In 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13, Financial Instruments – Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments. This new current expected credit losses methodology (CECL) changes the model for calculating and recording an entity’s allowance on trade receivables. For private companies, CECL will be effective for years beginning after December 15, 2022.
This article provides some context for how CECL came to be introduced, the key information you need to be aware of – especially if you believe this new standard won’t apply to your company – and several steps your company should take now in advance of the effective date.
In its simplest terms, a credit loss is a loss that an entity records that is caused by customers’ or others’ inability to pay the amounts owed to the entity.
Prior to CECL, credit losses were generally not recorded until it was probable that a loss had been incurred. As such, financial statements reflected only those credit losses that were probable but not forward-looking information or an entity’s consideration of its expected credit losses over time.
The challenges with this approach became readily apparent during the global financial crisis of 2007 and 2008. During this time, financial statement users utilized forward-looking information to make their own estimation of an entity’s expected credit losses. This resulted in an entity being devalued in the market before the losses were recorded on its financial statements. Both users and financial institutions became frustrated by this divergence between expectations based on then current events and an entity’s financial reporting in accordance with its accounting standards.
What does CECL do?
CECL is intended to provide financial statement users with a more complete estimate of the amount an entity expects to collect on certain assets. CECL replaces the current probable loss model with a current expected credit loss model for recording credit losses. The new standard requires an entity to estimate expected credit losses over the life of the financial asset and record these expected losses at the time the related financial asset is recorded.
The result of CECL is a more timely recognition of estimated credit losses at inception of the financial asset, rather than when a loss event has become probable.
Based on the background, it is reasonable to expect the CECL guidance to apply to financial institutions. However, because credit losses result from a customer or debtor not being able to pay the amounts owed to an entity, CECL applies beyond financial institutions to virtually any entity that measures financial assets utilizing the amortized cost basis and extends credit to customers or others.
Further, CECL will impact the accounting for trade receivables, loans to shareholders and employees, held-to-maturity debt securities, financial guarantees, and certain lessor transactions. The focus of this article is on trade receivables.
CECL and Trade Receivables
CECL does not provide a specific methodology for measuring expected credit losses on trade receivables. It does include credit and non-credit characteristics that may be considered; however, it is expected that credit-related characteristics would be included in any analysis of credit losses.
CECL requires an estimate of the expected losses over the life of the receivable to be recorded at the time the related receivable is initially recorded, rather than when a loss becomes probable under existing accounting standards.
In addition, CECL requires an entity to evaluate financial assets that share similar risk categories on a collective or pooled basis. As such, an allowance analysis may require an entity to consider and categorize its receivables and historical loss rates by geographic region, industry, credit rating, or other metric, in addition to age, in order to better determine the expected losses over the life of the receivables.
An entity should also estimate future conditions, which may include unemployment, recession, industry operating results and forecasts, or other key factors that may influence an entity’s ability to collect its receivables.
The most likely impact of this increased analysis is an allowance being recorded against current receivables, which under previous guidance was generally not recorded until the receivables aged. In addition, the reserve calculation is updated at every reporting period, with resulting adjustments being recorded through the income statement.
What to Do Now
While CECL is generally not required until your 2023 financial statements, there are a few items for you to consider at this time.
- Do not assume that CECL does not apply to you because you are not a financial institution. CECL will apply to most entities that extend credit to customers or others. Specifically, it applies to trade receivables; loans receivable from officers, employees, or others; certain investments in debt securities; and a few other transactions.
- Consider whether your entity has any financial assets carried at amortized cost (like those described in #1) where CECL would be applicable. Odds are the answer is yes, as most entities have trade receivables where CECL will require additional analysis.
- For each of the assets identified in #1 above, begin considering what data you have to aggregate the respective assets by risk (and what those risks are). Based on these risk pools, incorporate estimates about current economic conditions, credit quality, and future conditions into your analysis of expected credit losses.
Many companies will be tempted to assume CECL will not apply to them because they are not a financial institution. However, it is likely that the new standard will apply. And even though it isn’t effective until 2023, it is never too early to familiarize yourself with the standard and begin planning. We will be providing additional updates on the impact of CECL as the implementation date gets closer. In the meantime, if you would like to discuss CECL and its potential impact for your company or organization, please contact your Kreischer Miller relationship professional or any member of our Audit & Accounting team.
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