CECL Explained: What You Need to Know

The Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) 326, Financial Instruments-Credit Losses, became effective for all entities on January 1, 2023. This accounting standard introduces the current expected credit losses (CECL) methodology for estimating allowances for credit losses. Since accounting estimates are inherently risky from an audit perspective, auditors will be closely reviewing the implementation of CECL in conjunction with their 2023 attestation engagements.

The CECL model’s main change from current accounting rules is a requirement to incorporate forward-looking information while estimating credit losses. Companies will now be required to forecast the total expected credit losses of their financial assets over the entirety of the asset’s life rather than when the loss meets the probable threshold or when incurred. This forecast is based on a wider scope of data that includes past events, current conditions, and reasonable and supportable estimates for the future. As a result, entities will have to invest more time in reviewing past write-offs, past bad debts, creditworthiness, etc., to calculate a reasonable and fair estimate for future bad debts.

A common approach to estimating future bad debts is to review aging categories for receivables. These aging categories can then be assigned reserve percentages based on delinquency, prior bad debts, knowledge of who owes what, etc. Those values are then combined to determine an entity’s allowance or reserve for bad debts.

When estimating future bad debts for financial assets subject to ASC 326, management should also evaluate and consider consumer credit risk scores, credit ratings, credit risk grades, debt-to-value ratios, collateral, collection experience, or other internal metrics.

The new standard requires enhanced disclosures to provide transparency on credit risk management, methodology, and the impact on financial statements. This enables financial statement users to assess the credit quality of financial assets and understand changes in expected credit losses over time.  Entities must provide two types of disclosures: transition disclosures and recurring annual disclosures. In the initial year of adoption, entities must disclose the nature of the change in accounting principle, including an explanation of the newly adopted accounting principle, the method of applying the change, the effect of the adoption on any line item in the statement of financial position (if material) and the cumulative effect of the change on retained earnings or other components of equity in the statement of financial position.

For each class of financial assets, a reporting entity should describe the credit quality indicator that it is using and then disclose the amortized cost basis of the asset, grouped by indicator. Footnotes on an ongoing basis are required to include:

• • A description of how expected loss estimates are developed.
  • The entity’s accounting policies and methodology to estimate the allowance for credit losses.
  • Factors that influenced management’s current estimate and relevant risk characteristics.
  • Changes in the factors influencing management’s current estimate of expected credit losses and the reasons for those changes.
  • Changes to the entity’s accounting policies and reasons for significant changes in the amount of write-offs, if applicable.

CECL may not have a significant impact on a company’s allowance for credit loss, but it will require management to make new judgments and calculations to comply with the new standard. Entities should also consider updating their policies and procedures to ensure the necessary data is accurately captured. Once implemented, CECL will require ongoing monitoring to ensure that the methods and assumptions used for the initial credit loss calculations continue to reflect current conditions and variables. Forecasting should be a continuous process, and those factors will continue to evolve.

It is also important to consider the impact of CECL when entering into new transactions or relationships, as well as when economic conditions change. CECL could negatively impact liquidity measures and ratios, which could affect lending, bonding and other insurance.

 

Contributing author: Kaitlyn H. Axenfeld, CPA/CFF, CFE, has extensive experience providing audit, review, compilation and advisory services to a wide variety of clients with a focus on the construction, architecture/engineering and manufacturing industries. Kaitlyn specializes in forensic accounting and consulting services, including litigation support to law firms and privately held companies in fraud detection, damage calculations and prevention matters. If you have any questions or need any assistance, please contact Kaitlyn at kaxenfeld@dmcpas.com.