CECL’s Impact on Short-Term Receivables
While financial institutions have been preparing to adopt the new credit loss guidance (CECL) for years, non-financial institutions have focused on the adoption of other significant accounting changes, such as the new revenue and leasing standards. These non-financial companies, however, may not realize the impact that CECL will have on their balance sheets, specifically trade receivables. Issued in 2016, CECL is a response to concerns that arose following the 2008 financial crisis that losses were recognized too late for investors to react in a timely manner. In contrast to the historical approach of recognizing losses as incurred, the CECL guidance requires an estimate of expected lifetime credit losses when the financial asset is initially recognized. Given that most, if not all, non-financial entities carry short-term receivables on their balance sheet, the new guidance will have far-reaching implications for businesses regardless of industry.
For public businesses, CECL will take effect for annual periods beginning after December 15, 2019. For all other entities, the effective date has been extended to annual periods beginning after December 15, 2022.
Many entities currently record a reserve against trade receivables; however, CECL introduces some key changes for how that reserve must be estimated. Here are some key ways that measuring reserves under CECL will change and how companies can prepare for the transition.
Grouping assets by similar risk characteristics is required
When evaluating whether collection risk exists for trade receivables, previous guidance did not address the level at which an entity should develop a methodology to assess the adequacy of the allowance. Under the new CECL guidance, however, entities must group financial assets based on similar risk characteristics. Example risk characteristics for grouping trade receivables include geography, customer type, aging, segment, and service line. The more refined the grouping—such as the joint use of aging, customer type, and geography—the better able an entity will be to develop models for estimating losses and gathering historical data. Companies should not immediately default to historical groupings, as they may not reflect the portfolio’s current risk profile. Additionally, experimenting with alternative groupings may be helpful when evaluating a company’s new process under CECL.
Data must be assessed early
The new standard uses historical losses as the starting point to estimate expected credit losses over the lifetime of the asset. As a result, companies will be required to determine the historical losses that relate to their grouping of assets and to factor forward-looking data into their measurement process. To align with these requirements, entities should keep in mind the availability of data based on the risk characteristics used when gathering data. If a company wants to use three or four risk characteristics when grouping its trade receivables, management must have sufficiently granular data (both historical and forecasted) to align with those risk characteristics.
All receivables must be considered
The new guidance is clear that all receivables must be evaluated for a reserve, including current receivables. This guidance may result in a significant shift for entities using the common practice of basing their reserve on the aging of receivables, resulting in no reserve on amounts aged less than 30 days. This change could yield a material increase in reserve amounts if entities continue to use aging as a risk characteristic.
Another item to be aware of relates to credit enhancements, such as letters of credit. In some cases, entities have required customers to provide credit enhancements related to their receivables. Today, very few entities reserve against receivables with credit enhancements. The new guidance, however, will require such receivables to be considered for a reserve because generally some risk exists that the third party cannot cover receivables not paid by the customer.
Additional disclosures are required
Companies will need to provide additional disclosures to help financial statement users understand how the entity is evaluating credit losses. Disclosing how asset groupings were determined, how the company is measuring credit losses and why the approach makes sense will be the minimum requirements for disclosure. For entities with only trade receivables, disclosures will need to include how the determination of the estimate of credit losses compares to previous guidance. Similar to other standard changes, entities will also need to disclose how they assessed the new standard and its effect on their financial statements and related processes.
For public businesses, CECL will take effect for annual periods beginning after December 15, 2019. For all other entities, the effective date has been extended to annual periods beginning after December 15, 2022. Entities should be aware that CECL affects trade receivables and will therefore have an impact on a broad range of entities across different industries. Companies should assess their existing processes for recording reserves against trade receivables to determine whether they are in compliance with CECL ahead of the effective date.