Credit Losses: Return of Management’s Judgment

This article is the third in a series on the Financial Accounting Standards Board’s (FASB’s) Current Expected Credit Loss standard, inspired by Star Wars. You can read the first and second here.

If Jabba the Hutt reported under current US GAAP, he would have incurred a probable credit loss when Han Solo dumped a load of contraband to escape an Imperial patrol. If Hutt implemented the FASB’s new Current Expected Credit Loss (CECL) standard, he might have reported the loss much earlier based on news of other cargo losses in the area.

Banks and other depository institutions will have a higher level of flexibility in the application and implementation of the FASB’s new principles-based standard. This flexibility gives management more power to make decisions based on their own professional judgment. However, with great power comes great responsibility.

Just as Yoda taught Luke Skywalker the techniques of a Jedi Knight, if you’re implementing the CECL standard in your institution, you’ll need to empower your management with adequate professional judgment techniques and considerations.

Define the mission

In any decision based on professional judgment, you must first define the goal Take for example the following goals and their potential outcomes when it comes to a financial institution and its loan portfolio.

Mission Goal #1: Management’s goal is to efficiently apply the CECL calculation using currently available information.

Potential Result: Management might default to segmenting its portfolio based on call codes (or something similar that’s readily available in its portfolio), choosing the easiest reversion technique and then picking macro-level data adjustments for its portfolio to make qualitative adjustments.

This application of the standard is inherently flawed because management didn’t appropriately consider whether data points are appropriate and consistent with your underwriting risk or whether forecasting was reasonable and supportable. In addition, when segmenting, what risk characteristics did you consider? How did you determine relevant data? What data alternatives did you consider? And how did you pick the most appropriate reversion technique?

Now let’s take another look at the same goal, reframed:

Mission Goal #2:  Management’s goal is to appropriately apply the CECL standard with reasonable and supportable forecasting techniques using relevant factors, along with reversion techniques supported by relevant data that reflects potential underwriting risk within its portfolio to reach the best estimate.

Potential Result: Management would utilize professional judgment through the estimation process to make appropriate considerations and decisions in the application of the standard, including: reasonable and supportable relevant factors, appropriate segmentation, data accuracy, validation and relevant data determination, to name a few. Ultimately, management would be able to support its position and be able to appropriately apply the standard to reach their best reasonable estimate.

Expand your range

Consistent with the current incurred loss standard, management will be responsible for supporting its professional decisions with appropriate audit trails and support — with one additional twist:

One of the FASB’s key objectives is to broaden the range of information considered in determining expected credit losses. As a result, management will be required to consider a broader range of potential information, reversion techniques and application of the standard. In other words, the additional flexibility within the standard places more emphasis on the burden of proof now on management.

Management must consider relevant factors when applying reasonable and supportable forecasting and relevant data when applying reversion techniques, as defined by the standard.

Guard against common traps

Ultimately, it will be important to be aware and understand professional judgment bias as auditors will also have their own level of professional skepticism when reviewing preparers’ work.

• Rule of thumb or “heuristics bias”. Simply put, be careful not to oversimplify a complex assessment by focusing on one aspect and ignoring others.
• Anchoring. Our brains like to work from a certain point even if that point is completely irrelevant. Ask yourself why you started your calculations where you did. Your auditor may want to know, too.
• Availability. If we have a ready example in our memory, we tend to weigh it more heavily in our judgment.
• Confirmation. Once we’ve established a theory that we like, we tend to seek and put too much weight on confirming evidence.
• Overconfidence. This trap catches some of the most experienced managers. If you have a high level of confidence in your evaluation, ask someone known for their skepticism to review your assumptions.

Prepare for scrutiny

You can expect your auditors to ask many of the same questions they have under the current standard. New questions will arise from your auditors around professional judgment based on their professional skepticism. Below are examples of potential questions from your auditors on reversion techniques and reasonable and supportable forecasting. Please note, the questions listed are just examples and are not considered all-inclusive.

Reversion techniques:

• Why did you pick _____ technique?
• What alternatives did you consider?
• How did you determine relevant data?
• How did you determine the risks within your portfolio?
• How did you determine your segmentation?
  • What risk characteristics did you consider?
  • How do you reevaluate segmentation on a consistent basis?
  • How do you consider relevant data?
• How do you know your personnel have the right capabilities?
• How did you ensure your pooling technique was elastic enough to be reevaluated on a consistent basis?
  • If you determined your segmentation should be based off call report codes, how did you determine that the pooling was appropriate?

Reasonable and supportable forecasting:

• What is the source of the data you are using?
• How did you determine relevant risk factors?

When using economic data:

• Did you engage an expert?
• How did you get comfortable with accuracy of the economic data utilized?
• How did you determine the economic data was relevant?
• How did you determine the data utilized is complete and accurate?
• How did you determine that the forecast period was reasonable?
• How does the data utilized reconcile with other aspects of the institution?

Qualitative factors:

• Were qualitative factors utilized? If so, how were they utilized?
• How were the amounts determined?
• What documentation do you have supporting the data?
• How did you determine the completeness of the qualitative factors?
• What types of processes and controls are in place to ensure that the qualitative factors are current, relevant and reliable?
• Did the qualitative factors change?

The credit losses page on aicpa.org features helpful resources including a CECL issues tracker, webcasts, a PowerPoint template that you can share with your board and/or management and more.

Don’t forget to check out previous articles in this series: Credit losses: A new scope and Credit losses: May the force be with your mission to CECL.