With the issuance of significant new accounting standards such as ASC 606 (Revenue Recognition) and ASC 842 (Leases) having taken the forefront in recent years, companies now face another potentially significant change to the accounting standards that may have been flying under the radar. Accounting Standards Update 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments became effective for most non-public companies as of January 1, 2023. With the end of the year quickly approaching, there are several things companies should be doing now to comply with the new standard.
What is ASU 2016-13?
Also referred to as the Current Expected Credit Losses (CECL) standard, ASU 2016-13 requires a shift in the model of how entities account for the impairment of financial instruments, with the end goal being the recognition of expected credit losses earlier in the credit lifecycle. The standard impacts a broad number of accounts. Below are some common examples of accounts that are within the scope, as well as outside of the scope, of ASU 2016-13:
|In Scope||Out of Scope|
How Does ASU 2016-13 Differ from Previous Guidance?
Timing of Recognition
Under previous GAAP guidance, companies measured losses related to credit risk on the “incurred loss” method, meaning losses were recognized only when they had been incurred and were probable. For example, many companies waited to establish a reserve for doubtful accounts for a particular customer until the amounts owed had significantly aged out. The CECL standard intends to present a more complete and earlier view of a company’s prospects for collection (net realizable value). It requires management’s judgment to estimate lifetime expected losses on these instruments on Day 1 rather than waiting until it’s probable a loss has occurred.
Data and Modeling
In the past, companies would rely on historical data, loss events and current conditions, to develop an estimate of credit loss exposure. Under the CECL standard, companies must now layer in forward-looking information to develop reasonable and supportable forecasts to estimate credit loss exposure. Companies can build forecasts from internal data, external data or a combination of both. Depending on their individual facts and circumstances, they can incorporate several different data points, such as overall market conditions for their industry, macro/micro economic factors, internal credit policies and procedures, etc.
While this new requirement may seem daunting to many private companies, it’s important to note that the guidance does not prescribe a “one-size-fits-all” approach. Significant flexibility and room for management judgment are allowed in applying the guidance. Further, if companies cannot reliably forecast future economic conditions, they may revert to historical information in developing their reserves for credit losses.
Evaluation of Risk Characteristics
The CECL standard requires similar risk characteristics to be evaluated concurrently for each financial asset. For example, if the company has historically had difficulty collecting from customers in the southwest or this region is experiencing a much higher unemployment rate than other areas of the country, a higher loss rate may be applied to this segment for the current year. The standard provides extensive guidance for companies in assessing risk pools. Examples of risk characteristics in the CECL impairment model include:
- Geographic location
- Credit score
- Risk ratings
- Financial asset type
- Collateral type
- Effective interest rate
- Credit term
Companies must reassess these risk characteristics at each reporting period and account for any changes in scoping or pooling when applying the impairment model.
If you have any questions about implementing or maintaining compliance with ASU 2016-13 for your company, the Business Assurance experts at Moore Colson are here to help. Contact us for more information.