New Guidance on Measuring Credit Losses on Financial Instruments

In 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as well as subsequently issued ASUs, to clarify the implementation guidance in ASU 2016-13. Topic 326 applies to all entities in varying degrees and was issued to improve financial reporting by requiring earlier recognition of credit losses on financial assets measured at amortized cost and certain other financial instruments. Additionally, the change is intended to provide clarity and transparency on the collectability of these assets so that users of the financial statements are not left to make their own assessments.

Non-public businesses with fiscal year ends beginning after Dec. 15, 2022, (or interim periods during 2023) should begin preparing for the adoption of Topic 326 by developing policies and procedures, making sure historical data is available and accessible, considering which sources can be used for future projections, reviewing internal controls, selecting an appropriate measuring methodology, and reading the accounting guidance on Topic 326.

CECL Model

Topic 326 requires a financial asset (or group of financial assets) to be assessed for impairment under the current expected credit loss (CECL) model, rather than the previous incurred loss model. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current economic conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount at the reporting date.

Financial assets within the scope of Topic 326 include loan and note receivables, trade receivables and contract assets resulting from revenue transactions, held-to-maturity debt securities, loans to officers and employees, cash equivalents, receivables resulting from sales-type or direct financing leases, loan commitments, standby letters of credit, financial guarantees and other similar instruments. Assets that are not within the scope include loans held for sale, operating lease receivables, financial assets measured at fair value, loans and receivables between entities under common control and most grant receivables.

It’s also important to note available-for-sale (AFS) debt securities are covered under Topic 326, however, they do not follow the expected credit loss model. For AFS debt securities, impairment will be measured when the fair value falls below the amortized cost. The discounted cash flow model must be utilized and applied on an individual asset basis; grouping of similar assets is not permitted.

The standard does not require one specific forecasting model for measuring expected credit losses, however, suggested methods include:

• Discounted cash flows
• Loss rate — collective or individual evaluations
• Roll-rates
• Probability-of-default
• Aging schedule

Topic 326 also requires in-scope assets that share similar risk characteristics to be grouped in “pools” for applying the selected CECL methodology to estimate the lifetime of expected credit losses. If a specific asset does not share similar risk characteristics with the rest of the assets held within the scope of Topic 326, management must separate and measure such asset individually. Management is required to re-evaluate these considerations each reporting period and update pools as necessary based on any changes to the risk profiles. Example risk characteristics include but are not limited to:

• Internal or external credit ratings
• Financial asset type
• Collateral type
• Size
• Term
• Industry of the borrower

  Disclosures include, but may not be limited to, accounting policies and elections, allowance for credit losses, credit quality information, how credit risk is being monitored by management, past-due or delinquency status, nonaccrual status, purchased financial assets with credit deterioration, and key assumptions used to develop estimates.

Implementation

Implementing the new standard may be challenging for various reasons. Some things may not change, such as assessing aging of receivables and history of payment. However, some aspects are new, such as forward-looking estimates and forecasts, considerations including internal and external information, and, of course, additional disclosures. Entities will be required to maintain historical credit loss information on an aggregate basis for financial assets, so data collection will be key.