Is That No Longer the Question?
The adoption of the Credit Loss Standard has finally arrived for private companies. The FASB issued ASU 2016-13, Credit Losses – Measurement of Credit Losses on Financial Instruments (“CECL”), in June 2016, but with multiple deferrals, private companies with calendar year-ends will be adopting it this year - 2023.
CECL changes the reporting of credit losses from an impairment approach to an expected credit loss approach. The standard will result in earlier reporting of credit losses, which will result in financial reporting and process changes for private companies.
CECL applies to financing receivables (e.g., loans), investments in debt securities that are held-to-maturity, receivables from revenue transactions (e.g., trade receivables) and net-investments in leases. Net-investments in leases are direct-finance lease receivables and sales-type lease receivables, including the residual asset. Operating lease receivables are not in the scope of CECL and a private company will consider guidance in the Lease Standard to recognize losses, or guidance for loss contingencies.
The Credit Loss Standard is a measurement standard similar to the Fair Value Standard. It provides a framework for companies to consider in the measurement of credit losses. A private company will first consider how they monitor credit risk in a collection of assets or, as described in the standard, how they “pool” assets for credit risk evaluation. For example, a company that groups assets by delinquency and applies an aging schedule with loss rates is evaluating the assets by delinquency pools.
If an asset does not share a risk characteristic similar to other assets, the asset can be evaluated for credit loss on an individual basis, such as an asset that is in default and the company is in discussions with the borrower on an individual basis. Once a company determines the asset pools for evaluation or assets to assess individually, the company will apply a method to measure credit loss, which may include a loss rate approach, a probability of default approach or a discounted-cash flow approach. There is no one required measurement approach to recognize a credit loss under the new standard.
"Companies adopting CECL are wise to reconsider their financial reporting processes."
When measuring credit losses, a private company will now consider market and economic forecasts along with the current environment and historical loss experience. Forecasted information that is relevant for the assets should be reasonable and supportable. A company may not be able to forecast relevant market and economic metrics to the end of the contractual life of the asset, or the end of the estimated life of the asset if there are expected prepayments. If the asset life exceeds the forecast period, the company will revert to historical loss experience for that excess period.
A private company may be wondering if this standard will have a significant impact on their financial reporting. The answer will depend on the size and type of their asset profiles, the availability and accuracy of historical loss information, the current ability to forecast and the adequacy of their current loss monitoring activities.
A new accounting standard always provides a good reason to reconsider current financial reporting processes. One should never waste the opportunities of a good accounting standard adoption! Companies can consider the following:
- Review general ledger accounts potentially in scope of the standard and ensure they properly capture what is intended;
- Revisit when credit losses are recognized and ensure the process now meets the expected loss method;
- Review how the company is currently monitoring credit losses and determine whether the process can be redefined for improvement;
- Retrieve historical loss information, analyze for trends and scrub for incomplete or missing information; and
- Update loss rates or other metrics being used by the company that have not been updated in a while.
