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Forecasting Recoveries and Negative Allowance For Credit Losses 

Mergers, Acquisitions and CECL Accounting SME, Craig Engle, clarifies common questions regarding Negative Allowances when performing a CECL methodology.

As part of our CECL technical series, the following whitepaper details How, When, and Why negative allowance are permitted or required under the new CECL standard.

Introduction

As CECL adopters are taking on the challenge of calibrating and fine-tuning their forecasting models and non-CECL adopters are (or should be!) starting to perform parallel runs, many stakeholders are dealing with the financial impact that CECL can create amid a pandemic. Although down economic scenarios can initially lead to an accounting loss, charge-off’s, and/or provision expense, this creates an opportunity to recover these charge-offs at a later time. Since one of the pillars of CECL is forecasting economic factors and their impact on losses, it is important to contemplate both the losses and recoveries of those losses when generating a CECL Allowance for Credit Losses (ACL). FASB detailed specific guidance related to recoveries when ASU 2019-04 was published in April 2019. FASB not only allows for but requires that a negative allowance be recorded in certain circumstances, which often creates tension for the usually conservative CFOs, Audit Committee, and Board of Directors. See below for some technical backgrounds and takeaways related to projected recoveries and negative ACL.

Accounting Standard

FASB received feedback related to the initially published ASC 326-20-35-8 prior to ASU 2019-04. Some users were concerned that the bold sentence below should be interpreted that recoveries should not be factored into the ACL calculation in any respect:

Write-offs of financial assets, which may be full or partial write-offs, shall be deducted from the allowance. The write-offs shall be recorded in the period in which the financial asset(s) are deemed uncollectable. Recoveries of financial assets previously written off shall be recorded when received.

Analysis of Guidance

“Recoveries of financial assets previously written off shall be recorded when received”

When analyzing the original intent of this guidance, it is important to think about the ACL as two independent financial components (although often inter-dependent to one another): 1) the activity during the period that is based on charge-off’s, recoveries, and provision expense and 2) the calculation of the ending ACL at the end of the quarter. Valuant suggests that the bold sentence above referred specifically to the allowance activity during the period (this is very similar to the guidance under the Incurred Loss Model (ILM) that was/is used prior to CECL adoption). For example, when a recovery payment is received, the asset is immediately written up via the recovery and the payment simultaneously settles the asset.

This transaction will yield a favorable impact on the provision expense for the period, at least prior to adopting CECL. CECL differs from ILM in that this recovery transaction may be part of a reasonable and supportable forecast. In that case, ASU 2019-04 specifically clarifies that this forecasted recovery should be part of the ACL calculation at the end of the quarter. In essence, this recovery has the same overall impact on provision expense, but it is being realized as it is now part of the reasonable and supportable forecast period as compared to when the transaction actually occurs. However, to write up the asset (rather than just carry a lower allowance), the entity should wait for the recovery transaction to occur.

Many CECL methodologies (and ILM for that matter) already contemplate recoveries. For example, a Net Charge Off (NCO) methodology or a Probability of Default (PD) and a Loss Given Default (LGD) methodology can be calculated in a matter that is net of recoveries. This approach works well for “good”[1] loans that are collectively assessed. Said another way, using a CECL-compliant methodology for collectively assessed results in expected losses and recoveries of those expected losses that are embedded in the ending ACL calculation. However, ASU 2019-04 introduced some new concepts on projected recoveries on collateral dependent financial assets[1] that are measured using the fair value of the collateral. What happens on loans that have already received a charge-off but there could be a recovery that is part of the reasonable and supportable forecast? The guidance clarifies that when the fair value of the collateral exceeds the amortized cost basis, that a negative allowance shall be recorded.

Essentially the recovery is being projected and the favorable impact of the provision expense is being pulled forward to when it is first forecasted (or when CECL is adopted). A CECL purist would likely argue that this makes perfect sense and is in the spirit of FASB’s original intent when designing the CECL framework. ASC 326-20-35-5 excerpt, updated via ASU 2019-04:

If the fair value of the collateral is less than the amortized cost basis of the financial asset for which the practical expedient has been elected, an entity shall recognize an allowance for credit losses on the collateral-dependent financial asset, which is measured as the difference between the fair value of the collateral, less costs to sell(if applicable), at the reporting date and the amortized cost basis of the financial asset. When the fair value (less costs to sell, if applicable) of the collateral at the reporting date is equal to or exceeds the amortized cost basis of the financial asset, an entity shall adjust the allowance for credit losses to present the net amount expected to be collected on the financial asset equal to the fair value (less costs to sell, if applicable) of the collateral as long as the allowance that is added to the amortized cost basis of the financial asset(s)does not exceed amounts previously written off.

Loan Lifecycle

Hypothetical milestones within a loan’s life cycle and how these should be accounted for in a CECL-compliant model.

In summary, once an institution has adopted CECL or when they are performing parallel runs, be sure to verify that collateral dependent loans are being calculated in accordance with ASU 2019-04. Commonly, the population of loans that is subject to forecasted recoveries and negative allowances are on collateral dependent loans, when there has been a historic charge-off, and when the current allowance is $0. This would indicate the collateral value at least supports a $0 reserve, and likely has excess value to support a negative allowance up to the previous charge-off amount.

Considerations

Operationally, there are several challenges related to calculating negative allowances on collateral dependent assets:

Whether it is third party software systems or manual spreadsheets, updates must be made to allow for negative allowances as most legacy systems floor the allowance at $0.

Appraisals that previously supported a $0 allowance will be scrutinized and require additional documentation if they are drivers of a negative allowance on loans that have had historical charge-offs.

Purchased Credit Deteriorated (PCD) loans must be identified and follow a different calculation that does not result in a negative allowance that accelerates the noncredit discount into income.[i]

Cumulative life-to-date charge-offs, net of any recoveries received, must be tracked at the loan level as this amount limits the amount of negative allowance that can be recorded. Furthermore, acquired loans that may have charge-offs in a previous life add complexity. In some cases, using customer balance less book balance could indicate life-to-date charge-off amounts, but shadow accounting and nonaccrual interest paid can distort this difference.

Final Note

Finally, a CECL purist would also argue that there could or should be a recovery asset for fully charged-off loans. Generally, fully charged-off loans are not contemplated as a part of an ACL calculation since they are already fully written off but consider performing an analysis if such recoveries are reasonable and supportable. If you have any further questions about these topics, please connect with us at info@bevaluant.com.

[1] The good kind of loans where losses are projected over the remaining estimate life of the loan.

[2] These are individually assessed loans that do not have common risk characteristics that are modeled separately from collectively assessed.

[i] This was clarified in ASU 2019-11 as there was not a specific carve-out in the collateral dependent guidance for PCD loans in relation to using Amortized Cost or Book Balance when comparing to the collateral values. We will be covering this and other PCD specific technical topics in a future installment.

About the Author

Craig A. Engle Director of Product Management

Craig, CPA/ABV has over ten years of public accounting, consulting, and software development experience and specializes in providing services to financial institutions.

He is a co-founder and leads the product design and management function of ValuCast™, a proprietary suite of software solutions designed to assist banks with Day 1 and Day 2 accounting, allowance for loan loss calculations under ASC 450-20 and ASC 310-10, Current Expected Credit Loss calculations and implementation under ASC 326, and various other financial modeling tools.

Craig has assisted in consulting projects for numerous financial institutions ranging in size from $500 million to over $35 billion in assets.

Prior to founding Valuant, he served as a Director and external auditor in a top 30 accounting firm specializing in several industries including financial institutions manufacturing, insurance and real estate. Visit www.bevaluant.com/leadership for more information about Craig and Valuants Leadership team.

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