The FASB issued an accounting standard update (ASU 2016-13) on current expected credit losses (CECL) on June 16, 2016. Prior to this update, companies reported credit losses only when it was probable a loss had been incurred.
This “incurred loss method” became a problem during the 2008 financial crisis. Banks weren’t recognizing losses fast enough, as GAAP didn’t allow them to consider future developments. Thus, in spite of a bleak economic outlook, loan loss reserves weren’t being adjusted to account for the future expected losses.
Under the new CECL method, companies must incorporate information from forward-looking forecasts to estimate credit losses over the entire contractual life of the asset. In short, banks and other companies must now forecast future economic conditions and record expected credit losses. We are therefore shifting from an incurred-loss model to an expected-loss model, and this is intended to accelerate the recognition of impairments.
Now this accounting rule doesn’t just apply to banks. It applies to companies holding any of the following financial assets:
• Trade receivables
• Lease receivables from a sales-type or direct-financing lease
• Reinsurance receivables
• Receivables related to repurchase agreements
• Loans held for investment
• Held-to-maturity debt securities carried at amortized cost
• Some off balance sheet credit exposures like loan commitments and financial guarantees
Note that the CECL rules do NOT apply to:
• Loans held for sale
• Trading assets
• Financial assets for which the company has elected the fair value option
• Loans or receivables between entities under common control
So let’s talk about the journal entry that a company would record. If a company expects to have a future credit loss, it would:
• Record credit loss expense
• Record a credit loss allowance. The allowance account is a contra asset; you don’t reduce the asset directly
Credit loss expense 500
Allowance for expected credit losses 500
If circumstances later change and the company doesn’t believe it will have a credit loss, the company can simply reverse the entry. In any case, the balance sheet shows the net amount the company expects to collect. In rare cases, recognizing zero credit losses might be appropriate
So, how should a company measure the allowance?
The FASB didn’t mandate a specific method. Companies could use:
• Discounted cash flow methods
• Probability-of-default methods
• Loss-rate methods
• Roll-rate methods
• An aging schedule
It’s up to each company to develop its own estimation model. If a company has financial assets with similar risk characteristics (asset type, term, credit ratings, geography) it can pool those assets and evaluate them on a collective basis, and if the company ultimately finds that a financial asset is uncollectible, it should write the account off:
Allowance for expected credit losses 500
Financial asset 500
Now if you’re wondering about the international accounting rules:
The IASB adopted a similar credit loss model in 2014 (IFRS 9), so companies outside the U.S. also need to estimate future expected credit losses. However, there are differences between the international rules and U.S. rules, so make sure to refer to IFRS 9 if your company follows IFRS
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