The coronavirus (COVID-19) pandemic has quickly swept the globe, overwhelming healthcare systems, disrupting financial markets, stressing businesses and shocking humanity. Economists are predicting a severe recession - or worse - as a result of its short- and long-term financial effects.
As part of the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) passed on March 27, 2020, Congress included a deferral of CECL until the earlier of December 31, 2020 or the end of the National Emergency declaration. However, the CECL deferral currently only applies to financial and depository institutions. Most non-financial institutions that are SEC filers - such as retailers or manufacturers - would still have to comply with CECL for fiscal years beginning after December 15, 2019.
This rapid change in the economic outlook due to COVID-19 should definitely be considered in the first quarter 2020 CECL estimates, but not in the cumulative adjustment to retained earnings at January 1, 2020. Although the first coronavirus diagnosis was made in 2019, there was no evidence of an outbreak at year-end.
Factors to Consider
The economic fallout of this pandemic likely means that many key assumptions used in calculating your CECL estimate - such as economic forecasts, the historical loss period, and the duration of the volatility - need to be revisited.
Let’s first consider impacts on economic forecasts over the reasonable and supportable period: Interest rates are falling and expected to continue to decline, the unemployment rate is expected to increase rapidly and significantly, there has been significant contraction in overall supply and demand, and the stock market is in a freefall. This pandemic is global, and most commerce has ground to a halt. All of these factors contribute to make it even more difficult to forecast economic conditions over the reasonable and supportable period as required under CECL. Daily volatility is unprecedented in financial markets. Many entities were using periods ranging from one to three years to forecast reasonable and supportable future events. Given that the pandemic significantly increases uncertainty in economic forecasts, management will need to take uncertainty into account when estimating credit losses.
Next, let’s consider the historical loss period that was chosen to estimate expected credit losses under CECL. It is appropriate to use historical credit losses as the foundation for your CECL estimate, but they should be adjusted for significant differences in current conditions, forecasts of reasonable and supportable economic outlooks, and portfolio composition because today’s deteriorating economic outlook was not anticipated in the historical loss periods and scenarios used by most institutions.
The historical loss periods utilized for CECL will need to be revisited, especially with instruments with longer contractual maturities. Qualitative factor adjustments will likely be key in adjusting those historical credit losses to incorporate a more adverse current environment and economic outlook. Furthermore, for any periods beyond the reasonable and supportable forecasts, an entity is required to revert to historical credit losses. Institutions may prefer to leave the reasonable and supportable periods unchanged (i.e. two years) and make qualitative adjustments to account for uncertainties, rather than adjusting the reasonable and supportable period to one year and reverting to historical loss rates after year one. However, those historical credit losses that are reverted to are adjusted for asset-specific characteristics and the reversion method chosen, but not for future economic conditions.
Finally, let’s consider the implications of the duration of the economic decline and related volatility. The contractual maturities of in-scope CECL assets will continue to significantly impact your estimate but possibly in different ways than before. Some shorter-term assets like accounts receivable may experience delayed or delinquent payments while longer-term assets, such as mortgages, may require shorter-term loan modifications, but resume more normalized collections over the longer-term.
In addition to the Congressional action outlined above, banking regulators issued an Interagency Statement to specifically address the coronavirus impact on loan modifications, which would often result in classification as a troubled debt restructuring (TDR). In this statement, regulators agreed that coronavirus-related loan modifications would not automatically be classified as TDRs, provided that the modifications were short-term and that the borrowers were current prior to the outbreak. The precedent previously set in times of natural disasters to permit leniency on the classification of a loan modification as a TDR is expected to encourage financial institutions to assist borrowers in times of extreme events.
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