Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 326, also known as the Current Expected Credit Loss (CECL) standard, represents a significant shift in the accounting treatment of credit losses. Effective for fiscal years beginning after December 15, 2022, for private companies (previously effective for certain public business entities), ASC 326 introduces a forward-looking approach to estimating and reporting credit losses on financial assets reported at amortized cost, including, but not limited to, accounts receivable, contract assets, retainages receivable, held-to-maturity debt securities and net investment in sales-type and direct financing leases held by a lessor. For most private, non-financial institution entities, the primary in-scope financial asset is trade receivables and is the focus in this article.
Key Provisions of ASC 326
ASC 326 replaces the previous “incurred loss” model with an “expected credit loss” (ECL) model. Under the ECL model, entities are required to recognize credit losses based on their expectations of future events, incorporating both historical information and forward-looking factors that may affect collectability.
Entities must estimate credit losses over the entire contractual term of a financial asset. This involves considering various factors, such as historical credit loss experience, current conditions, and reasonable and supportable forecasts. The goal is to provide a more accurate representation of the actual credit losses expected over the life of the financial asset.
Applying This Guidance to Trade Receivables
FASB ASC 326-20-30-10 states “An entity’s estimate of expected credit losses shall 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.” This means if an asset has a 99% chance of full collection and 1% chance of total loss, the expected loss estimate should reflect the 1% chance of a total loss. In other words, the allowance should not solely be based on the most likely outcome if such an outcome ignores potential loss scenarios. An example of this is an entity that has no history (or expectation) of loss for a particular corporate borrower, however, corporate bond default studies show that there is a risk of loss or a probability of default, even for highly rated borrowers. And when the highly rated customer defaults, a loss will generally occur.
FASB ASC 326-20-30-10 continues, “However, an entity is not required to measure expected credit losses on a financial asset (or group of financial assets) in which historical credit loss information adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the amortized cost basis is zero.” Example 8 in the implementation guidance supports this guidance as follows:
[Excerpt from FASB ASC 326-20-55-49-50]: Entity J invests in U.S. Treasury securities with the intent to hold them to collect contractual cash flows to maturity. As a result, Entity J classifies its U.S. Treasury securities as held to maturity and measures the securities on an amortized cost basis.
Although U.S. Treasury securities often receive the highest credit rating by rating agencies at the end of the reporting period, Entity J’s management still believes that there is a possibility of default, even if that risk is remote. However, Entity J considers the guidance in paragraph 326-20-30-10 and concludes that the long history with no credit losses for U.S. Treasury securities (adjusted for current conditions and reasonable and supportable forecasts) indicates an expectation that nonpayment of the amortized cost basis is zero, even if the U.S. government were to technically default. Judgment is required to determine the nature, depth, and extent of the analysis required to evaluate the effect of current conditions and reasonable and supportable forecasts on the historical credit loss information, including qualitative factors. In this circumstance, Entity J notes that U.S. Treasury securities are explicitly fully guaranteed by a sovereign entity that can print its own currency and that the sovereign entity’s currency is routinely held by central banks and other major financial institutions, is used in international commerce, and commonly is viewed as a reserve currency, all of which qualitatively indicate that historical credit loss information should be minimally affected by current conditions and reasonable and supportable forecasts. Therefore, Entity J does not record expected credit losses for its U.S. Treasury securities at the end of the reporting period. The qualitative factors considered by Entity J in this Example are not an all-inclusive list of conditions that must be met in order to apply the guidance in paragraph 326-20-30-10.
Some analyzing this guidance cite factors that are unique to the U.S. Government, which are generally not seen with private trade receivables, including an explicit guarantee and ability to print its own currency. However, FASB ASC 326-20-55-48 indicates “This Example illustrates one way, but not the only way, an entity may estimate expected credit losses when the expectation of nonpayment is zero. This example is not intended to be only applicable to U.S. Treasury securities.” Although, it seems to create a “high bar” for zero expected credit losses. There is no list of other assets that may qualify for zero expected credit losses in the codification. The AICPA Audit and Accounting Guide for Credit Losses (Guide) interprets this example in Chapter 4.151 stating “FinREC believes that the analysis of whether a measure of credit loss is required focuses on an asset’s loss given default. FASB ASC 326 explicitly contemplates the probability that an asset could default, but the lender would not experience a loss in such an event.”
So, can the expected credit loss be zero if an entity has historically experienced zero bad debt expense? Yes, possibly. For an entity to assert that the risk of loss is zero, it will need to have appropriately developed the information required by the standard to prove and support its assessment.
Implications of This New Standard
The implementation of ASC 326 necessitates documentation and data analysis. Entities must gather historical credit loss information, evaluate current economic conditions, and develop reasonable and supportable forecasts. This involves a comprehensive review of customer creditworthiness, payment history, and changes in market conditions. Entities will need to factor in macroeconomic indicators when estimating expected credit losses, including economic conditions, unemployment rates, and other relevant factors that may impact the ability of customers to fulfill their payment obligations.
The shift to the ECL model can lead to earlier recognition of credit losses, especially for accounts receivable with longer payment terms. This may result in increased volatility in reported financial results, as entities are required to consider forward-looking information that may affect the collectability of receivables.
Furthermore, ASC 326 requires continuous monitoring of credit risk factors and periodic adjustments to the estimated credit losses. As economic conditions evolve, entities must update their assessments to reflect the most current information available.
This new standard represents a significant shift in the accounting treatment of credit losses. If you have questions regarding the adoption of the new standards, Selden Fox can help. For additional information call us at 630.954.1400 or click here to contact us. We look forward to connecting with you soon.