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 eliminates the “incurred loss” model for estimating credit losses that is in current U.S. Generally Accepted Accounting Principles (GAAP) and introduces the new “current expected credit loss” (CECL) model for financial assets measured at amortized cost.
While the ASU impacts banks and financial institutions most significantly, it applies to all reporting entities, including not-for-profits (NFPs). The ASU is effective for all entities with fiscal years beginning after December 15, 2022 (i.e., January 1, 2023, for a calendar year NFP and July 1, 2023, for a June 30 fiscal year NFP).
Legacy GAAP and why the change?
Legacy GAAP requires an “incurred loss” methodology for recognizing credit losses, which essentially delays recognition until it is probable that the loss has been incurred. This model is based on historical experience and does not consider future trends or possible additional losses, and thus is criticized for limiting an entity’s ability to record credit losses that are expected, but do not yet meet the “probable” threshold. This model delayed the timing of loss recognition and was inconsistent with management’s expectations of collectability. Due to these stakeholder concerns, the FASB issued this ASU with the objective of better aligning the financial reporting for credit losses with the informational needs of financial statement users.
For NFPs, the most common financial instruments that are in scope of the standard include (but not limited to):
- Trade receivables from revenue transactions under Topic 606. For example, receivables from membership dues, conferences, tuition, sales of publications etc.
- Financing receivables (loans receivable, notes receivable). For example, student loans receivable, fraternity notes receivable from local housing corporations, and other third-party loans and notes receivable.
- Financial guarantees and loan commitments. For example, guarantees of a non-consolidated entity’s debt, off-balance sheet credit exposures etc.
- Program-related investments (PRIs).
- Loans to officers and employees.
- Lessor net lease receivables (sales-type or direct financing leases only).
- Reinsurance receivables/recoverable.
Equally important to note are the financial instruments that are excluded from application of the CECL model. For NFPs, these include (but not limited to):
- Receivables arising from contribution and grant revenue in scope of Topic 958 (i.e., contributions and grants receivable arising from non-exchange transactions).
- Promises to give (pledge receivables) accounted for under Topic 958.
- Investments measured at fair value with changes in fair value reported through the change in net assets. For example, trading securities, equity securities etc.
- Equity method investments.
- Derivatives and hedging instruments that are in scope of Topic 815.
- Loans and receivables between entities under common control.
- Operating lease receivables.
Mechanically, there is no significant change to the expected credit loss calculation. Consistent with legacy 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.
- The requirement for entities to utilize forward-looking information in estimating credit losses.
- 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 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. NFPs generally will not need complicated modeling to develop forecasts for assets such as short-term receivables.
The ASU requires extensive disclosures regarding an entity’s estimate of expected credit losses, including (i) information about the entity’s estimation methodology, (ii) relevant risk factors, (iii) changes in management’s estimates and inputs, (iv) qualitative and quantitative information about credit quality information, past-due status, nonaccrual status, off-balance sheet credit exposures etc. The standard also requires a quantitative roll forward of an entity’s allowance for credit losses for each period presented. The extent of the disclosure requirements depends significantly on the nature and types of financial instruments an entity has that is within the scope of CECL. Entities may need to implement new controls to gather and present the required information.
For a detailed FAQ on application of CECL to trade receivables and for additional information on the CECL model, download Blue’s CECL Model Implementation Guide here. If our Blue & Co., LLC experts can be of assistance, we would welcome an opportunity to discuss this standard and its implications for your organization. Reach out to your local Blue & Co. advisor today.