On June 16, 2016, the FASB issued its new standard on credit losses, ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” Although financial institutions with loan portfolios are expected to see the most significant effects of this standard, its impact is not exclusive to those institutions. The new credit loss model (the current expected credit loss (CECL) model) introduced by the standard will be applied to many financial assets, including trade accounts receivables (see “CECL Scope” later), held by entities regardless of the industry in which they operate. Additionally, this standard revises the impairment guidance for any entity that holds available-for-sale (AFS) debt securities (see the “AFS Debt Securities Model Revised” section later).
The CECL methodology applies to the measurement of credit losses on the following financial assets measured at amortized cost:
- Financing receivables (such as trade accounts receivable and loans receivable)
- Receivables from revenue transactions (including accounts receivable from customers)
- Held-to-maturity debt securities
- Receivables from repurchase agreements and securities lending transactions
- Reinsurance receivables
It also applies to:
- Off balance sheet credit exposures not accounted for as insurance (including loan commitments, standby letters of credit, financial guarantees, and other similar instruments, except for instruments within the scope of Accounting Standards Codification 815, “Derivatives and Hedging”)
- Net investments in leases recognized by a lessor
An allowance for credit losses reflecting the current estimate of all expected credit losses will be established on the balance sheet. The income statement will reflect the change in the estimate of credit losses (credit deterioration or improvement resulting from changes in credit risk, current conditions, and reasonable and supportable forecasts) since the previous reporting date.
Consistent with existing GAAP, write-offs will continue to be recognized in the period in which the receivable is deemed uncollectible, and recoveries will be recorded when received.
CECL Method for Trade Accounts Receivable
The CECL methodology will move the measurement of credit losses from an incurred loss basis to an expected loss basis by 1) requiring that entities consider information that is more forward-looking than is permitted under current GAAP and 2) recognizing the expected lifetime credit losses on trade accounts receivable at the initial measurement date.
The expected credit loss estimate should consider available information relevant to assessing the collectibility of contractual cash flows – including information about past events (for example, historical loss experience), current conditions, and reasonable and supportable forecasts. Adjustments to historical loss experience should be made to reflect differences in asset-specific risk characteristics that arise between the current receivables portfolio and the assets on which the historical experience is based. In addition, adjustments may be necessary when management’s expectations about current conditions and reasonable and supportable forecasts differ from the conditions that existed for the period over which the historical information was evaluated.
Example 5 in the ASU illustrates how an entity may use an aging schedule to apply the CECL methodology to (that is, estimate expected credit losses for) trade accounts receivable. The illustration emphasizes that in order to assess whether adjustments to historical loss rates are necessary at the balance sheet date, an entity should 1) evaluate the risk characteristics of an entity’s customers and its lending practices over time and 2) evaluate the current and reasonable and supportable forecasted economic conditions over time. That example provided by the FASB highlights changes to existing GAAP when applying CECL to trade receivables. Specifically, adjustments to historical loss rates may be necessary to reflect changes in either asset-specific risk characteristics or current and forecasted conditions.
Many of the existing disclosures for financing receivables (including trade accounts receivable) are carried forward.
However, the credit quality indicator disclosure now must be disaggregated by year of the asset’s origination (that is, vintage year) for all classes of financing receivables, net investments in leases, and major security types (excluding revolving lines of credit such as credit cards, reinsurance receivables, and repurchase and securities lending agreements). The disaggregation years are limited to no more than five annual reporting periods, with the balance for financing receivables originated before the fifth annual reporting period shown in aggregate. For an interim reporting period, the year-to-date originations of the current annual reporting period are considered to be current-period originations.
Relief has been provided for certain entities:
- For PBEs that are not SEC filers (see the definition in the “Effective Dates and Transition” section later), a practical expedient is available during transition. That is, disclosure of only three years of the required vintage information in the year of adoption and only four years in the year after adoption is allowed. In years thereafter, those entities must comply with the full five-year disclosure requirement.
- Non-PBEs (including private companies, employee benefit plans, and not-for-profit entities) may elect to not make the vintage disclosure.
AFS Debt Securities Model Revised
Although the new standard is outside the scope of the CECL model, it revises the credit loss model for AFS debt securities, which is the other-than-temporary-impairment (OTTI) model. The OTTI model is revised by removing two factors: 1) the length of time that a security has been underwater and 2) whether recoveries or further declines in fair value exist after the balance sheet date. In addition, an entity is no longer required to consider the historical and implied volatility of the fair value of the security.
Debt securities will use an allowance for credit losses instead of a direct write-down, which means losses may be reversed if conditions improve. Finally, because AFS debt securities are carried at fair value, the FASB introduced a fair value floor, which limits the amount of credit losses that can be recorded to fair value.
The standard requires an entity to consider whether it intends to sell or is more likely than not to be required to sell the security before the recovery of its amortized cost basis. This guidance, retained from the current guidance, will require an entity to charge off the allowance if either of those considerations exists.
- In his speech on May 5, 2016, at the 2016 Baruch College Financial Reporting Conference, Deputy Chief Accountant Wesley R. Bricker provided advice for management when transitioning to the new credit impairment standard.
- Crowe released an e-communication, “Here’s CECL: FASB Issues Final Standard for Credit Losses,” on June 16, 2016, the same date that the FASB issued the CECL standard.
- The Crowe series of articles on adapting to CECL include implementation considerations for the new CECL standard:
- On Aug. 19, 2016, Crowe released a comprehensive article on the CECL standard, “Inside the New Credit Loss Model: Requirements and Implementation Considerations.”
- The SNL Knowledge Center posted an archived webinar, “CECL: What You Need to Know.”
- The FASB also posted an archived webinar, “In Focus: FASB Accounting Standards Update on Credit Losses.”
Effective Dates and Transition
The FASB split the PBE definition for the purpose of limiting certain disclosure requirements and providing additional time for PBEs that are not SEC filers. An SEC filer is an entity that either files or furnishes its own financial statements in SEC filings as well as entities subject to Section 12(i) of the Securities Exchange Act of 1934 that file with the appropriate regulatory agency under that section.
- For PBEs that meet the definition of an SEC filer, the standard is effective in fiscal years beginning after Dec. 15, 2019, including interim periods in those fiscal years. For calendar year-ends, the standard must be adopted no later than the March 31, 2020, interim financial statements.
- For PBEs that do not meet the definition of an SEC filer, it is effective in fiscal years beginning after Dec. 15, 2020, and interim periods within those fiscal years. For calendar year-ends, this first applies to March 31, 2021, interim financial statements.
- For all other entities, the standard is effective in fiscal years beginning after Dec. 15, 2020, and interim periods within the fiscal years beginning after Dec. 15, 2021, which first applies to Dec. 31, 2021, annual financial statements for calendar year-end non-PBEs.
Early adoption is permitted for all entities in fiscal years beginning after Dec. 15, 2018, including interim periods in those fiscal years. That means that any calendar year-end entity may adopt the standard as early as the March 31, 2019, interim financial statements.