A Cure for CECL

Joshua Ronen
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Before implementation, CECL needs to be corrected to prevent the reporting of accounting losses in the absence of economic losses.
By Joshua Ronen
The Current Expected Credit Loss (CECL), or loan-loss rule, is expected to go into effect in 2020 with a serious conceptual flaw: discounting expected cash collections by the contractual rate, as prescribed in the Financial Accounting Standards Board (FASB) guidance, which would result in accounting losses where no economic losses exist. Fortunately, there is a “cure” to CECL’s deficiency: use as discount rate the internal rate of return (IRR).

But first, let’s examine the new FASB guidance, which requires entities to project lifetime losses—albeit only taking into consideration information that is reasonably available—upon the origination of loans. Projected cash collections are then to be discounted by the contractual rate. If the resulting present value is below the amount of loan extended, the difference would be reported as a loss, decreasing regulatory capital.

The guidance fails to consider lenders’ behavior. Once a prudent lender has projected cash collections as required by the guidance, he/she would either refuse to extend the loan if projections suggest a loss, or charge a higher contractual interest rate, if and when feasible, to compensate for the expected loss. Discounting cash collections by such higher contractual rates would result in accounting losses, decreases in regulatory capital, and consequent decisions to suppress lending. Consider this against the recent market drops and the expectation of an economic slowdown following the possible failure of a trade deal and other uncertainties—it is almost certain to exacerbate the backsliding of the U.S. economy.

In both bullish and bearish markets, the importance of loans cannot be overstated: Many billions of mortgages alone (not considering other types of loans) are underwritten every quarter (for example, $457 billion in mortgages originated in the country in the third quarter of 2018). In light of this, the potential for depressed lending resulting from the CECL rule, especially during downturns when the reported accounting loss is likely to be particularly large, can spell disastrous economic consequences.

Read the full Bloomberg Tax article
Joshua Ronen is a professor of accounting at New York University Stern School of Business and co-editor of the Journal of Law, Finance, and Accounting