By Janell Wilson, CPA – Partner
In 2016, the FASB issued Accounting Standards Update (ASU) 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. Several amendments were subsequently issued, and the effective dates were delayed. The time has now come for private companies to follow Accounting Standards Codification 326 (Standard). If you have accounts receivable, this Standard applies to you.
What is the Standard and who may be impacted?
In general, the Standard changes how companies measure credit losses of financial assets, the most common of which is the allowance for doubtful accounts. It applies to all financial assets measured at amortized cost, impacting both financial and non-financial institutions. Privately-held non-financial institutions with receivables, contract assets, financing receivables, held-to-maturity debt securities, or certain lessor leasing arrangements may be impacted. If your company issues financial statements prepared in accordance with U.S. generally accepted accounting principles and has any of these financial assets, the Standard will apply.
How might the Standard impact my company?
Under previous rules, the incurred loss methodology was used by companies to determine an allowance for doubtful accounts. Companies generally recorded an allowance for a receivable when collectability was uncertain based on historical loss experience and current economic conditions. Under the new Standard, the current expected credit loss (CECL) model is used for estimating an allowance for credit losses. This means that an allowance should be set up when the receivable is initially recorded, even if the probability of loss is remote, and the evaluation should include forecasts of future conditions. Most companies will need to increase their accounts receivable allowance due to the new Standard.
Under the CECL model, the allowance for credit losses may be determined using various methods, for example, the discounted cash flow method, loss-rate method, roll-rate method, probability-of-default method, or methods that utilize an aging schedule. Company management must develop an estimate of expected credit losses by considering available information relevant to assessing the collectability of cash flows. This information may include internal information, external information, or a combination of both, relating to past events, current conditions, and reasonable and supportable forecasts. Management is to consider relevant qualitative and quantitative factors that relate to the environment in which the company operates.
Historical credit loss experience generally provides a basis for a company’s assessment of expected credit losses. However, companies must also consider the need to adjust historical information to reflect the extent to which management expects current conditions and reasonable and supportable forecasts to differ from historical conditions.
A company’s estimate of expected credit losses shall be measured on a collective (pool) basis. This requires companies to aggregate accounts receivable based on similar risk characteristics, such as vintage, industry, term credit rating, or other characteristics. The estimate must include a measure of the expected risk of credit loss even if that risk is remote, regardless of the method applied to estimate credit losses.
How might the Standard impact my company’s financial statements?
What was previously called “allowance for doubtful accounts” or “allowance for bad debts” is now referred to as “allowance for credit losses” on the balance sheet. What was previously called “bad debt expense” is now referred to as “credit loss expense” in the income statement. The financial statements now must present the allowance for credit losses on the face of the balance sheet. Write-offs of uncollectible accounts are to be deducted from the allowance and the activity in the allowance for credit losses is to be disclosed in the notes to the financial statements.
The financial statement disclosures for the allowance for credit losses must enable financial statement users to understand:
- Management’s method for developing its allowance
- The information that management used in developing its current estimate of expected credit losses
- The circumstances that caused changes to the allowance, thereby affecting the related credit loss expense
The disclosures required to meet the above objectives include descriptions of how expected loss estimates are developed, a description of the accounting policy and methodology used to estimate the allowance, and a discussion of the factors that influenced management’s estimates, including past events, current conditions, and reasonable and supportable forecasts about the future. Additionally, disclosures of risk characteristics and details of changes in factors, policies, and methodologies must be disclosed.
What is the effective date?
For privately held companies, the Standard is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. For calendar year 2023 financial statements, management must calculate the allowance for credit losses as of both December 31, 2023, and 2022, using the CECL model.
What approach should my company use?
The Standard does not require that a specific approach be followed in estimating expected credit losses, as there are many alternatives as noted above. Estimating expected credit losses is highly judgmental and will require management to develop estimation techniques applied consistently over time. Those techniques should faithfully estimate the collectability of financial assets and should be practical and relevant to the circumstance. Details of the methodology used, the estimation techniques followed, and the assumptions made should be well-documented by management.
If you would like more information and guidance on implementing Accounting Standards Codification 326, please contact your MichaelSilver advisors at 847.982.0333.