The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13, Financial Instrument—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, on June 16, 2016.
While the new current expected credit loss (CECL) standard particularly impacts financial institutions, nonfinancial institutions that hold financial assets or other assets—including, but not limited to trade receivables, contract assets, lease receivables, loan commitments, financial guarantees, and debt securities—are also subject to the new guidance.
The following summarizes the accounting implications of the new CECL model and the impact to nonfinancial institutions.
For entities that haven’t yet adopted the CECL standard, it’s effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.
The CECL standard changes the way companies evaluate impairment of financial assets. It replaces the long-standing incurred loss model used in calculating credit losses with the CECL model contained in ASC Subtopic 326-20, Financial Instruments—Credit Losses—Measured at Amortized Cost.
Under the CECL model, the allowance for credit losses is a valuation account, deducted from the amortized cost basis of the financial asset, and remeasured each reporting period.
The CECL model requires the consideration of forward-looking information when establishing the allowance for credit losses. The allowance should represent all contractual cash flows an entity doesn’t believe it will collect over the contractual life of the financial asset.
The new guidance is principles-based with broad concepts that require tailoring based on individual circumstances. The CECL standard is meant to simplify the accounting by requiring all financial assets measured at amortized cost basis to be presented at the net amount expected to be collected.
Under the CECL model, the estimate of expected credit losses must reflect any risk of loss, even if that risk is remote.
The measurement of expected credit losses should be based on relevant available information about:
- Past events and historical experiences
- Current conditions
- Reasonable and supportable forecasts that affect the collectability of the reported amount
An entity should assess relevant historical loss data for similar assets and adjust the data to account for current conditions and reasonable and supportable forecasts. Entities should compare conditions that existed during the historical period to current conditions and future expectations, and adjust the historical data accordingly.
The CECL model must be applied at origination of the financial asset and in subsequent reporting periods. This requires periodic reevaluation of historical performance, current conditions, and expectations about future conditions.
The CECL model doesn’t prescribe a specific way of estimating expected credit losses over the life of financial assets. Rather, the allowance for credit losses may be determined using various methods, and entities may apply different estimation methods to different groups of financial assets.
While estimating expected credit losses is highly judgmental, entities can use many of the same methodologies used today, including but not limited to:
- Discounted cash flow
- Vintage analysis
- Probability of default
- Provision matrix
- Regression analysis
Financial assets with similar risk characteristics should be evaluated on a collective basis when measuring expected credit losses. Financial assets that don’t share risk characteristics should be evaluated on an individual basis.
An entity is required to provide quantitative and qualitative information that enables a financial statement user to understand management’s method for developing its allowance for credit losses and the information management used in developing its current estimate of expected credit losses.
A notable new disclosure under the CECL model is the requirement for public business entities to present the amortized cost basis of financing receivables and net investments in leases within each credit quality indicator by year of origination—vintage year.
The amendments in ASU 2022-02, Financial Instruments—Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures, address the inconsistencies between the guidance and illustrations included in ASU 2016-13 in regard to the vintage disclosure requirements.
ASU 2022-02 clarifies that a public business entity must only disclose current-period gross write-offs by year of origination for financing receivables and net investments in leases within the scope of Subtopic 326-20.
The new disclosure requirement doesn’t apply to receivables measured at the lower of amortized costs basis or fair value, or to trade receivables due in on year or less—except for credit card receivables.
Key Accounting Considerations for Nonfinancial Institutions
The scope of the CECL model is broad and applies to financial assets measured at amortized cost and other assets, including but not limited to:
- Financing receivables, such as loans and notes receivables
- Investments in held-to-maturity (HTM) debt securities
- Trade receivables and contract assets recognized in accordance with ASC Topic 606
- Loan commitments, standby letters of credit, and financial guarantees
- Net investments in sales-type or direct financing leases recognized by a lessor in accordance with ASC Topic 842—but not lessor operating lease receivables
Scope exceptions include:
- Loans made to participants by defined contribution employee benefit plans
- Policy loan receivables of an insurance company
- Promises to give—pledge receivables—of a not-for-profit entity
- Loans and receivables between companies under common control
The following discussion summarizes the types of financial assets and other assets that nonfinancial institutions may have that are subject to the CECL model.
Receivables that result from revenue transactions within the scope of ASC Topic 606, Revenue from Contracts with Customers, are subject to the CECL model. ASC Topic 606 clarifies that a receivable is an entity’s right to consideration that’s unconditional, and that a right to consideration is unconditional only if the passage of time is required before payment of that consideration is due.
Under ASC Topic 606, an entity is required to assess collectability at contract inception.
It should determine whether it’s probable the entity will collect substantially all the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. The collectability assessment is based on if the customer has the ability and intention to pay—probable collectability doesn’t imply a credit-risk-free receivable.
When a trade receivable is recorded, an entity is required to measure and record the expected credit losses on the trade receivable over its contractual life.
Consistent with the CECL model, the expected credit losses on trade receivables are typically estimated using the loss-rate method where historical losses—percentages of receivables that have historically gone bad—are adjusted based on relevant information around current conditions and future estimated loss estimates.
Many entities will continue to use the loss-rate method. But considering current trade receivables even if they aren’t past due is an expected change from applying the CECL model.
Under ASC Topic 606, an entity has a right to consideration when the entity transfers goods or services to a customer before the customer pays.
A receivable should be recorded when the entity has an unconditional right to consideration—meaning only the passage of time is required before payment of that consideration is due.
A contract asset should be recorded when the entity has a right to consideration that’s conditioned on something other than only the passage time, such as the satisfaction of another performance obligation in the contract.
Once an entity has an unconditional right to consideration, it should present that right as a receivable separately from the contract asset.
ASC Topic 606 requires an entity to assess contract assets for credit losses in accordance with the CECL model, even though ASC Subtopic 326-20 doesn’t explicitly mention contract assets.
The distinction between a receivable and contract asset is important as the risks associated with each asset are different—while both are subject to credit risk, a contract asset is also subject to other risks such as performance risk.
In addition, ASC Subtopic 326-20 requires reversion to historical loss information for periods beyond which an entity is able to make or obtain reasonable and supportable forecasts of expected credit losses. As compared to receivables, contract assets may have longer durations, and entities will need to consider how that may impact the development of their reasonable and supportable forecast about future economic conditions.
Net investments in sales-type and direct financing leases recognized by a lessor in accordance with ASC Topic 842, Leases, are subject to the CECL model.
The net investment is the sum of the present value of the lease receivable—lease payments and any guaranteed residual value of the asset—and the expected unguaranteed residual value of the asset for sales-type leases. For direct financing leases, the net investment is the sum of the present value of the lease receivable and the expected unguaranteed residual value of the asset less any deferred selling profit.
Net investments in sales-type and direct financing leases are required to be evaluated for impairment under the CECL model; any loss allowance should be recorded in accordance with ASC Topic 326.
A lessor should consider both of the following:
- Cash flows it expects to receive or derive from the lease receivable during the remaining lease term
- Expected cash flows to be received from the unguaranteed residual asset at the end of the lease term when evaluating the allowance for credit losses on net investments in sales-type and direct financing leases
When measuring expected credit losses using a discounted cash flow method, the discount rate used in measuring the lease receivable under ASC Topic 842 should be used in place of the effective interest rate.
Operating lease receivables are outside the scope of the CECL model and the guidance within ASC Topic 842 should be applied when the collection of operating lease payments isn’t probable.
Off-balance-sheet arrangements—including unfunded loan commitments and standby letters of credit—are subject to the CECL model as long as they aren’t within the scope of ASC Topic 815, Derivatives and Hedging. An entity should apply the CECL model as it would for other financial assets to funded loan commitments—when cash has been provided to the borrower.
For unfunded commitments—amounts that haven’t yet been borrowed—and other off-balance sheet arrangements, an entity should estimate expected credit losses for the full contractual period over which an entity is exposed to credit risk and the issuer doesn’t have the unconditional right to cancel the commitment.
The CECL model doesn’t require an allowance for expected credit losses beyond the contractual term or beyond the point in which a loan commitment may be unconditionally cancelled by the entity.
The estimate of expected credit losses should consider both the likelihood there will be future drawdowns over the lifetime of the commitment and the probability those borrowings won’t be repaid. The estimated expected credit losses should be recorded as a liability.
Similar to loan commitments, financial guarantors are under legal obligation to extend credit if certain events occur. Financial guarantees that aren’t accounted for as insurance, or within the scope of ASC Topic 815, also are subject to the CECL model.
At inception of the guarantee, an entity should record both of the following:
- A guarantee liability at fair value in accordance with the guidance in ASC Topic 460, Guarantees
- A liability for expected credit losses, as calculated using the CECL model
Debt securities are defined as a security representing a creditor relationship with a company. This includes, but isn’t limited to:
- Certain preferred stock
- US Treasury and government agency securities
- Municipal and corporate bonds
- Interest-only and principal-only strips
- Securitized debt instruments
The term debt security explicitly excludes the following:
- Option contracts
- Financial futures contracts
- Forward contracts
- Lease contracts
- Trade or loan receivables that aren’t securitized
The CECL standard separates the credit loss models for debt securities classified as available-for-sale (AFS) and HTM, which is a major change from current GAAP.
HTM Debt Securities
Investments in debt securities should only be classified as HTM if the entity has the positive intent and ability to hold those securities to maturity.
HTM securities are measured and reported at amortized cost. As a result, they’re subject to the CECL model. Under current GAAP, HTM debt securities are impaired when the fair value of the investment is less than the amortized cost basis and an impairment loss should be recognized when the impairment isn’t temporary.
The CECL model replaces the current impairment guidance and doesn’t differentiate between temporary and other than temporary losses.
Investments in HTM debt securities should be evaluated for impairment, both at acquisition and subsequent reporting dates, using the CECL model. Any expected credit losses should be recognized as an offsetting allowance to the amortized cost basis of the HTM debt security.
AFS Debt Securities
Investments in debt securities classified as AFS are measured at fair value and are therefore not subject to the CECL model. However, the CECL standard introduces ASC Subtopic 326-30, Financial Instruments—Credit Losses—Available-for-Sale Debt Securities. ASC Subtopic 326-30 supersedes and improves the accounting guidance for credit losses on AFS debt securities currently contained in ASC Topic 320, Investments—Debt and Equity Securities. Under ASC Topic 320, and similar to HTM debt securities, AFS debt securities are considered impaired if the fair value of the investment is less than its amortized cost and an impairment loss should be recognized when the impairment isn’t temporary.
The CECL standard replaces the existing other-than-temporary impairment model and requires an allowance for credit losses to be recognized for AFS debt securities.
The allowance for credit losses is determined on an individual basis and measured as the difference between the security’s amortized cost basis and the amount expected to be collected over the security’s lifetime using a discounted cash flow model.
Under this approach, an entity would record impairment related to credit losses through earnings offset with an allowance for credit losses at each reporting date. Consistent with existing guidance, noncredit related losses are required to be recognized in other comprehensive income.
Any noncredit impairment in excess of the calculated allowance related to credit losses should be recorded through other comprehensive income in equity net of tax. This is unchanged from current accounting for unrealized gains and losses on AFS debt securities. However, this approach differs from the accounting treatment of HTM debt securities under the CECL model, which requires a company to measure expected credit losses at acquisition and subsequent reporting dates—as discussed above.
Effective Dates and Transition
For public business entities that meet the definition of an SEC filer, excluding smaller reporting companies as defined by the SEC, the effective date was for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.
For all other entities—all other PBEs including smaller reporting companies, private companies, not-for-profit organizations, and employee benefit plans—the effective date is for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.
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