Accounting Standards Update 2016-13, Financial Instruments—Credit Losses: Measurement of Credit Losses on Financial Instruments (CECL) has been in effect for most organizations for several months now, but you may not know it. Organizations with calendar year ends will have the standard implemented for their 2023 audit. In this article we’ll focus on the impact the standard has on receivables and discuss a practical step your organization can take now to prepare for the impact that CECL will have on your organization and its audit.
Receivables impacted by the new CECL standard will include financing receivables and receivables from exchange transactions. An example of financing receivables includes, but is not limited to, loaning money to local small businesses, and examples of receivables from exchange transactions include, but are not limited to, tuition receivables, patient receivables, and customer receivables. Unconditional promises to give or pledge receivables are not included in the scope of the new standard.
If your organization has financing receivables or receivables from exchange transactions, Hawkins Ash recommends that you establish a policy that includes (1) what method of estimated credit loss will be used (2) what risk characteristics will define receivable pools.
Methods for Estimated Credit Loss
If your organization already has an Allowance for Doubtful Accounts or Allowance for Doubtful Loans account, the Estimated Credit Loss (ECL) will replace this account under the new standard. CECL does not dictate what method must be used to determine ECL, so your organization can choose a method that best suits the type(s) of receivables that you have. Below are a couple of examples to choose from:
- Aging Schedule: ECL is based on the percentage of collections expected in each category of the aging schedule
- Loss Rate: ECL is calculated using a loss rate (ex: historically, organization bad debt expense is 3% of related revenue) and multiplying the loss rate by the asset’s amortized cost (carrying amount) as of the balance sheet date
- Roll Rate: ECL is calculated by the percentage of receivables that move from one category of delinquency to the next (ex: percentage moving from 30 days past due to 60 days past due)
- Discounted cash flow method: ECL is the difference between the asset’s amortized cost (carrying amount) the present value of future cash flows (time value of money)
Pooling of Financial Assets
CECL requires that ECL is measured on a pooled basis when similar risk characteristics between the various individual receivables exist. Again, CECL does not dictate which characteristics should determine how your receivables should be pooled, so you can choose a method that best suits the type(s) of receivables that you have. Below are a couple of examples:
- Credit score or risk rating
- Receivable term
- Financial asset type (trade receivable vs convertible loan vs forgivable loan vs etc.)
- Customer type (government vs individual vs business)
If you have any questions regarding CECL or would like to discuss how the standard will impact your organization, please reach out to your Hawkins Ash representative.