The overhauled model for estimating the collectability of receivables is here for private companies and smaller reporting companies. For accelerated and large accelerated filers, this model has been effective for fiscal years beginning after December 15, 2019. The new guidance issued in Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2016-13 is effective for fiscal years beginning after December 31, 2022 for these companies. It requires the measurement of current expected credit losses related to financial instruments, including receivables, instead of using the incurred loss model that was the prior standard under US GAAP.
ASU 2016-13 “Financial Instruments—Credit Losses, ASC 326, Measuring Credit Losses on Financial Instruments” (CECL) is broad and expansive, impacting various types of financial transactions a company may encounter. The scope of the guidance includes financing receivables, held-to-maturity debt securities, and revenue receivables resulting from transactions covered by Topic 605 Revenue recognition (superseded by Topic 606), Topic 606 Revenue from contracts with customers and Topic 610 Other income, to name a few. The extensive nature of this ASU impacts companies in many industries, including financial services, consumer products, manufacturing and more.
Although CECL is applicable to many different types of financial instruments, ASU 2016-13 specifically excludes the following items from the CECL rules:
- Financial assets measured at fair value through net income,
- Available-for-sale debt securities,
- Loans made to participants by defined contribution employee benefit plans,
- Policy loan receivables of an insurance entity,
- Promises to give (pledges receivable or contributions receivable) of a not-for-profit entity (this includes grants receivable accounted for under the contribution model), and
- Loans and receivables between entities under common control.
In addition, ASU 2018-19 “Codification Improvements to Topic 326, Financial Instruments – Credit Losses” excludes operating lease (rent) receivables from the CECL rules.
One of the more significant changes with CECL addresses the window for assessing collection on in-scope financial instruments. It shifts the horizon for considering potential credit losses further into the future, where companies now need to think about the entire contractual life of its financial instruments and measure the amount of losses that could occur over that lifetime. Under the previous incurred model for estimating credit losses, companies mainly focused on events that had happened as of the measurement date that could cause financial loss for a reasonable future time period, normally around 12 months or so after the measurement date. Now, the financial statements need to reflect the impact of events happening after the measurement date that could result in credit losses related to in-scope receivables and other financial instruments.
Another large change in the CECL guidance removes the probability threshold from the previous guidance. When recording the impact of incurred losses, the literature allowed companies to only reflect the financial impact of losses deemed to be “probable”, which generally equated to losses that had at least a 70-80% likelihood of occurring. However, when measuring current expected credit losses, the threshold of probability has been eliminated.
Both of these changes can lead to an increase in the amount of losses a company could experience, as well as the types of events that could cause credit losses to manifest. Companies will need to assess a wide range of available information and consider the relevancy of this data in its expected loss measurement process. Companies can use its discretion and professional judgment to determine what information should inform its measurement process. Some measurement approaches a company could use are discounted cash flow models, loss-rate or roll-rate methods, probability of default methods, and aging schedules.
In addition to the conceptual changes above, there are significantly more disclosure requirements under the CECL guidance. Companies will need to present credit quality information to illustrate the credit performance of its financial assets, process descriptions about how management estimates the allowance, past-due and nonaccrual status commentary including aging analysis and criteria for when an asset is considered past due or nonaccrual, additional information regarding purchased financial assets with credit deterioration, collateral-dependent financial assets and off-balance-sheet credit exposures, and more.
Many of these new disclosures may necessitate a company to take a hard look at the information they currently gather around the financial impacts of in-scope instruments and ensure that they collect the right data to support the litany of information now needed in their financial statements. The matters of presentation and disclosure should be read carefully and thoroughly to make sure all requirements are being met.