Another new accounting pronouncement’s effective date is looming for private companies and nonprofits. ASU 2016-13: Financial Instruments — Credit Losses (Topic 326) is effective for these entities for fiscal years beginning after Dec. 15, 2022. Topic 326 has overhauled the processes of measuring credit losses on most financial assets carried at amortized cost, among others. Although this ASU will most significantly impact financial institutions and insurance companies, adoption is required by all entities.
Legacy GAAP required entities to recognize estimated credit losses when a loss has been triggered by a probable event. The new ASU represents a significant amendment to this model by demanding recognition of both current and expected future credit losses, under a new model called the current expected credit loss model (CECL).
WHAT IS IN THE SCOPE OF CECL?
CECL application is required for various financial instruments, but certain assets are out of CECL’s scope. The following table summarizes what does and does not fall under the new model:
In-Scope |
Out-of-Scope |
Financing receivables |
Equity securities |
Held-to-maturity debt securities |
Debt investments categorized as trading |
Trade receivables |
Promises to give (pledges receivable) of a not-for-profit entity |
Contract assets (Topic 606) |
Other financial assets measured at fair value through net income |
Net investment in sales-type and direct-financing leases (Topic 842) |
Operating lease receivables |
Reinsurance receivables |
Policy loan receivables of an insurance entity |
Receivables that relate to repurchase agreements and securities lending agreements (Topic 860) |
Loans made to participants by defined contribution employee benefit plans |
Off-balance-sheet credit exposures not accounted for as insurance |
Loans and receivables between entities under common control |
WHAT CHANGES WITH CECL?
CECL represents a new challenge, in large part due to the estimation of future credit losses for the lifetime of a financial asset. This process involves expanded considerations and a breadth of information that must be utilized in measuring a credit loss allowance. The use of historical experience is necessary for establishing the baseline for current expected losses. This, in addition to the consideration of credit portfolios and macroeconomic conditions, can be used to estimate future credit losses over a reasonable and forecastable period commensurate with the contractual terms of the respective asset.
The ASU provides flexibility in how companies can measure and set an allowance for credit losses under CECL. In fact, it does not prescribe a specific method. Methods known as the loss-rate, roll-rate, probability of default, discounted cash flow and aging schedule are some commonly used measurement approaches to arrive at expected credit losses. Methods can vary between entities and classes of financial instruments that share common characteristics (asset classes shall be bifurcated based on risk-based characteristics).
Whatever the method, CECL eliminates the “probable” initial recognition threshold and requires that expected credit loss measurement be based on available internal and external information about past events, current conditions and reasonable and supportable forecasts.
To learn more about this topic, reach out to GHJ’s Audit and Assurance Team.
