Background
After the financial crisis in 2007–2010, the Financial Accounting Standards Board (FASB) determined that the existing approach in U.S. generally accepted accounting principles (GAAP) for financial asset impairment did not recognize credit losses in a timely manner. At that time, the press criticized GAAP by saying its ability to recognize these losses was “too little, too late.”
As a result of this criticism, in June 2016 the FASB issued Accounting Standards Update (ASU) No. 2016-13 – Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU sets forth the CECL model and amends the impairment model for available-for-sale (AFS) debt securities. The FASB believes that adopting this ASU will result in more timely recognition of impairment losses.
Scope of CECL
The CECL model applies to most financial assets not recorded at fair value. Although it will have a greater impact on the banking industry, most nonbanks have assets subject to the CECL model (e.g., trade receivables, contract assets, lease receivables, reinsurance recoverables, receivables related to repurchase agreements, receivables related to securities lending, certain financial guarantees and held-to-maturity securities).
CECL does not apply to financial assets that are measured at fair value through net income, available-for-sale (AFS) debt securities (see AFS debt securities below), loans by defined contribution employee benefit plans to participants, policy loans of insurance companies, pledges to nonprofit entities, and loans and receivables between entities under common control.
Accounting under CECL
CECL will likely affect how companies account for their allowance for doubtful accounts (i.e., allowance for credit losses) in the following areas:
- Recognition threshold: Under legacy GAAP, credit losses are recognized when it is probable that such loss has been incurred. CECL replaces this “incurred loss” model with an “expected credit loss” model and it removes the probability threshold in legacy GAAP. More specifically, CECL requires the allowance for credit losses to represent the portion of a financial asset’s amortized cost basis that a company does not expected to recover even if the likelihood of that loss is remote. This may cause companies to recognize credit losses that they would not have under legacy GAAP or to recognize them earlier. For example, companies may be required to recognize an allowance for credit losses for highly rated investment securities that are held to maturity and for short-term receivables that are current regarding their payment terms.
- Economic conditions: Under legacy GAAP, companies need only consider current economic conditions when determining their allowance of bad debts. CECL requires companies to consider future economic conditions in addition to current economic conditions when determining their allowance for bad debts. Forecasting future economic conditions may prove to be a challenge for many companies because they will need to develop a process for evaluating the availability and quality of information to develop their views on future economic conditions. If internal data is not available, gathering external data may be necessary. Considering future economic conditions may make estimates of credit losses more volatile.
- Pooling of assets: Unlike legacy GAAP, CECL requires that assets that share similar credit risk characteristics be pooled when determining the allowance for credit losses. This pooling must be reassessed on an ongoing basis to determine if it is still appropriate.
AFS debt securities
The ASU will change how companies account for credit losses on AFS debt securities. Under legacy GAAP, companies record a credit impairment loss on AFS debt securities if they determine that the security is impaired and that impairment is deemed to be other than temporary. The ASU removes the other-than-temporary impairment screen.
The ASU changes the accounting for credit losses on AFS debt securities as follows:
- Credit losses will be presented as an allowance rather than as a write-down.
- Reversal of credit losses will flow through the allowance account.
- Companies will not be able to use the length of time a security has been in an unrealized loss position to avoid recording a credit loss.
- Companies will not be able to consider the historical and implied volatility of the fair value of a security and recoveries or declines in fair value after the balance sheet date in determining credit losses.
Policies, procedures and systems under CECL
To implement the changes required by CECL, companies may need to use data they have not collected before or data that was not subject to strong internal controls and audit. Therefore, companies may need to create new policies or improve their existing policies, processes, controls and information technology systems. This could include controls over the historical loss experience, which will be necessary in calculating an allowance and for new disclosure requirements.
Effective date of new credit losses ASU
| Entity | Annual report and interim reporting |
| Public business entities that are Securities and Exchange Commission filers, excluding entities eligible to be smaller reporting companies as defined by the SEC |
Fiscal years beginning after Dec. 15, 2019, and all interim periods within those fiscal years |
| All other entities | Fiscal years beginning after Dec. 15, 2022, and all interim periods within those fiscal years |
Key take-aways
To appropriately adopt CECL, engaging a trusted advisor is the best course of action. The advisor can help your organization:
- Analyze and assess the impact of CECL
- Assess current processes to identify where changes may be needed
- Facilitate a practical and efficient implementation plan, and leverage best practices
- Execute an implementation plan including accounting, reporting and process documentation
