Like me, you might have been under the impression that FASB’s update to the standards for credit losses applies only to banks and financial institutions. While banks will feel the deepest impact and have the most challenging time with implementation, ASU 2016-13, Financial Instruments – Credit Losses, applies to almost every organization.
This new standard, commonly referred to as current expected credit losses or CECL, will impact any organization with financial assets that include “a contractual right to receive cash.” This includes things such as trade receivables, contract receivables, receivables from direct financing or sales-type leases, and investments in debt securities. The new standard also applies to loans to officers, employees, customers, and any off-balance-sheet loan commitments. This means that your clients who issue GAAP-basis financials will need to take a closer look at this standard.
Public companies will be implementing this starting in January 2020. Private companies and not-for-profits recently got a reprieve when FASB proposed extending the effective date until January 2023.
FASB developed this standard in response to the financial crisis of 2008 as an attempt to increase transparency into the long-term financial health of organizations. Under the previous standard, expected losses were not recognized until they reached the “probable” threshold. During the financial crisis, that threshold proved to be too late for many investors.
What are the changes under the new standard?
Under the old standard, organizations generally only considered past events and current conditions when estimating their allowance for doubtful accounts. For example, an organization might apply the historic collectability percentages of trade receivables on an aging schedule to estimate the allowance for doubtful accounts.
CECL, on the other hand, is forward-looking, and requires management to measure their expected credit losses “based on relevant information about past events, including historical experience, current conditions, and reasonably and supportable forecasts that affect the collectability,” according to FASB. Overall, this will result in earlier measurement of credit losses.
This means that management will need to develop forecasts of future conditions and include those forecasts in their estimates of future losses. For example, historic percentages for an aging schedule may need adjustment for current and forecasted economic conditions that differ from the past.
Organizations will now recognize expected losses when they record new receivables, even if the probability of loss is remote. For example, let’s look at an organization that recognizes revenue under ASC 606 at 100 percent of the contract price. If their historic records indicate that only 97 percent of contract revenue is actually received, then an allowance of 3 percent of the contract receivable will be recorded, even if it is nearly certain that a particular contract will be fully collectible.
What methods can be used for forecasts?
FASB allows organizations to apply their own judgment in selecting the best method and suggests – but does not define or mandate – several acceptable models. These models include discounted cash flows, loss-rate methods, roll-rate methods, probability of loss models, and the use of aging schedules. However, all of these models will have to be modified to include forecasts.
Organizations can pool assets that share expected loss characteristics, such as trade receivables from vendors with similar credit profiles. This may lead to more precision in estimates if the pools are clearly delineated.
What will be the challenges for applying the standard?
Many organizations have not collected historic data on collectability because this was not a part of their previous method for estimating credit losses. This means they will have to develop processes and controls for collecting this information. Organizations may need to look to external sources if their data is incomplete.
Estimates of any kind require significant judgment from management. Developing reasonable and supportable forecasts for future losses may be particularly challenging for organizations that have not done this before, so they will need the help of their advisors.
According to the standard, estimates for credit losses are to be considered over the contractual life of a receivable. This may be difficult to determine for things such as trade receivables, which have no clearly defined period for collection.
How can I find out more?
Implementing the new standard means organizations and their advisors will have to make big changes in accounting for receivables. This will be an excellent opportunity for advisors to work closely with their clients to develop forward-looking models for their businesses and offer more value!