No Material Impact to Disclose with CECL? Prove It!
Public companies are relieved that the implementations of two major accounting standards—revenue recognition (ASC 606) and lease accounting (ASC 842)—are finally behind them. The only major standard remaining is ASU 2016-13, which is effective January 1, 2020 and introduces the current expected credit loss (CECL) model in ASC 326. However, many companies in the manufacturing, consumer products, healthcare, energy and defense industries believe that CECL’s impact on receivables is immaterial since losses have historically been low. While that may be true, companies must still consider how they will prove and document this conclusion.
SEC Staff Accounting Bulletin No. 74 (SAB 74) requires disclosure on the impact of standards issued but not effective and continues to be an area of focus for auditors and the SEC. Despite its importance, auditors may not have flagged the need for this disclosure to companies, requiring management teams to proactively engage auditors to preempt any questions close to filing deadlines. As part of this process, companies should provide an analysis supporting their disclosure that the impact of the expected credit loss standard will be immaterial. As companies work through this analysis, here are some considerations to keep in mind.
Many have found that adopting a historical loss rate approach may result in a lower expected credit loss than other approaches, such as applying loss rates to customers based on a credit rating.
Leverage historical loss data
In a perfect world, public companies will have been gathering and organizing historical loss data ahead of CECL’s January 1, 2020 effective date. In reality, tracking down this data can be a difficult logistical exercise given that detailed information often sits at business units in different geographies, with only summary information available at the corporate headquarters. Management teams may be too short on time to leverage this data in a historical loss approach to support the SAB 74 disclosure.
Although companies may need to take a different approach in the near term to prepare their SAB 74 disclosures for the 2019 10-K, they should continue to press forward with organizing their loss data to measure the allowance in their 2020 Q1 Form 10-Q. Many have found that adopting a historical loss rate approach may result in a lower expected credit loss than other approaches, such as applying loss rates to customers based on a credit rating.
Dive into customer-level detail
Another potential approach that companies might take for evaluating the materiality of the change in their allowance is analyzing customer-level receivables data at the balance sheet date.
For corporate customers, especially those that are large, this approach may involve identifying a Moody’s or S&P credit rating and associated loss rate to apply to receivables. Some companies find this approach difficult because pulling credit ratings for individual customers and calculating associated loss rates is a manual process that often involves paying for data from rating agencies. For the purposes of the SAB 74 disclosure, however, a company with highly-rated customers may find this approach allows them to calculate a rough estimate of an expected credit loss to support the immateriality conclusion.
If companies are able to identify any receivables due from governments or quasi-government agencies, they should consider the applicability of the zero-loss expectation. The zero-loss expectation allows companies to recognize no losses on certain receivables. In practice, this scope exception is applied very narrowly, generally to governments and similar entities when requirements are met. Applying this expedient can save time since it increases the population of receivables assessed by the company for the purposes of a materiality conclusion.
While this likely will not be the optimal process for calculating the expected credit loss on a go-forward basis, using a snapshot of the balance sheet date customer-level detail may be sufficient for the SAB 74 disclosures in the 2019 10-K.
Leverage ASC 606 assessments
Most companies invested significant effort documenting their arrangements with customers during their ASC 606 implementation. Revisiting this documentation can be helpful when it comes to supporting SAB 74 disclosures for CECL.
ASC 606 scoping analyses can provide insight into the definition of a company’s revenue streams. While this information does not correlate directly to the distribution of the collectability of receivables related to these revenue streams, it may give companies a starting point from which they can hone in on the specific types of arrangements or contract terms that may provide helpful information for evaluating credit losses.
Companies may find that certain contracts require the customer to provide a letter of credit, insurance, or financial guarantee to ensure payment is made. ASC 326 refers to these types of items as credit enhancements and may, in certain circumstances, allow companies to consider mitigating effects in the calculation of an expected credit loss.
For example, if a customer is required to provide a letter of credit from a highly rated bank for an amount greater than the balance due on the receivable, this factor is helpful in supporting a qualitative conclusion that the expected credit loss is immaterial. However, for the purposes of measurement in Q1, the company must still calculate an expected credit loss on these receivables that incorporates various attributes of the guarantor.
Furthermore, the company may find that it receives collateral or advances as part of the contract with the customer, which may impact the measurement of the expected credit loss under the new standard. For instance, if the company performs services on a piece of equipment and has a mechanic’s lien on the equipment, this factor might assist in qualitatively supporting a SAB 74 conclusion that the impact of the new standard is immaterial.
While companies are not required to finalize their CECL implementation for their SAB 74 disclosures, auditors and regulators will expect that an assessment supporting the conclusion in the SAB 74 disclosure has been done. By proactively presenting this analysis to its auditors, a company can avoid unnecessary surprises during the year-end audit and get a head start on its first quarter reporting under the new standard.