You may have seen articles about the upcoming change in accounting for expected credit loss. While the change may seem to only affect the financial services industry, the impact of the new model is far more widespread, and it may affect your company’s financial statements.
What is CECL?
There has been much discussion in the financial services industry on the impact of the forthcoming accounting requirement (ASU 2016-13) to use the current expected credit loss (CECL) model in estimating future losses on financial instruments. This is not surprising, given the importance of lending to banks and other financial institutions and the relative size of loans and other financial assets on the balance sheets of such financial service industry companies.
However, the impact of ASU 2016-13 (effective for private companies for years beginning after December 15, 2020) is not restricted to banks and other financial institutions. The new standard applies to all of a company’s financial assets, with few specific exceptions. Financial assets subject to the new standard for estimating credit losses include trade receivables, loans, held-to-maturity debt securities, lease receivables and financial guarantees.
It will be imperative for every company that holds these assets on its balance sheet to determine the impact of the new standard’s adoption on its financial statements.
The New Standard: Accounting for Expected Losses
The CECL model’s main change from current accounting rules is a requirement to incorporate forward-looking information in estimates of credit losses, hence the word “expected” in the model’s name. Companies will be required to forecast the total expected losses on their total accounts receivable, even those that are not past due at the reporting date. The forecast is based on historical information, current information and reasonable and supportable forecasts.
Financial assets with similar risk characteristics (e.g., all current accounts receivable from domestic entities, all past due accounts receivable from foreign entities, etc.) should be pooled to determine the estimated loss. The CECL does not require a specific methodology for developing a forecast of expected losses, the length of the forecasting period or the amount of precision required. As such, judgment will be applied in estimating the overall expected loss.
Many companies currently use a matrix of percentages to reserve for accounts receivable based on aging categories. While these matrices may still be used under CECL, the percentages used will depend on both historical loss data and reasonable and supportable forecasts of future losses. Therefore, many companies will be applying a reserve percentage for credit losses on their current receivables for the first time under the new standard.
The CECL model applies to loans, including loans to officers and employees, so companies will have to estimate their projected losses on those assets as part of the overall adoption of the standard. ASU 2016-13 does not apply to receivables between entities under common control.
With the potential changes to systems, processes and controls being driven by the new CECL model, companies should consider adoption challenges sooner rather than later, involving stakeholders and accounting professionals as necessary.