Yes, that’s all you have to do. For each loan in your portfolio, determine the cash flow by year so you can figure out what cash flows won’t be collected. Then calculate the present value of what won’t be collected. For every loan. Repeat every year.
That’s the model FASB is thinking about.
For a critique, check out Tom Selling’s post, “Anything But Market” is the FASB’s Mantra for Loan Loss Accounting.
Here is a one paragraph overview of the concept:
Under the “Current Expected Credit Loss Model” (CECL) proposed by the FASB, Bankco must not only be able to estimate the total amount of contractual cash payments expected to be uncollected, but also the timing of the non-collections. That’s because the estimated non-collections are to be discounted at the “effective interest rate” to “reflect the time value of money.”
The determination of uncollectible cash flows starts on day one. On a practical basis at the next quarter-end the company would have to determine the loan loss on those brand new loans.
The post is written as if it were a court decision. That is a fun tool which makes reading about a possible change to loan loss methodology quite entertaining. (Yes, yes, I know you’re very worried about me because I use the words “fun” and “entertaining” to describe an article on loan loss rules that aren’t even in effect.)
Here is Judge Selling’s ruling:
This court finds the FASB guilty on the following counts: (1) misappropriation of the term “measurement objective”; (2) time value of money malpractice; (3) manslaughter of basic accounting principles; (4) reckless endangerment of auditors; and (5) obstruction of accounting justice.
Check out the full article to see what he means by each of the ‘charges’ committed by FASB.
Of particular concern to me as an auditor is the reckless endangerment of auditors:
Isn’t it already enough that auditors put themselves at risk simply by attesting to the “reasonableness” of management’s estimates of the allowance for doubtful accounts on short-term, trade receivables? The CECL method is orders of magnitude more complex than that. It would require management to estimate expected losses for multiple periods extending out for decades.
Then auditors will have to audit the multi-decade cash flow forecast for the loans.
Maybe my brain isn’t big enough, but I’m struggling with how I could opine on whether it will be the first quarter of 2023 or the third quarter of 2026 when that $50 million loan will stop paying and whether 50% or 25% of the remaining balance will be recovered in bankruptcy 3.5 years later.
In the far distant past when I was the in-charge accountant on bank audits, it was hard enough trying to evaluate the estimate of loss on a loan that is currently 90 days past due. I cannot get my brain around auditing which borrowers will stumble 5 or 20 years from now.
Check out the full post. As always, it is a good read and persuasive. Also makes me glad I don’t audit any banks, credit unions, or church extension funds.