Adopting CECL: What Private Companies Should Know
The new credit loss standard, ASC 326 – Current Expected Credit Losses (CECL), took effect for most SEC filers on January 1, 2020. This guidance requires entities to estimate and recognize expected credit losses on their financial assets measured at amortized cost, including certain off-balance sheet exposures.
Because the Financial Accounting Standards Board recognizes that the challenges when adopting a new standard are amplified for private companies, the CECL adoption date for private companies (and smaller reporting companies) was delayed to January 1, 2023. The additional challenges identified by the Board include the availability of resources, as well as the time needed to implement system changes, create business solutions, and improve data gathering and estimation processes. Delaying the adoption date for private companies means that, in addition to having more time to identify resources and refine processes, they have the opportunity to learn from the challenges public companies faced during adoption and start planning now to facilitate a smooth transition.
Management at private companies can start implementing minor adjustments to their processes in the current year so that the adoption process is smoother in 2023.
Public company implementation process and pitfalls
The first step in the implementation process is to identify the population of financial assets in the scope of the guidance. Once this population has been identified, management must determine how best to estimate an expected credit loss. A widely used approach is a historical loss rate methodology, which allows companies to use their own data, adjusted for current market conditions, to develop a loss rate to apply to asset pools.
Using this methodology means that a significant component of implementation is the compilation and analysis of the company’s historical receivables and loss data. Many public companies underestimated the data required for this exercise prior to adoption and, as a result, found themselves underprepared for implementation. Through the information gathering process, management teams have realized that historical data was not always organized in a consistent and sufficiently detailed format that was ready for analysis. In many cases, this lack of organization resulted in a significant time commitment to transition the data into a more usable format.
Two common pitfalls public companies experienced during the information gathering and analysis process were a) the inability to readily identify financial assets within the “other” or “miscellaneous” captions on the balance sheet to easily assess the underlying assets and b) the lack of organization of historical receivable balances, including identifiers that associate write-off amounts to a customer or pool of assets in prior periods.
Identification of financial assets and scoping
Identifying in-scope financial assets measured at amortized cost is an integral first step in calculating an expected credit loss, as this provides the population of financial assets impacted by the new guidance.
Management teams have faced difficulty documenting the composition of the “other” financial statement captions (e.g., other assets, other investments) because they are often catch-all captions for one-off transactions and other smaller items. level, which can become more cumbersome and time consuming than expected.
The additional time that public companies spent disaggregating and identifying underlying assets often led to less time to perform thorough analyses of whether these assets were in scope of CECL.
Organization of historical receivables and loss data
Another common pitfall for public companies occurred when compiling historical loss information to calculate loss rates for prior periods. To calculate historical loss rates in prior years, assets are first grouped into pools based on common risk characteristics. A loss rate is then calculated for each asset pool. Companies can then apply an average historical rate to the pools of assets that exist at the effective date.
Obtaining historical data, primarily trade receivable and write-off data, by customer, revenue stream, and/or identified asset pool is difficult, especially when it needs to be organized in a consistent and detailed format over each of the periods utilized in the calculation. Since many companies go back three years to develop historical loss rates, this analysis may involve a significant amount of data.
If the underlying detail is not organized consistently by customer or asset pool, a review of customer listings over each of the three years within the period may be required in order to group customers into pools. Matching details within the bad debt expense account to the respective customers may also be required to group this information by pool.
Steps companies can take now
Management at private companies (and smaller reporting companies) can start implementing minor adjustments to their processes in the current year so that the adoption process is smoother in 2023.
For the financial asset scoping process, these adjustments can be made by creating a detailed schedule to identify the various assets and transaction-related balances that are included in the “other” or “miscellaneous” accounts and compiling the supporting detail in a central location.
For historical activity, management can perform a baseline analysis of current activity, including determining tentative asset pools and grouping customers into those pools. Maintaining this analysis and detailing the bad debt expense transactions in a way that they can be readily mapped to the associated customer will allow the company to begin developing and, in future periods up until adoption, refining a loss rate by pool of assets. Management will then be able to merely book the loss rate upon transition, relieving the pressure felt and saving additional time during the adoption year.