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CECL: Get the Conversation Started
2023 is here and all private companies will be required to adopt the new Current Expected Credit Loss Model (also known as CECL).
The Financial Account Standards Board’s (FASB) new standard, ASC Topic 326, mandates that by January 1, 2023, private companies will have to adhere to the CECL model, which is based on expected losses rather than incurred losses.
Extant U.S. GAAP required an "incurred loss" methodology for recognizing credit losses that requires loss recognition when it is probable a loss has been incurred. The new standard will require an organization to measure expected credit losses for financial asset measured at amortized cost and held at the reporting date based on historical experience, current conditions,
and reasonable and supportable forecasts. The upshot: Management will be required to consider forward-looking information in its determination of an allowance for credit losses (ACL).
The time is now to be discussing the new standard to your attest clients, as it will significantly change their accounting for credit impairment losses. Although the new standard has a greater impact on banks, most non-financial institutions have financial instruments or other assets (such as accounts receivables, contract assets, lease receivables, financial guarantees, loans and loan commitments, and held-to-maturity debt securities) that are subject to the new standard.
For private companies that have not yet adopted CECL, management, those charged with governance, and auditors need to focus significant efforts on the implementation of the standard to ensure that, among other considerations:
- Management is prepared to adopt the standard by the effective date.
- Management has identified the credit loss model(s) it will use, understands how the model(s) work, and assessed the historical data needed.
- Inputs and assumptions used in the model(s) are reasonable.
- Financial statement disclosures prior to the effective date properly address the anticipated effects of CECL.
It’s important to note that the FASB does not require management to use a specific method when measuring their estimate of expected credit losses. Instead, it allows companies to exercise judgment to determine which method is appropriate for their specific circumstances, including the nature of their financial assets. With that in mind, here are some factors to consider when determining what methods to use to meet the new standard:
- Management can select from a number of measurement approaches to determine the allowance for expected credit losses.
- Some methods project future principal and interest cash flows (i.e., a discounted cash flow (DCF) method), while other methods project only future principal losses.
- ASC Topic 326 emphasizes that management should use methods that are “practical and relevant” given the specific facts and circumstances and that the methods used to estimate expected credit losses may vary based on the type of financial asset, the entity’s ability to predict the timing of cash flows, and the information available to the entity.
Since there is no specifically prescribed approach, here are some available measurement approaches to consider:
- DCF Method - Expected credit losses are determined by comparing the asset’s amortized cost with the present value of the estimated future principal and interest cash flows.
- Loss-Rate Method - Expected credit losses are determined by applying an estimated loss rate to the asset’s amortized cost basis.
- Roll-Rate Method - Expected credit losses are determined by using historical trends in credit quality indicators (such as delinquency or risk ratings).
- Probability-of-Default Method - Expected credit losses are determined by multiplying the probability of default by the loss given default (the percentage of the asset not expected to be collected because of default).
- Aging Schedule - Expected credit losses are determined based on how long a receivable has been outstanding (example: under 30 days, 31–60 days, etc.). This method is commonly used to estimate the allowance for bad debts on trade receivables.
This is only a high-level introduction to the new standard. Transitioning from the incurred loss model to CECL is a large undertaking, and as an auditor, it’s important to evaluate your client’s methodology and processes for estimating expected credit losses to ensure they are compliant. If you haven’t yet had a conversation with clients about how they are going to manage the new standard, now is the time to open the discussion!
Need additional guidance? Collemi Consulting leverages more than two decades of experience to provide trusted technical accounting and auditing expertise when you need it the most. One example: We’ve devoted considerable time over the past year working with CPA firm leadership and their respective clients to navigate ASC Topic 326. To schedule an appointment, contact us at (732) 792-6101.
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