By Deepa Bhat, CPA, CFE, ACA, Principal
Starting in January 2023, businesses must conform to a new accounting standard for measuring expected credit loss. It’s perhaps one of the biggest accounting changes for financial institutions in a decade – but they’re not the only ones affected. Nonfinancial institutions may still have financial instruments and other assets that will require a different accounting approach and new internal controls. Implementing the current expected credit loss (CECL) accounting methodology takes a forward-looking approach to risk modeling and will be a significant undertaking for many.
What is CECL?
Current expected credit loss (CECL) is a new accounting standard that’s meant to better protect against potential credit losses. Instead of recognizing a probable loss of credit once a certain threshold was reached, CECL requires entities to calculate expected credit loss over the life of a loan. Essentially, CECL is a switch from accounting for losses when they’re incurred to accounting for an expected loss at the outset.
The foundation for CECL began in the aftermath of the 2008 financial crisis. The Federal Reserve was bailing out financial institutions following rapid, historic losses in debt-based portfolios. It had become clear that an accounting method based on potential loss thresholds was a dangerous weakness. Regulators’ immediate focus then was to guard against systemic risk, which they did via more stringent stress tests on a financial institution’s ability to hedge against losses. In the years that followed, the CECL accounting standard was developed, and will apply to financial statements outside the scope of financial institutions as well
The Financial Accounting Standards Board (FASB) first issued Accounting Standards Update (ASU) 2016-13 (Topic 326) in June 2016. This standard replaced FAS-5 and FAS-114, the previous rules for accounting for credit losses.
Implementation has been delayed due to COVID-19 but is effective beginning in January 2023. After that, entities have a three-year transition period in which to fully adopt the new standard.
CECL Accounting Methodology
Unlike accounting for incurred losses, accounting for expected credit losses doesn’t have an impairment threshold. Estimates of credit losses are recognized at the end of reporting periods. Any credit impairment, or expected loss, is recognized as an allowance, rather than writing down the amortized cost basis of an asset.
The goals of the CECL accounting methodology all aim to decrease complexity, increase transparency, and protect against undue risk from credit losses. Several objectives support those goals, including:
- Decrease GAAP complexity by using fewer credit impairment models to account for debt instruments.
- Switch to an expected credit loss model rather than the existing incurred credit loss model.
- Make available different calculation methods to estimate expected credit losses.
By comparison, some large entities now have up to five different impairment models to use to calculate incurred credit loss under GAAP. Which impairment model to use depends on the type of asset or financial instrument; for example, large groups of smaller loans are accounted for differently than debt securities or assets with deteriorating credit quality. Once CECL is fully adopted, two to three impairment models will account for forward-looking losses.
Who Is Impacted by CECL?
While CECL will affect financial institutions most of all, many other types of entities will need to adopt CECL accounting standards, too, like:
- all entities holding loans, debt securities, trade receivables, and off-balance-sheet credit exposures.
- Public companies, except those eligible as a “smaller reporting company” under the SEC
- Certain employee benefit plans
- Insurance entities
- Certain not-for-profits
- Lessors holding operating leases
CECL Scope and Applicability
Some financial instruments are outside CECL’s scope. They include:
- Any financial asset measured at fair value, like securities or derivatives
- Lessor receivables from operating leases
- Participant loans from defined contribution employee benefit plans
- Insurance entity policy loan receivables
CECL Implementation for Nonfinancial Entities
Nonfinancial entities may already be at a disadvantage since financial institutions have been preparing for this change since before the pandemic. Because applying CECL is more ambiguous in many scenarios for corporate entities, internal finance teams will need to carefully examine all contract details, transactions, and other line items.
The first step is to identify what falls under the new standards, even if the result is immaterial. Any recorded receivable needs to be considered, though longer-term receivables are a good place to start. Entities with trade receivables of 90 days or more will need to assess whether existing financial forecasting models comply with CECL. For example, an entity may compile historical loss data for receivables. The entity calculates credit loss percentages depending on whether the receivable is current, one month past due, two months past due, three months past due, and more than 90 days past due. This historical data is a reasonable starting point, but to comply with CECL, the entity will also need to factor in current and forecasted economic conditions to estimate future expected credit losses.
Unbilled receivables, or contract assets, may be within CECL as well. Entities will want to look for contracts where the ability to invoice depends upon meeting certain milestones that aren’t fulfilled yet. Construction, real estate, and technology are three industries where this is more likely to come into play.
Debt securities will also be within the CECL scope when they’re held to maturity and expected losses must be measured according to CECL. Credit risk, especially in highly regulated industries, off-balance sheet commitments, like letters of credit, and certain financial guarantees may also be subject to CECL standards. Subsidiary transactions with third parties that could impact the parent entity are another area to look at.
Organizations may need to develop new or different internal controls, processes, and data sets to meet CECL requirements in these areas, whether the balance sheet is affected or not. Even historic loss data, which supports future financial forecasts, may need to be adjusted.
Collaboration across departments and thorough documentation will both help nonfinancial entities determine if CECL applies to them, and to what extent.
Contact Us
Please call us at, 408-377-8700 or contact us if you have questions about the new CECL standards or need assistance with another tax or audit issue.