CECL: The ghost of past, present (and future) for credit loss reserves for all companies

The standard applies to financial assets measured at amortized costs (balance sheet line items), commonly present for companies in all industries, public or private. The standard’s purpose is to reflect the expected amount of the asset that will be realized/collected based on historical experience, current conditions, and reasonable and supportable forecasts about future conditions and events. CECL helps standardize the reporting of various assets held at amortized costs and shifts focus onto the collectability of those assets.

We’re used to hearing about CECL applied to the financial sector, but it applies to companies in all sectors and is effective for private companies’ application for periods beginning after Dec. 15, 2022 (i.e., January 2023). This includes financial statements issued within the period (e.g., March 2023) and all year-end audits thereafter.

What does this mean for private companies outside the financial sector?

Most private companies outside the financial sector have many different types of financial assets within CECL’s scope (see examples below). CECL effectively revised how we should calculate and account for the credit risk related to receivables and many other types of assets.

The most significant change is that those calculations now include not only past and present, but also future, information based on reasonable and supportable forecasts over the remaining contractual life of the financial asset. Important to note is that the estimate for credit risk is calculated, even if the risk is remote. However, risks other than credit risks, such as product returns, volume rebates, etc., shouldn’t be included in the allowance for credit losses (ACL).

Examples of assets CECL will apply to are:

• Trade accounts receivable and contract assets recorded as part of ASC 606 Revenue guidance or other income
  • Note: Contract assets aren’t financial assets, but ASC 606 specifically includes them in the scope of applicability of CECL.
• Loans and notes receivable and other financing receivables
• Held-to-maturity debt securities
• Net investment in leases (sales-type or direct financing-type leases)
• Off-balance sheet credit exposure not accounted for as insurance or derivatives (i.e., standby letters of credit, financial guarantees, etc.)
• Exclusions are mostly centered around financial assets measured at fair value through net income, employee loans from benefit plans, operating lease receivables (ASC 842), pledge receivables for not-for-profit entities and transactions between entities under common control

Note that the contractual term of the financial asset includes prepayments, but not any expected extensions, renewals or modifications unless those options are explicitly stated in the contract and not within the lender’s control.

The components and methodologies outlined below are applicable across different types of financial assets; however, we’ve focused on examples related to trade receivables.

Components of CECL

Primary components of allowance for credit losses under CECL include:

The above can be summarized by the following questions:

• What economic factors will affect collections?
• What are the projected values of those factors?
• How do those projected values affect the value of the expected collections?

For example, a general contractor is working on a large project susceptible to storm damage in the current reporting period. Under previous guidance, the allowance might have been based on historical loss experience. However, under CECL, the current and reasonable and supportable forecast conditions might worsen as compared to those included in historical information. Therefore, the allowance for the current reporting period might increase.

Analyzing your receivables for future collectability will require detailed prospective contract performance analysis and making reserves that will affect the cash flow and company cash management process. It can serve to create a useful cash projection and management tool for the business.

Methodology

CECL requires the use of a pooled approach to estimate expected credit losses for all assets with similar risk characteristics. For instance, receivables will be grouped based on similar risk characteristics such as the rating of the customer, aging category, industry subsector, geographical location, etc.

Prior to CECL (under the incurred loss model), historical loss experience and current conditions were the common approach to calculating valuation adjustments. Now, forward-looking is a required part of the valuation method. The significant change is that current accounts receivable may have an expected credit loss calculated for reporting purposes if forecasts of the future conditions indicate a risk.

All of these measurements are meant to be revisited and reevaluated at each reporting period.

Does this mean you must discard the old method of reserving losses based on historical percentages? No. But it does mean that you now must add future expectations to that mix of factors. The determination and quantification of data that is most relevant to the credit risk of your customer base will become critical.

Here are some of the future-driven methods that can be used to assist in CECL calculations:

• Discounted cash flows from the asset
• Loss-rated method
• Roll-rate method
• Probability of default
• Methods that utilize the accounts receivable aging categories

Once calculated, the allowance for credit losses should be deducted from the expected amortized value of the asset, and the asset is reported at the net present value expected to be collected. It’s important to note that any significant changes in the factors used to calculate credit losses must be evaluated in the subsequent period and disclosed if material.

Initial application

A cumulative effect adjustment to retained earnings must be made in the initial application period with some exceptions (debt securities and purchased financial assets with credit deterioration). Disclosures in the year of adoption are also required (see below).

Disclosures

The disclosure requirements in the ASC 326 are designed to enable users of financial statements to understand the credit risk inherent in the portfolio and how management monitors the related credit quality, management’s estimate of expected credit losses and information about the change in the estimate of expected credit losses occurring during the period.

Therefore, in the year of adoption, the following transition disclosures are required:

• Nature of change in accounting policy, including an explanation of newly adopted accounting principles
• Method of applying the change
• Effect of adoption on any line item in the statement of financial position, if material, as of the beginning of the first period when CECL became effective
• Cumulative effect of change on retained earnings or other components of equity in the statement of financial position, as of the beginning of the first period when CECL became effective

Thereafter, CECL requires quantitative and qualitative disclosures for each reporting period as listed below (however, many of the required disclosures don’t apply to trade receivables with an original maturity of one year or less):

• Credit quality indicators information **
• Allowance for credit losses methodology and information management used to develop the ACL
• Past-due status**
• Non-accrual status**
• Purchased financial assets with credit deterioration
• Collateral dependent financial assets
• Off-balance-sheet credit exposures.

**These disclosures don’t apply to trade receivables due in one year or less.

Summing up, applying CECL may seem tedious, but it will prompt a detailed analysis of the creditworthiness of your customer base and economic conditions (current, as well as reasonable and supportable forecasts). CECL will continue to improve and align reporting with actual business operations and decision-making for business owners and investors.

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The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.