Non-financial services companies hold financial assets that will be subject to the current expected credit loss (CECL) model. Now’s the time to start preparing.
As companies are busy implementing the new revenue recognition standard and the new leases standard, one thing is clear — implementation is no small feat. When non-financial services companies consider the changes on the horizon, many are relieved that the new credit impairment standard, ASU 2016-13 (Topic 326): Financial Instruments — Credit Losses, is seemingly specific to financial institutions … or is it?
While the new current expected credit loss (CECL) model will indeed impact financial institutions more heavily, non-financial services entities are also included in the scope of this standard. Trade receivables, certain lease receivables, held-to-maturity debt securities, and financial guarantees will all be affected by the new model — and these are just a few of the financial assets held by non-financial services companies that are subject to CECL.
Read more about how to implement CECL in financial institutions.
CECL requires companies to estimate credit losses
Under current U.S. Generally Accepted Accounting Principles (GAAP), a variety of credit impairment models are used to assess and record credit losses for financial assets not measured at fair value through net income. These models are based upon an incurred loss methodology, in which an impairment allowance is recognized largely based on historical losses only after a loss event has occurred or is probable. This accounting treatment delays impairment recognition until it is probable a loss has been incurred, restricting an entity’s ability to consider forward-looking information or expected losses.
The Financial Accounting Standards Board (FASB) acknowledged concerns with this methodology, criticized the incurred loss model for delaying loss recognition, and expressed the desire to provide financial statement users with more useful information about an entity’s expected credit losses on financial instruments. As a result, ASU 2016-13 replaces the incurred loss model with the CECL model, which requires entities to estimate credit losses expected over the contractual life of the financial asset. Measurement under the new methodology is based on relevant information about past events, including historical experience, current conditions, and a broader range of reasonable and supportable information to make credit loss estimates for certain financial assets. By nature, management will be required to apply significant judgment in estimating credit losses.
The CECL model doesn’t specify the methodology to be used, but rather allows entities to select the methodology that management deems the most appropriate for the business and the nature of the company’s financial assets. Some methods for estimating expected credit losses include Probability of Default/Loss Given Default Method, Vintage Analysis Method, Discounted Cash Flow Method, and Loss Rate Method.
Scope of the new standard
ASU 2016-13 affects entities holding financial assets and net investments in leases that are not accounted for at fair value through net income. Specifically, this expected credit loss guidance applies to:
- Financial assets measured at amortized cost basis
- Trade receivables — from revenue transactions in the ordinary course of operations
- Held-to-maturity debt securities
- Financing receivables — loans receivable (including loans to officers or employees and store credit card arrangements)
- Reinsurance receivables — from insurance transactions
- Other receivables — including those that relate to repurchase and securities lending agreements
- Net investments in leases recognized by a lessor in accordance with ASC 842, including lease receivables arising from sales-type and direct financing leases (operating lease receivables not in scope)
- Certain off-balance-sheet credit exposures, including financial guarantees not accounted for as insurance, loan commitments, standby letters of credit, and other similar instruments
Although the FASB determined available-for-sale (AFS) debt securities are not subject to the CECL model, ASU 2016-13 does require significant changes to the recognition of AFS debt securities impairment. In particular, it includes changes to the concept of “other-than-temporary impairment” and requires entities to record credit losses for AFS debt securities as an allowance rather than a write-down of amortized cost basis.
New standard accounting considerations
Under CECL, credit impairment is recognized as an allowance for credit losses, rather than as a direct write-down of the amortized cost basis of a financial asset. The impairment allowance is a valuation account deducted from the amortized cost basis of financial assets to present the net amount expected to be collected on the financial asset.The allowance for credit losses must be adjusted for management’s current estimate at each reporting date.
The new guidance provides no threshold for recognition of impairment allowance. Therefore, entities must also measure expected credit losses on assets that have a low risk of loss. This is a notable change, as trade receivables that are either current or not yet due (which may not require an allowance reserve under current GAAP) will have an allowance for expected credit losses under ASU 2016-13. Similarly, expected credit losses must be measured on investment-grade held-to-maturity debt securities.
For most debt instruments under the modified retrospective approach, entities will record a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period the guidance is effective.
Implementation and impact of CECL model on your organization
The new standard could impact many company’s accounting process and the way credit impairments are assessed and recognized, but many companies have not yet started an implementation plan. Controllers and CFOs should take action now to understand how CECL may affect internal controls, data gathering, systems, and financial reporting processes, and to evaluate transition options for an effective implementation.
Form an implementation team
CECL implementation cannot be the responsibility of just one person. It requires a team that should include:
- A chief financial officer or controller who has accounting knowledge and is familiar with the company’s allowance calculation and modeling
- A chief audit executive or equivalent to identify key controls necessary to the new process
- A chief credit officer with deep knowledge of your business lines and areas subject to credit losses
- A data analyst or information technology officer to assist with data gathering and retention
Conduct an overall impact assessment
Your implementation team should lead management in a preliminary assessment that includes the following:
- Evaluating the types of financial assets that are subject to the new guidance
- Assessing the data that can be extracted from your systems and gathered for financial assets in scope
- Evaluating your company’s processes for assessing impairment of financial assets
- Reviewing your company’s model, methodology, or matrix used for calculating and recording an allowance
Entities can leverage current systems, but you may need to modify existing data collection and retention processes to accommodate CECL requirements. Companies are required to obtain and maintain historical loss information for the life of financial assets on a disaggregated basis. A broader range of reasonable and supportable information to make credit loss estimates is essential, and this expanded data on a disaggregated level is not only required in accounting for the allowance, but also for the new extensive disclosure requirements. Updating your data collection and retention procedures could require substantial time prior to the adoption date. In addition, internal controls will need to be designed, documented, and tested.
Companies should be sure to document the impact assessment along the way, including significant judgments and estimates.
Confirm your implementation deadline
The new credit impairment standard will be effective for fiscal years beginning after December 15, 2019, for public business entities (PBE) that are SEC registrants; after December 15, 2020, for other public business entities that are not SEC filers; and after December 15, 2021, for non-public business entities and nonprofit organizations. Early adoption is permitted.
Establish an implementation project plan
A CECL project plan does not need to be voluminous to be effective. Start with a single page implementation timeline as a foundation. Next, break the project into manageable segments. For near-term segments, record specific tasks and dates, assigning broader timeframes to the latter segments to allow sufficient time in the event that you experience changes in your operations, such as an acquisition or PBE classification updates.
Assess available team resources who understand your company’s sources of credit loss exposure and data capabilities and can work on implementation. Consider providing training for these individuals, if needed. Discuss if there is a need to include third-party consultants and vendors as part of the overall project plan.
How we can help
As the effective dates draws near, planning and preparation are imperative. While preparing for CECL is more involved and complex for financial institutions, non-financial services companies will be affected. If you haven’t planned for these changes, don’t waste any time.
Our professionals offer tailored accounting and advisory services to help you implement the requirements with confidence and help make a smooth transition to the new guidance. Whether you need help identifying where to start or are looking for assistance with the detailed steps of implementation, CLA has studied the new guidance in depth and understands how it will impact organizations in a variety of different industries. We can help your team understand the transition approaches (modified-retrospective versus prospective), and the steps to be taken to identify and gather the necessary data required for implementation. Together, we can explore the factors to be considered in estimating credit losses, the different methods available, accounting implications, and the financial reporting and disclosure requirements.