By Priya Singleton, CPA, Director at Blue & Co.
The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13 Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments in 2016. The ASU applies to all reporting entities, not just banks and financial institutions, and is effective for all entities with fiscal years beginning after December 15, 2022 (i.e., January 1, 2023, for a calendar year entity).
Mechanically, there is no significant change to the allowance calculation. Consistent with legacy generally accepted accounting principles (GAAP), credit losses are captured through the establishment of an allowance/valuation account. The allowance is presented as an offset to the asset and is deducted from (or added to) the amortized cost basis. The estimated allowance is updated at each reporting period, with changes recorded in net income for that period.
The key changes come in the requirements within the estimation process and, critically, the documentation of the process. These include:
- The requirement to evaluate the allowance on a pooled basis. Trade receivables must be pooled and evaluated on a collective basis when similar risk characteristics exist. This requirement is a major change from current GAAP which permits, but does not require, pooling. Entities can no longer default to a general reserve or a specific reserve for each trade receivable. Criteria to consider in pooling assets may include credit scores, risk ratings, past due status, geographical location, product line, industry, etc. Entities should have processes to evaluate whether assets should continue to be grouped with other assets if risk characteristics change.
- The requirement for entities to utilize forward-looking information in estimating credit losses. While entities can leverage their existing historical loss information, they should adjust this information for current conditions and reasonable and supportable forecasts to estimate credit losses. Such factors may include customers’ financial condition, ability to make scheduled payments, payment terms, volume and severity of past due assets, changes in credit / lending policies, changes in credit staff, and other environmental factors.
- The requirement to determine the most applicable factors which correlate to data and risk pools. These include qualitative and quantitative factors that relate to the operating environment and are specific to the customer(s)/borrower(s). The available data used must be reliable and proven to be relevant to the portfolio. Considerable judgment is required and must be reassessed annually.
What method should be utilized to calculate the allowance on trade receivables?
The Current Expected Credit Loss (CECL) model does not prescribe a specific method for determining the allowance for credit losses. Rather, it discusses a variety of methods which might be appropriate and consistent with methods entities have previously used, including aging, loss-rate methods, roll rate methods, discounted cash flows, etc. Non-financial institutions generally will not need complicated modeling to develop forecasts for assets such as short-term receivables.
Entities need to define and implement internal controls related to their selected calculation method and their key assumptions process. The external audit process will require visibility into the calculations, and an audit trail to allow selection and testing of historical and current data utilized in this process.
Is there an example of how to apply CECL to one or more of these methods to estimate credit losses?
Yes. Accounting Standards Codification (ASC) 326-20-55-37 Example 5, provides an example of how to apply the aging schedule to trade receivables. Specifically, it illustrates how an entity adjusts its historical loss rate information in each aging bucket for current economic conditions such as unemployment.
Does the model require an estimate of credit loss, even if risk of loss is remote?
Yes. The CECL model is clear in its direction that risk of loss may exist even when the overall risk of loss is judged to be remote. Examples of scenarios where an entity historically may not have considered a risk of loss, but will be required to consider going forward include:
- Receivables from customers that are current on their payment.
- Individually significant receivables from large customers (e.g., sales to large wholesale customers) that have always paid on time.
- Very short-term receivables that are typically settled in a matter of days (e.g., credit and debit card receivables from banks).
The CECL model also requires that the amount reflects losses over the entire contractual life of the asset. The longer the contractual term of the asset, the larger the allowance for credit losses due to inherent uncertainty and risk.
If an entity has historically experienced zero bad debt expense, is an expected credit loss of zero still inappropriate under the CECL model?
No, not necessarily. For an entity to assert that the risk of loss is zero, it must have appropriately developed the information required by the standard to prove/support its assessment. No measure of credit loss would be required for trade receivables if the entity’s historical credit loss information, adjusted for current conditions and reasonable and supportable forecasts, results in an expectation that nonpayment is zero.
What is the impact of CECL for entities that have material trade receivable balances, but no related allowances recorded?
An entity may have been able to justify not recording an allowance for credit loss based on not meeting the “probable” threshold under the previous “incurred loss” model. However, under CECL, no such probability threshold exists and thus, a zero allowance may be less frequent going forward.
If an entity had historically not recognized an allowance based on proper application of the previous incurred loss model, but now needs to recognize an allowance for credit losses based on the adoption of CECL, it would do so through a cumulative effect adjustment through opening retained earnings at the beginning of the period of adoption of ASC 326. Thus, the impact of the initial allowance for credit losses will not be recognized in the income statement.
Should an entity consider factors unrelated to credit risk that could impact payment of trade receivables?
No. Non-credit related adjustments such as returns, discounts, etc. should not be considered for CECL purposes. These adjustments may be needed for other reasons, however, and should be accounted for under other GAAP (i.e., revenue recognition).
How does the collectability criteria in ASC 606, Revenue from Contract with Customers, interact with the CECL model?
An entity must meet the collection probability criteria based on a customer’s ability and intent to pay in order to recognize the receivable/revenue. This does not imply a credit-risk free receivable! When a trade receivable is recorded, it is subject to the CECL model.
What are the presentation and disclosure requirements for trade receivables?
Allowance must be presented in one of two ways:
- Deduction from the asset’s amortized cost basis (i.e. separate line item)
- Amount disclosed, but asset shown net (for example, “Receivables, net of allowance of $100”)
“Bad debt expense” is retitled to “credit loss expense”.
ASC 326 requires extensive disclosures regarding an entity’s estimate of expected credit losses, including information about the entity’s estimation methodology, relevant risk factors, and changes in management’s estimates and inputs. For trade receivables, disclosure should be provided for each portfolio segment or class of financing receivable, as defined in the standard. Additionally, a roll forward of the allowances for credit losses is required.
If our Blue & Co. experts can be of assistance, we would welcome an opportunity to discuss this standard and its implications for your business. Reach out to your local Blue & Co. advisor today.
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Please note that this guide should be used in combination with a thorough analysis of the relevant facts and circumstances and review of the authoritative accounting literature.