New accounting standards you should know, Part 2: Credit losses both now and later under CECL (ASC 326)

For anybody in the accounting world, one thing is clear: accounting standards never stay the same. In this multi-part series, “New accounting standards you should know,” I’ll catch you up on the latest accounting standard updates. Previously, we talked about the recent overhaul to revenue recognition due to ASC 606. Now let’s dive into something even sexier: the Current Expected Credit Loss (CECL) model under ASC 326.

The FASB was not quite done with their major initiatives during the 2010s. In addition to the new revenue recognition and leasing models under ASC 606 and ASC 842, the FASB also released new guidance around the broad topic of financial instruments. This new model focuses on evaluating a loss reserve for financial instruments held by a company based on the instrument’s Current Expected Credit Losses. As we know, the accounting world is a big fan of using acronyms, so we commonly refer to this as “CECL” (pronounced “Cecil”).  

The guidance around credit losses on financial instruments related to a broad range of instruments, including but not limited to loans and other financing receivables, held-to-maturity debt securities (as an investment), lease receivables for a lessor, off-balance-sheet credit exposures, and even accounts receivable and other trade receivables. Think of it as a Loan Loss Reserve that you may see with financial institutions, or a Bad Debt Allowance that nets down outstanding Accounts Receivable (AR). The old model required companies to estimate a reserve for any losses related to uncollectible amounts on such financial instruments. That reserve was based on the amounts that would likely be uncollectible based on events and circumstances that were occurring at the time. If a certain receivable had indications of being uncollectible, such as a far past due invoice or a loan with multiple missed payments, then you would evaluate it as part of the reserve. However, anything that still appeared unaffected was not evaluated.  

The new guidance under CECL (ASC 326) requires companies to take that reserve methodology one step further. All financial instruments that are indicative of a loss continue to be evaluated; however, now all financial instruments are required to be evaluated as well, even if there are no indications of loss at the time of evaluation. This means including estimated loss reserves for even the loans in your portfolio that are still current, since some of those loans may eventually become delinquent or uncollectible. The same goes for AR/trade receivables; even your population of AR that is not past due may have some invoices that eventually become uncollectible and written off.  

At this point, you are probably wondering, “How the hell am I supposed to estimate losses for my assets that have no indication of being a loss?” And I understand the frustration! Many times, the best information for a company will be based on relevant historical activity. Reviewing your loan/AR portfolio in prior periods, and the subsequent collection vs. write-off activity of those amounts, can provide a starting point; however, any changes in the credit policies and makeup of your portfolio from prior periods need to be considered as well. Oh, and this evaluation should be updated for every financial reporting period-end.  

It should be noted that this new standard will have a different impact on different industries. For many companies that only have short-term trade receivables, this may be a simple exercise of adding an additional reserve % for AR populations that were previously not subject to reserve (e.g., current invoices, invoices less than 30/60 days past due, etc.) based on prior write-offs, and the impact of the new reserve may be immaterial. Other industries that deal with significant amounts of financial instruments like banks and other financial institutions will be hit harder and may need an extensive and time-intensive model prepared based on the size and complexity of its portfolio.  

As is the trend, publicly traded companies have already started the fun by being required to adopt CECL for fiscal years beginning after December 15, 2019 (calendar year 2020). Nonpublic companies have a bit more time, with required adoption delayed until fiscal years beginning after December 15, 2022 (calendar year 2023). However, it should still be on the radar for nonpublic companies for potential increases to their loss reserves, especially for those in industries heavily involved with financial instruments.  

Stick around because in our next Zeroed-Insight, we'll share an update that actually simplifies the accounting evaluation for complex debt and equity. Believe it or not, some of these updates actually make things EASIER!