Most private companies are adopting the accounting standard for current expected credit loss, which is commonly referred to as CECL, during the calendar year 2023. While this exercise may be daunting for financial institutions, all other entities are not completely escaping the impact of adoption despite a belief held by many non-financial institutions that their accounting will not change. This article explores a roadmap to estimating expected credit losses under the CECL framework and provides a step-by-step guide.
1. Identify In-scope Population of Financial Assets and Determine Portfolios
This first step is to identify the population of financial assets within the scope of the CECL standard and assign each financial asset to a portfolio based on shared risk characteristics, such as risk rating, effective interest rate, type of receivable, size, term, geographic location, vintage or industry. The CECL standard applies to all entities and generally applies to all financial instruments measured at amortized cost, with limited exceptions. Private companies should carefully review the financial assets on their balance sheets, as well as off-balance sheet exposures, to properly identify the population of assets subject to the CECL standard.
For entities other than those considered to be traditional financial institutions, typical financial assets held that may fall within the scope of the CECL standard include (but are not limited to) trade receivables, contract assets, loan and note receivables, held-to-maturity debt securities and net investments in leases. Keep in mind that the definition of a financial asset broadly includes any contract that conveys to one entity a right to (a) receive cash or another financial instrument from a second entity or (b) exchange other financial instruments on potentially favorable terms with the second entity. Having an accurate picture of your in-scope population is critical to ensuring a complete assessment of credit losses at each reporting date.
2. Select the Methodology
Every private company is unique, and the CECL standard does not prescribe a methodology for measuring expected credit losses. The second step involves selecting a methodology that best fits each entity’s individual circumstances. The standard does not require a specific credit loss method, as entities are permitted to use judgment in determining the appropriate estimation method for their circumstances. Common methodologies include discounted cash flow, loss rate, roll rate, probability-of-default (PD), loss-given default (LGD) methods or methods that utilize an aging schedule. The aging schedule method is frequently used for credit losses on trade accounts receivable. Choosing the right methodology for your entity on the front end of the process may result in a more efficient overall process.
3. Determine the Historical Period
Estimating current credit losses involves utilizing historical loss experience. The third step is determining the appropriate historical period on which to base the historical credit loss information. As part of this step, entities also consider whether changes to the customer base, business operations and overall market conditions have occurred over the historical period compared to the current period. Application of the CECL model requires entities to maintain historical loss experience information to be used as a starting point for estimating credit losses. A clear understanding of historical losses is fundamental to estimating future losses.
4. Adjust for Portfolio Differences
No financial asset portfolio remains static over time. The fourth step is to adjust the historical loss information for known differences in the current financial asset portfolio. Adjustments as a result of this fourth step ensure that the resulting estimate reflects the composition of the current portfolio as of the reporting date, both as it relates to the risk characteristics of the portfolio as well as any significant changes to the entity’s credit practices.
5. Consider Economic Factors
Current economic conditions may significantly impact the credit loss estimate. The fifth step involves determining what economic factors impact the financial asset portfolios being evaluated. This includes assessing the current conditions and incorporating reasonable and supportable forecasts. The result is to adjust the historical loss rates to reflect the effects of the differences in current and forecasted economic conditions.
6. Apply the Methodology to Portfolios
With the methodology determined and any necessary adjustments, this sixth step involves applying the selected approach to each financial asset portfolio. This step represents the actual calculation and internal control review process to estimate the expected credit loss for each portfolio.
7. Address Subsequent Events
Judgment is required when evaluating subsequent events, including those that impact credit loss estimates. The seventh step requires entities to regularly monitor for any subsequent events that could affect the credit loss estimate. One important consideration is whether the subsequent information is related to facts that existed at the balance sheet date. Entities must consider all facts about events existing at the balance sheet date and update the estimate of credit losses when the information is received. However, the impact of information received related to forward-looking assumptions is driven by the timing of the entity’s internal estimation process. Entities can include or exclude information received before the completion of their internal estimation process; however, they should not reflect such information if received after the completion of the internal estimation process. Entities should develop an accounting policy regarding the treatment of subsequent events when the information received relates to forecasting assumptions.
8. Prepare Disclosures
The intent of disclosures is to provide users with transparency and insight into the entity’s exposure to credit risk and management’s methodology, inputs and assumptions used to estimate the allowance for credit losses. The last step is to prepare all necessary disclosures related to the credit loss estimates required by portfolio segment or class of financial asset. This includes disclosing the methodologies and key assumptions used in developing the estimate, as well as the sensitivity of the estimates to changes in economic conditions.
Navigating the Roadmap
Estimating credit losses under the CECL model requires careful consideration of the key concepts in the new accounting standard. Furthermore, entities must continually monitor changes to their financial asset portfolios coupled with changing economic conditions. Following these eight steps may assist entities in developing a robust estimation process.
For More Information
If you have any questions about the new CECL standard, please connect with a member of our team.
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