CECL standard considerations for nonbanking companies

Sean C. Prince, Jeffrey Schaeffer, Mandi Simpson

Now that the deadline for CECL standard implementation is upon us, let’s consider some of the most frequently asked questions by nonbanking entities.

What is CECL?

Current expected credit losses (CECL) refers to the Financial Accounting Standards Board (FASB) credit impairment standard, Accounting Standards Update (ASU) 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The CECL standard addresses how to account for credit impairment on certain financial assets, such as loans, certain debt securities, and trade receivables.

Doesn’t the CECL standard apply only to banking institutions?

No. CECL guidance applies to all entities. While the CECL standard is expected to have the greatest impact on banks (which typically have extensive financial instrument portfolios), even nonbanking entities are likely to hold financial instruments within the scope of CECL.

What types of instruments are within the scope of the CECL standard?

The CECL standard applies to all entities and generally applies to all financial instruments measured at amortized cost, with a few exceptions. For nonbanking entities, typical items that might fall within the scope of CECL include:

Instrument type	CECL impact(s)
Trade receivables – receivables and contract assets recognized under Topic 606, “Revenue From Contracts With Customers”	While generally short term in nature, receivables and contract assets are still subject to CECL when estimating an entity’s allowance for bad debt expense.
Loans and loan commitments – for example, loans provided to officers, employees, or customers that are accounted for under Topic 310, “Receivables,” or other than unconditionally cancelable loan commitments	When an entity recognizes a loan at amortized cost, the loan will be subject to CECL. Similarly, expected losses arising from off-balance sheet loan commitments that are not unconditionally cancelable are to be measured using CECL and recognized as a liability.
Reinsurance receivables – for example, a receivable recognized by an insurer or a captive insurance entity for amounts recoverable under a reinsurance agreement	While these receivables generally result from insurance transactions within the scope of Topic 944, “Financial Services – Insurance,” entities outside the insurance industry (for example, a commercial entity that offers insurance through a captive insurance entity) also might have these receivables.
Available-for-sale (AFS) debt securities – for example, government or corporate debt securities classified by an entity as AFS	While AFS debt securities are not subject to the expected credit loss model, CECL did slightly amend the impairment model for AFS debt securities (see discussion later).
Held-to-maturity (HTM) debt securities – for example, government or corporate debt securities classified by an entity as HTM	Because these items are carried at amortized cost, they will be subject to CECL.
Net investment in sales-type, direct-financing, and leveraged leases – for example, any receivable arising from an entity’s lessor-related activities other than under an operating lease	CECL will require entities to recognize an allowance for credit losses on net investments in sales-type, direct-financing, and leveraged leases accounted for under Topic 842, “Leases.”
Financial guarantees (other than those that are accounted for as insurance or as a derivative) – for example, an entity’s guarantee of a nonconsolidated entity’s debt	While the financial guarantee still will be subject to Topic 460, “Guarantees,” entities also will be required to apply CECL to estimate the expected credit losses arising from the guarantee.
Other	CECL also will apply to items such as store credit card receivables, insurance settlements, tax refunds, and more.

How might the CECL standard affect nonbanking entities?

The following table summarizes some of the key changes resulting from CECL that likely will affect nonbanking entities:

Key change	Potential impact
Replacement of the “probable incurred loss” concept with “expected losses”	Under CECL, an entity no longer waits for the occurrence of a triggering event (for example, notification of a customer’s financial difficulty) before recognizing an allowance for credit losses. Rather, an entity will recognize an allowance for expected lifetime losses upon initial recognition of the asset. This will result in entities recognizing credit losses earlier under CECL as compared to current practice.
Expansion of information set used to measure credit losses	Under CECL, an entity must consider not only historical loss information and current conditions when estimating its allowance but also reasonable and supportable forecasts about future conditions. That is, CECL requires a more forward-looking estimate as compared to current practice, which generally has focused primarily on historical loss information and current conditions. This likely will require changes to an entity’s process and surrounding controls for estimating credit losses as historical loss information, and current conditions will need to be compared against reasonable and supportable forecasts about future conditions (for example, expected changes in unemployment rates).
Requirement to reflect risk of loss in estimate, even if remote	Under CECL, an entity’s estimate of expected credit losses must reflect the risk of credit loss, even when that risk is deemed remote. While CECL does acknowledge that there may be circumstances in which the potential for default exists but expected loss is zero (for example, U.S. Treasury securities¹), it is expected to be uncommon for other types of instruments.
Revisions to the impairment model for AFS debt securities	Under CECL, the expected credit loss model applies only to financial instruments measured at amortized cost. However, CECL also amends the existing impairment model for AFS debt securities, including in the following ways: Prohibits entities from considering the length of time a security has been in a loss position when determining whether a credit loss exists Prohibits entities from considering subsequent recoveries or declines in fair value after the balance sheet date when estimating credit losses Requires credit losses (and recoveries) to be recognized through an allowance against the security’s carrying amount (versus as a direct reduction against the carrying amount)
Incremental disclosure requirements	CECL requires extensive disclosure about an entity’s estimate of expected credit losses, including information about the entity’s estimation methodology, relevant risk factors, and changes in significant inputs. CECL also requires a quantitative rollforward of an entity’s allowance for credit losses and, for most financing receivables, disclosure of credit quality indicators.² Depending on the nature and amount of items an entity has within the scope of CECL, the entity might need to implement new processes and controls to gather and summarize the information required under the new disclosures.

What is an example of how the CECL standard might affect the accounting for trade receivables?

The following example highlights how CECL might affect an entity’s current practice of estimating an allowance for bad debt for trade receivables.

Facts
At year-end, Widget Co. has on its balance sheet trade receivables with a gross carrying amount of $50 million. The aging schedule for the outstanding receivables as of year-end is as follows:

Current balance	31-60 days outstanding	61-90 days outstanding	91-120 days outstanding	121+ days outstanding
$37 million	$9.5 million	$2.7 million	$0.5 million	$0.3 million

Historically, Widget Co. has estimated its allowance for bad debts by applying historical loss rates to each aging category. Using 12 months of historical credit sales and collections data, Widget Co. has calculated historical loss rates for each aging category as follows:

Current balance	31-60 days outstanding	61-90 days outstanding	91-120 days outstanding	121+ days outstanding
0%	3%	7%	23%	100%

Based on these rates, under a probable incurred loss model, Widget Co. would recognize an allowance for bad debt expense equal to $0.89 million.

However, under CECL, the historical loss rate must account for reasonable and supportable forecasts of future losses. For example, assume that during the most recent quarter, unemployment rates have increased, and it is expected that unemployment rates will increase even further over the next 12 months. In addition, under CECL, the allowance should reflect the risk of loss – including for current or not yet due receivables – even if the risk of loss is remote.

Based on the changes in unemployment rates and the future expected changes, as well as the need to incorporate the risk of loss in its estimation, Widget Co. believes its historical loss rate for each aging category will need to be adjusted upward, consistent with the historical impact that increases in the unemployment rate have had on Widget’s allowance. As a result, Widget Co. would adjust its estimate of its allowance for bad debt expense to reflect the expected impact of the change in unemployment rate as follows:

	Current balance	31-60 days outstanding	61-90 days outstanding	91-120 days outstanding	121+ days outstanding
$ amount	$35 million	$9.5 million	$2.7 million	$0.5 million	$0.3 million
Historical loss rate	0%	3%	7%	23%	100%
Loss rate adjusted for future conditions	1.15%	3.36%	8.05%	27.60%	100%
Adjusted allowance	$0.43 million	$0.32 million	$0.22 million	$0.14 million	$0.30 million

As the preceding example demonstrates, CECL requires an entity to incorporate reasonable and supportable forecasts of future conditions in its reserving process. CECL also requires entities to record an allowance against current or not yet past due receivables if an entity estimates expected credit losses. For example, under Topic 606, an entity may conclude – based on its typical credit check procedures – that collection is probable from each individual customer contract and, therefore, recognize revenue and a trade receivable for the entire contract price. However, the entity’s historical experience with a portfolio of customer contracts might indicate that, on average, the entity will collect only 97% of the amounts invoiced.

In such circumstances, even though the entity records revenue at the full contract amount (under Topic 606), the entity most likely will need to record an allowance for bad debt against the receivable to reflect the risk of loss, even if that risk is remote.

How should nonbanking entities prepare for CECL standard implementation?

First, the entity should establish an inventory of all its assets that fall in scope of CECL. Next, depending on the materiality of assets affected by CECL, it should determine how the new accounting guidance differs from prior GAAP. It should then identify how those key differences will affect its existing policies, processes, and controls. Parties from across the organization should be involved to best ensure all perspectives are considered.

¹ ASC 326-20-55-48 indicates that a U.S. Treasury security is not the only instrument for which an entity may estimate a potential default of greater than zero but an estimated nonpayment of zero. However, this outcome is expected to be uncommon.

² ASC 326-10-50-9 exempts entities from having to provide information about credit quality indicators for trade receivables due in one year or less (except for credit card receivables).