Are we there yet?
In recent months, not-for-profits (NFPs) have been hit especially hard with “the big 3” standards: the new NFP financial reporting model, revenue recognition, and grants and contracts. Understanding and implementing these standards has taken up our most precious resource: time. But alas, we can reallocate that time and focus on our missions and other important projects that may have been “on hold” while implementation efforts were at an all-time high. Today, after tackling the big 3, we feel relieved that the new credit impairment standard, ASU 2016-13: Financial Instruments — Credit Losses (Topic 326), is seemingly specific to financial institutions … or is it?
Most of us don’t even look up when we hear someone speak of “credit losses” and “CECL.” Those are terms from a standard that is simply not applicable to our organizations. Right? Not exactly. While the new current expected credit loss (CECL) model will indeed impact financial institutions more heavily, NFPs are within the scope of the ASU. Trade and financing receivables, including program-related investments, are two financial instruments common to NFPs that will be affected by the new model.
First, let’s talk current status.
Under current GAAP, most organizations follow the incurred loss methodology, which is largely based on historical losses. That is, a loss is recognized only after a loss event has occurred or is probable. In other words, we book an allowance for doubtful accounts in anticipation of future losses, based past experience.
So, what’s changing?
ASU 2016-13 replaces the incurred loss model with the CECL model, which requires entities to estimate credit losses expected over the contractual life of a financial asset. Although measurement under the new methodology is based on relevant information about past events, including historical experience, now management also must consider current conditions and a broader range of reasonable and supportable information to make credit loss estimates for certain financial assets. Credit loss estimates under the new guidance will require significant judgment. Yes, you’ll need your crystal ball.
But seriously, how do I estimate?
The CECL model doesn’t specify the methodology for estimating, but rather allows management to select the most appropriate approach for the organization and the nature of the entity’s financial assets. Some methods for estimating expected credit losses include the following:
- Probability of Default/Loss Given Default Method
- Vintage Analysis Method
- Discounted Cash Flow Method
- Loss Rate Method
Under CECL, credit impairment is recognized as an allowance for credit losses, rather than as a direct write-down of the financial asset. The new guidance provides no threshold for recognition of an impairment allowance. Therefore, entities must also measure expected credit losses on assets that have a low risk of loss. This is a notable change, as trade receivables that are either current or not yet due (which may not require an allowance reserve under current GAAP) will have an allowance for expected credit losses under ASU 2016-13. Read: more of that most precious resource.
So, for now?
We do get a little breather because the new credit impairment standard will not be effective for most NFPs until fiscal years beginning after December 15, 2021. Early adoption is permitted.