In a June 2016 report by Big Four accounting firm PwC, it stated that each entity’s “estimate of expected credit losses (ECL) should consider historical information, current information, and reasonable and supportable forecasts, including estimates of prepayments.”
The actual methodology used to calculate ECL is left up to each financial entity, so it may be that several models are tested and used in combination to assess loan portfolio risk. Again, the new methodology is an assessment of risk of future losses as opposed to calculation of actual incurred losses, so you will need to use reasonable judgments based on historic data and the nature of current contracts and customer profiles — even types of cars sold — to determine the ECL.
Let’s look at two methodologies commonly used by BHPH operators to determine portfolio value and discounts, and how these might be adjusted and work in tandem to support the new standard:
Vintage analysis is based on loss curves that include expectations of losses at each point in the life of a financial asset. Under the CECL model, dealers would look at the remaining area under the loss curve rather than one point of time on the loss curve. Dealers can use vintage analysis to report expected credit losses on the remaining life of the assets in their portfolio. This calculation can then be measured against a baseline of portfolio performance.
Static Pool Analysis
A baseline of portfolio performance — that is, historic performance — must be established in order to forecast expected losses. Using a static pool concept, you collect data on common risk characteristics within existing segments or classes of loans. Using origination dates by same month, quarter or year will help you develop a pool that can be tracked for lifetime of loss. By looking back over several years of origination and collection data, you will develop a stronger baseline to support implementation of the CECL and recording a risk-focused ALLL on your financial statements.
In light of this new federal accounting standard for monitoring and calculating expected credit losses, BHPH operators of all sizes will likely require additional professional support. A CPA knowledgeable in BHPH operations can help you determine the standard’s impact on your current accounting methods, monitoring and reporting. Talk to the audit group at Cornwell Jackson to start planning for internal and external finance changes in the next few years.
Mike Rizkal, CPA is the lead partner in Cornwell Jackson’s Audit and Attest Service Group. He provides advisory services, including financial audit and attest services, to privately held, middle-market businesses.
Contact him at email@example.com.