Hot Topic: ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Current Expected Credit Losses (CECL) on Financial Instruments

ASU 2016-13, Financial Instruments – Credit Losses (Topic 326)- Measurement of Current Expected Credit Losses (CECL) on Financial Instruments

The ASU 2016-13 CECL Standard (ASC 326), also known as Accounting Standard Update 2016-13, has emerged as a significant accounting change amidst the recent importance of standards like ASC 606 (Revenue Recognition) and ASC 842 (Leases). Effective January 1, 2023, for most non-public companies, including manufacturing entities, consumer industry entities, and other non-financial entities, it mandates the measurement of expected credit losses on financial instruments. Companies should take proactive steps to ensure compliance with this new standard.

The existing method for recognizing impairment losses on financial assets under US GAAP has long been criticized for its shortcomings, which include delayed recognition of losses. The new model intends to shift from incurred losses to expected losses as the basis for impairment assessment. Additionally, ASU 2016-13, CECL, intends to achieve the following objectives:

  • Reduce the number of impairment models in US GAAP
  • Recognize losses timely using the expected loss model instead of the incurred loss model
  • Recognize an allowance of lifetime expected credit losses for financial instruments under ASU 2016-13 scope

The following financial instruments are under ASU 2016-13, CECL, scope:

  • Trade receivables (See considerations and example below)
  • Contract assets – receivables (ASC 606)
  • Notes receivables
  • Loans to officers and employees
  • Lease receivables
  • Held-to-maturity debt securities
  • Financial guarantees
  • Loan commitments

The following financial instruments are out of scope of ASU 2016-13, CECL:

  • Receivables and loans between entities under common control – like related-parties
  • Financial assets measured at fair value through net income
  • Available-for-sale debt securities
  • Contributions (pledges) and grants

Because the standard’s primary objective is to prompt the early recognition of expected credit losses within the credit life-cycle, we believe it is important to start analyzing your Company’s financial instruments to identify expected credit losses using the impairment models and guidance provided by the FASB when implementing the CECL standard. The impact of this guidance extends beyond the banking sector. Although banks will experience significant changes in accounting for credit impairment, other non-bank entities (aka regular companies like yours) with financial instruments, such as trade receivables, contract assets- receivables, notes/loans receivables, and lease receivables, are also required to implement CECL.

Here is a summary of some key changes from current US GAAP to CECL:

In situations where an entity previously did not recognize an allowance for bad debts due to the prior incurred loss method but must now recognize an allowance for credit losses based on the adoption of FASB ASC 326, the cumulative effect adjustment will be recorded to opening retained earnings at the beginning of the period of adoption (January 1, 2023 for calendar year entities). Therefore, the initial recognition of an allowance for credit losses is not reflected in the income statement for these entities.

In addition to the changes mentioned above, entities are required to incorporate additional information into the existing disclosure requirements. The new disclosures, under ASC 326, will include a mix of both qualitative and quantitative information about the methodology (see methods table below) used to arrive at the estimate for expected credit losses while also retaining certain disclosures that existed under previous US GAAP. In general, the new requirements intend to provide users of the financial statements an understanding of how the entity determines the amount of estimated lifetime losses for the various financial instruments with the scope of ASC 326 at the reporting date.

The disclosures should include information about the following topics:

  • Allowance for credit losses –
    • Describe management’s method
    • Describe information used in developing its current estimate of expected credit losses
    • Describe circumstances that led to changes to the allowance for credit losses in the current reporting period
  • Past-due status (e.g., Aging analysis) –
    • Not applicable to trade receivables due in one year or less.
  • Credit quality information
    • Describe management’s credit quality indicator(s)
    • Include information on the credit quality indicator showing the date or range of dates of the last update
  • Off-balance-sheet credit exposures (e.g., Standby letters of credit, off-balance-sheet loan commitments, financial guarantees not accounted for insurance)
    • The entity must disclose details regarding the accounting policies and methodology used to estimate its liability for off-balance-sheet credit exposures and associated charges for those credit exposures. The following are examples of factors that influence management’s judgement that should be disclosed
      • Existing economic conditions
      • Historical losses
      • Reasonable and supportable forecasts

There are several methods that management can use to determine its expected credit losses. The allowance should reflect management’s expectation regarding the amounts expected to be collected on a financial instrument (see financial instrument list above). Entities are not required to use a specific method (see methods table below) when measuring their estimate of expected credit losses. Entities can select their method; however, the FASB recommends that selected methods are relevant and use facts specific to the type of financial instrument. The chosen method for one specific financial instrument should be consistently applied to similar financial instruments.

See table below for a summary of some methods that an entity could use to estimate expected credit losses under ASU 2016-13:

Considerations:

The most common financial instrument amongst private companies under CECL scope is Trade Receivables (Trade A/R). The following is a list of specific considerations for trade A/R:

  • Pool all open Trade A/R (include current A/R): Evaluate all trade A/R collectively and assign pools based on similar characteristics. Pooling can be based on age, internal or external credit scores, product line, industry, location, terms (30/60/90 days, etc.)
    • Unique Trade A/R accounts should be evaluated for credit loss individually.
  • Evaluate historical information: review collections history. Have you always collected 100% from this customer? Have there been any collection issues with this customer in the past? Extend your historical analysis using all information available to you.
  • Consider qualitative factors of comparing historical loss information to current conditions, such as using the Purchasing Manager Index.
  • If the company currently uses a matrix model when calculating its allowances, then the application of CECL is expected to be similar and with no significant impact. The company may need to include the current A/R if there has been no allowance historically.

Trade Receivable Example:

Need help?

In summary, there is a lot to know and do if your company has any of the financial instruments in scope (see financial instrument list above).

As requested, we will work with you on establishing your plan and offering GAAP assistance, training, and other resources. Though the financial statements are management’s responsibility, Shannon & Associates is here to help, so get in touch today!

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