Give Credit Where Credit is Due
For the non-public, non-financial sector, it took a while for the new standard on credit losses to get here. But it’s here now and breathing down our necks with a vengeance. CECL (pronounced cecil) was issued by the FASB in 2016. For the non-financial sector, it’s somewhat of a wolf in sheep’s clothing. Not that it was intended to be that way, but it just is. So beware. It’s a peer review “gotcha” event. As the song says, “Things ain’t what they used to be.” This article will address some CECL issues in a question-and-answer format.
- When was CECL’s (ASC 326) effective for non-public companies?
ASC 326 was effective for all non-public companies for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. So, in other words, it is effective for calendar year 2023 financial statements, including interim financial statements that begin in 2023.
The interim financial statement’s effective date for non-public companies is a change from the customary practice of the FASB. Usually, for private companies, new standards are effective for interim financial statements the year after it is effective for the annual financial statements. When the original pronouncement was issued in 2016, that’s how it was – the interim financial statement’s effective date was a year later. However, this decision was later reversed by the FASB in an ASU released in 2018. This change may have flown under the radar screen for many busy accountants.
- To whom does CECL apply?
While the standard was primarily directed to financial institutions like banks and credit unions, it also applies to non-financial institutions. That includes construction companies, manufacturing companies, and non-profit entities, to name a few. However, as discussed in the next question, the standard does scope out specific areas.
- So, what is CECL, and which financial assets does it apply to?
CECL stands for “current expected credit losses” related to financial instruments. The key phrase is “current expected.” The standard intends to inform the financial statement user what credit losses (bad debts) the company currently (upfront) expects to incur on its financial assets over the contractual life of those assets (the future). Generally, the standard applies to financial assets carried at amortized cost and includes:
- Cash equivalents
- Trade receivable
- Contract assets (such as underbillings and retainage receivables)
- Loans receivable/Notes receivable
- Loans to officers and employees
- Investment in debt securities held-to-maturity
- A lessor’s receivables from sales-type or direct financing leases
Notably, the following financial assets are not within the scope of CECL:
- Receivables between entities under common control (see following two paragraphs)
- Equity securities
- Loans made to participants by defined contribution employee benefit plans
- Pledge receivables of a not-for-profit organization
- Lessor receivables from operating leases
- Other financial assets measured at fair value through net income
- Securities available-for-sale (though ASC 326-30 did make targeted changes to this area related to CECL)
The AICPA’s Center for Plain English Accounting report for August 16, 2023, observed that “(T)he scope exception in FASB ASC 326-20-15-3f is for loans and receivables between “entities” under common control and makes no mention of “individuals.” Therefore, it is not clear based on the omissions in the plain language whether individuals (natural persons) such as a controlling shareholder are within the scope exception for CECL in FASB ASC 326-20-15-3f.”
However, the article further states: “FASB staff has indicated that the scope exception for entities under common control also applies to natural persons (i.e., controlling shareholder) within a common control group. We should note that the scope exception for common control entities would NOT extend to an (sic) loan to an unrelated officer of one of the entities who did not hold a controlling financial interest.”
- What is the difference between the legacy standard and ASC 326?
The former standard used an “incurred loss” methodology to recognize credit losses if it was deemed probable to be uncollectible. While probable is not defined, many practitioners consider probable equal to or greater than a 75% threshold. The collection loss had to be incurred and probable under the previous standard to be recognized.
The new accounting standard’s model is designed to be forward-looking and considers the entire contractual life of a financial instrument. Moreover, it significantly reduces the threshold for recognizing credit losses. Under ASC 326, a credit loss can be recognized on financial assets, such as a class of trade receivables, at the asset’s inception, even if the likelihood of a loss is considered remote. CECL mandates that management consider expected credit losses throughout the entire life of a group of financial assets, regardless of the absence of any current signs of trouble. Accordingly, under CECL, losses are expected to be recognized sooner than losses were under legacy GAAP.
Key takeaway: The loss recognition is forward-looking over the contractual life of the financial instrument, recognized at the asset’s inception, and the loss recognition threshold is considerably lower than previous GAAP.
- Does ASC 326 specify a particular way to estimate current expected credit losses?
No. The standard is principle-based. The particular methodology used to arrive at the expected loss at the origination or acquisition date of the financial instrument is management’s decision. In a broad sense, the standard requires that the company base its estimate on:
- Relevant information about past events, such as historical loss experiences,
- Current conditions,
- Reasonable and supportable forecasts.
- For periods when the company cannot obtain supportable forecasts for expected credit losses, it may revert to historical loss information.
ASC 326-20-30-7 states, in part, that “(A)n entity shall consider relevant qualitative and quantitative factors that relate to the environment in which the entity operates and are specific to the borrower(s).”
Additionally, as stated in the AICPA’s Center for Plain English Accounting report, same date given above, “…CECL requires measurement of the expected credit loss even if that risk of loss is remote, regardless of the method applied to estimate the credit losses.”
- Can an entity ever have an expected credit loss of zero?
It’s possible. But in most cases, it’s unlikely or even rare. The standard permits a zero credit loss in narrow situations where the expectation of not being paid is zero, even if a technical default were to occur. An example would be U.S. treasury securities guaranteed by the good faith and credit of the U.S. government, which can also print currency to retire the debt.
- Does ASC 326 require additional disclosure?
As you probably expect, the answer is yes.
On the balance sheet, there is a requirement to separately present the allowance for credit losses for financial assets measured at amortized cost, such as trade receivables, contract assets, and loans receivable. Also, investments in available-for-sale debt securities carried at fair value must present both amortized cost and allowance for credit losses parenthetically on the balance sheet.
There are many required disclosures to achieve the stated objectives of ASC 326. For example, ASC 326 requires a roll-forward of the allowance for credit loss accounts. We suggest having your disclosure checklist for non-public companies readily available for reference as you draft the disclosures for financial instruments.
In summary, ASC 326, the credit loss standard, has a broad scope encompassing financial institutions and non-financial companies, including entities like construction firms. It applies to a wide array of financial assets measured at amortized cost, including items like trade receivables and contract assets. Notably, the threshold for recognizing credit losses has shifted from probable to remote, and this new standard mandates a forward-looking estimation of credit losses. It’s important to note that the new standard does not apply to specific financial instruments that are excluded, such as receivables between entities under common control or between companies and majority owners who are natural persons, in my opinion. Additionally, recognition is only required for amounts and disclosures considered material.