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Accounting Standards Codification (ASC), Financial Instruments–Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (CECL), and related Accounting Standards Update (ASU) (ASU No. 2016-13) are effective for public business entities that meet the definition of an SEC filer, excluding those that meet the definition of a smaller reporting company for annual periods beginning after Dec. 15, 2019 (that is, calendar periods beginning on Jan. 1, 2020), and interim periods therein.

For all other entities, the ASU is effective for annual periods beginning after Dec. 15, 2022 (that is, calendar periods beginning on Jan. 1, 2023), and interim periods therein.

The new guidance, issued as ASU 2016-13, Financial Instruments—Credit Losses (ASC 326), makes significant changes to the accounting for credit losses on financial instruments. This new standard is expected to have a significant effect on entities in the financial services industry, particularly banks and others with lending operations. However, this guidance affects all entities in all industries and applies to a wide variety of financial instruments, including trade receivables.

Scope

Many companies will find that they’re subject to the new Current Expected Credit Loss (CECL) requirements because the standard applies to several commonly held assets:

• Some debt instruments held to maturity (other than those measured at fair value through net income).

• Trade receivables and contract assets recognized under ASC 606.

• Lease receivables resulting from sales-type or direct financing leases.

• Reinsurance receivables from insurance transactions.

• Financial guarantee contracts.

• Loan commitments, such as letters of credit.

The CECL model does not apply to available-for-sale debt securities.

This article covers the recognition, measurement and related disclosures for estimating credit losses related to trade receivables under ASC 606.

Recognition of Current Expected Credit Loss

ASC 326-related to CECL model requires an estimate of expected credit losses, measured over the contractual life of an instrument, that considers forecasts of future economic conditions in addition to information about past events and current conditions.

ASC 326-20 has replaced the legacy “incurred loss” model with an “expected credit loss” model that considers broader range of information to estimate expected credit losses over the lifetime of the asset.

ASC 326 covering initial measurement does not define the term “expected credit loss;” it says the allowance for expected credit losses should represent the portion of the amortized cost basis of a financial asset that an entity does not expect to collect. It also says the allowance is intended to result in the financial asset being reflected on the balance sheet at the “net amount expected to be collected.” The standard does not define what is meant by the phrase “net amount expected to be collected” nor does it provide a recognition threshold.

Figure 1 summarizes the key differences between legacy US GAAP and the CECL model:

Key Principles and Implementation Considerations Related to Current Expected Credit Loss

The standard requires the allowance for expected credit losses to be based on the underlying financial instrument’s amortized cost basis. That is, the allowance represents the portion of amortized cost that the entity doesn’t expect to recover due to credit losses, and it is presented as an offset to the amortized cost basis Based on an asset’s amortized cost:

• Primarily comprised of Unpaid Principal Balance (UPB), accrued interest, premium or discount, write-offs, foreign exchange adjustments, fair value hedge accounting adjustments

• Implementation Consideration:

  • Limited historical loss information may be readily available for components of amortized cost other than the UPB.

  • Entities will need to develop processes and controls to capture the expected credit losses on those components of amortized cost that may not have historically been addressed.

Reflect the risk of loss:

• Assets should be evaluated collectively based on similar risk characteristics. Even when risk is remote, should be captured.

Implementation Consideration:

• The standard requires an entity to consider some possibility of a default, even if that risk is remote. Therefore, an entity’s assessment of the instrument’s loss upon a default needs to be zero to arrive at an allowance of zero.

• It’s key to reconsider whether assets grouped in a pool continue to share similar risk characteristics at each measurement date.

Reflect losses expected over the remaining contractual life:

• Contractual life should consider expected prepayments but should not consider expected extensions, renewals and modifications unless the lender has no control over whether a contractual extension option will be exercised by the borrower.

Implementation Consideration:

• It’s challenging to determine the life of instruments with no stated maturity date (e.g., accounts receivable, credit card receivables). As such, entities must use historical data that reflects the timing and pattern of historical lifetime credit losses.

• The modeling of contractual extension and renewal options can be challenging.

Consider available relevant information:

• Consider historical data about the collectability of cash flows, current conditions and reasonable and supportable forecasts of future economic conditions.

Implementation Consideration:

• Significant judgment will be required to determine the historical data that should be used and the adjustments that may need to be made to historical loss information.

The new CECL standard does not prescribe one mandatory method for estimating expected credit losses. An entity can use the measurement approaches in Figure 2 to determine the allowance for credit losses, which may be consistent with methods it previously used:

ASC 326 Implementation Practical Tips & Steps to Consider

ASC 326-20 provides no practical expedients with respect to historical information or the adjustments to such historical information. Based on my prior experience, the adoption of ASC 326 standard required more effort than initially anticipated by the management. Entities had trouble in determining the life of instruments with no stated maturity date (e.g., accounts receivable, credit card receivables). Therefore, it’s important for entities to start planning now and consider following factors for effective implementation:

1. Project plan (including need for resources):

The first step is understanding the requirements of ASC-326, establishing a project team and preparing a project plan. Entities also might need to engage consultants/advisers to help in both the project planning, accounting and monitoring the project progress for accurate implementation of ASC 326. Also, entities will need to plan for this additional cost of consultants/advisors in their annual budgeting process.

2. Information regarding receivables:

When preparing the estimate, it is important to understand the interaction between the historical loss data chosen, the application of current conditions and the reasonable and supportable forecast of future economic conditions. Historical information for receivables may require adjustments for the following:

• Asset specific characteristics

• Current conditions

• Reasonable and supportable forecasts of economic conditions expected to exist throughout the contractual life of the receivable.

3. Existing process and controls:

Availability of system and organization controls (SOC) reports and user control considerations over data and, if applicable, over models and assumptions used. The entities will need to consider the completeness and accuracy of the information especially following:

• What controls are in place to ensure information is complete and accurate?

• Have reported losses been recorded in the proper period?

4. Auditor involvement:

Consider reading additional guidance from the large independent accounting firms and discussing the timing of the auditing of the ASC 326 adoption process with your independent auditors to ensure that there is time for timely remediation or consideration of timely feedback, if needed.

Presentation and Disclosure

Entities are expected to ensure their disclosures are relevant, reliable and transparent to the users of the financial statements. The disclosures allow users to:

• a. Understand the key components of management’s estimation process, methodology and judgments.

• b. Understand that the entity has based its information on reliable information.

• c. Assess the quality of the entity’s overall estimate.

• d. Assess whether the estimate is free from professional judgment bias.

For financial assets measured at amortized cost within the scope of this subtopic, an entity shall separately present on the statement of financial position, the allowance for credit losses that is deducted from the asset’s amortized cost basis.

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