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August 3, 2017

The new accounting standard for Current Expected Credit Loss (CECL) that will be enforced in January 2018 will require significant changes for many banks and other institutional investors who own troubled debt. In particular, it requires that loan losses be estimated over the remaining life of the debt and not just over the immediate future or the next year.

This new standard has been set by the Financial Accounting Standards Board (FASB). It requires investors in a debt asset to establish provisions and reserves depending on that asset’s expected losses, even if the borrower or issuer has not defaulted. This differs significantly from today’s accounting standard, which requires increasing loan loss reserves only when it becomes highly probable that a loss is imminent and only if the amount of that loss can be reasonably estimated.

At its core, then, CECL concerns the forecasting of future streams of revenue on a debt instrument, determining if those cash flows will take place as planned, and how any interruption impacts the value of the instrument. As a result, CECL means that holders of debt will have to forecast these defaults and losses, using methodologies that many of them do not use today.

This paper examines the discounted cash flow methodology and some limitations of this widely-accepted approach to valuing financial assets.