Current Expected Credit Loss (CECL) Standard for Non-Financial Entities

In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-13 Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments which enacted changes to credit loss recognition thresholds for certain financial instruments. The new current expected credit loss (CECL) standard is particularly impactful for banks and financial institutions, however, nonfinancial entities that hold certain financial instruments and other assets (including, but not limited to: trade receivables and contract assets recognized under ASC 606, loans and notes receivable, lease receivables, and held-to-maturity debt securities) are also subject to the new standard.

The CECL standard was effective for all entities that are not SEC filers for fiscal years beginning after December 31, 2022. 

Overview and Key Changes

The new CECL standard replaced the “incurred loss” methodology for recognizing credit losses in prior U.S. GAAP, which delayed recognition of a loss until it was probable the loss had been incurred, with an expected loss methodology. The CECL standard removes the “probable” threshold for recognition and instead, requires an entity to estimate and measure lifetime expected credit losses over the contractual term of the financial asset(s) based on historical experience, current conditions, and reasonable and supportable forecasts about the future and record an allowance. 

The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net amount expected to be collected on the financial asset (i.e. it is a contra-asset account). Each type of financial asset measured at amortized cost must have its own respective allowance, and the allowance should be updated and adjusted at each reporting date for management’s current estimate of expected credit losses.

What Type of Assets are Subject to CECL?

The CECL model in ASC 326-20 applies to any entity with the following:

• Financial assets measured at amortized cost including, but not limited to:
  • Trade receivables and contract assets recognized under ASC 606 (including retainage receivables)
  • Financing receivables (i.e. loans and notes receivable)
  • Investments in held-to-maturity debt securities
• Net investment in leases as a lessor recognized under ASC Topic 842 (i.e. receivables from sales type/direct financing type leases)

CECL does not apply to the following assets:

• Financial assets measure at fair value through net income
• Loans and receivables between entities under common control. This includes those from individuals within the common control group (i.e. a controlling shareholder).
• Contributions/pledges receivable (promises-to-give) and most grants receivable, if following the contribution model in ASC Topic 958-605.
• Receivables from operating leases as a lessor

These are not exhaustive lists of all assets included or excluded from the new standard. Refer to the ASU and the codification for additional information.

Developing an Estimate of Expected Credit Losses

The new standard requires entities to “pool” or group financial assets that share similar risk characteristics when developing an estimate of the allowance for expected credit losses. Examples of risk characteristics include age, term, industry, size, or geographic location. The groupings should be consistent with the company’s policies for monitoring credit risk, but the standard does not require a specific number or method for developing the “pools”.

The new standard does not prescribe a specific estimation method to be used, or what type of information to be used when developing an estimate of expected credit losses. Entities can use judgement in determining what information is most relevant to management and your company and what estimation method(s) are appropriate for your circumstances.

The measurement of estimated credit losses should be based on relevant information (either internal, external, or a combination of both) about past events (including historical loss experience), current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. The estimate of expected credit losses should include a measure of the expected risk of credit loss for an asset even if that risk is remote, regardless of what method is used to determine the estimate.

The allowance should be assessed and updated at each reporting date and should generally follow the same method used to initially measure expected credit losses for the financial asset. The amount necessary to adjust the previously recorded allowance to the current estimate should be recorded through net income as either credit loss expense, or a reversal of credit loss expense. 

Presentation and Disclosure

The allowance is required to be presented in one of the following two ways: (1) as a separate line item on the face of the balance sheet, deducted from the asset’s amortized cost basis, or (2) presented net of the asset’s amortized cost basis on the balance sheet (e.g. Accounts receivable, net of allowance of $x,xxx) and disclosed separately in the footnotes.

The new standard also requires certain enhanced disclosures, including the following additional information, by portfolio segment for financing receivables, and by major security type for held-to-maturity debt securities: how the expected credit loss estimates are developed, descriptions of significant accounting policies and the methodology used to estimate the allowance, factors that influenced management’s current estimate of expected credit losses, risk characteristics relevant to each portfolio segment, and a roll-forward of the activity in the allowance for credit losses during each reporting period, among others.

Where Should We Start?

If you haven’t already, be sure to communicate with your CPA regarding the new standard. As a starting place, below is a list of some initial steps to consider:

• Gain an understanding of which of the company’s financial assets are subject to CECL.
• If the company has historically estimated an allowance for its receivables, gain an understanding of the key factors and considerations in how the allowance was historically measured, and how that methodology may need to change to align with the requirements of the new standard.
• Consider what risk characteristics will be used to “pool” each type of financial asset (i.e. AR aging category? geographical location of customer? product line?)
• Gather historical loss information for each applicable type of financial asset
• Consider how current conditions, economic or otherwise, may differ from the conditions that existed over the historical loss period.
• Any future forecasts, consisting of reasonable and supportable information, that could be applicable and impact collectability.

For a copy of the full ASU 2016-13, visit the FASB website.