determine how the model will change under CECL. This should help you identify the additional data needed for financial disclosures, risk assessment and model inputs. For companies with longer-dated financial assets impacted by CECL, it is not uncommon to have to close an initial gap with external data feeds.
In the meantime, governance leadership should revisit data remediation decisions. New or modified internal controls and processes may be necessary. Either way, don’t underestimate the effort it could take to integrate production data acquisition and management with the CECL model calculation.
Evaluate existing models and processes
Consumer industry companies may need to adapt their current credit loss estimation models — along with the associated risk management and internal controls — for CECL compliance. If the resources aren’t there to build the model in house, company leadership will need to decide whether to acquire new talent or use external providers. By the same token, if out-of-the-box technology falls short of project requirements, plan for additional work to align the solutions with the company’s risk profile.
Existing allowance oversight may also turn out to be inadequate under the CECL standard. Many companies discover they need more and better information to understand the provision drivers for each period, as well as the sensitivity of the estimate to the various assumptions driving a loss (such as forecasts). These insights will help to inform not only allowance decisions but internal management and external communications as well. Additional disaggregation of balances into pools with similar risk characteristics may also be required.
Once you have a handle on your existing models and processes, document what they need to look like for effective CECL implementation and draw up a plan to make it happen. Consider tabletop reviews or walkthroughs of the end-to-end production process with representatives of all impacted functions. This way, you can surface issues early, avoiding costly eleventh-hour fixes. A well-designed parallel run can also boost management confidence in the implementation.
Take advantage of improved capability
CECL isn’t just an accounting standard. It requires discussion among the various teams responsible for new customer segments, new products and other go-to-market strategies. Because data and automation are affected, IT will be in the mix as well. Pulling all this cross-functional interaction into a repeatable process is the pragmatic response to getting everyone on the same page for financial reporting purposes.
And that’s the little-known secret of CECL. The new standard may come with more work for consumer industry companies, but it can also bump up the flow of information. As a result, companies can tighten their disclosures of what’s driving changes in financial results from a credit perspective. New modeling capabilities can also help guide companies in adjusting financing options, tweaking customer terms and even evaluating new customer bases and products by forecasting the potential effects under different business environments.
CECL ushers in a new era of accountability for credit loss allowances. Companies in the consumer industry can get ahead of this shift in compliance and reporting requirements by understanding the challenges that implementation is likely to present and tackling them early on. At the same time, the new capabilities required for CECL implementation can be put to work delivering greater insight and control to management teams across the organization.
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