CECL’s Impact on the Healthcare Industry
CECL will have major implications for healthcare companies, including pharmaceuticals, hospitals, and insurance providers.
The new current expected credit loss model, known as CECL, drastically changes the way healthcare companies record losses on financial instruments such as receivables, reinsurance receivables, available-for-sale securities, sales and financing leases, off-balance sheet credit exposures, and commercial mortgage loans carried at amortized cost. Under the new standard, companies must record an allowance for expected future credit losses over the lifetime of the asset and consider past events, current conditions, and reasonable and supportable forecasts. The estimated credit loss is booked concurrently with recognition of the asset and the credit loss estimate must be updated during each future reporting period.
While CECL will likely have the most significant impact on financial institutions due to their large loan portfolios, the new guidance will have major implications for healthcare companies, including pharmaceuticals, hospitals, and insurance providers. Although many within the healthcare industry are aware that CECL affects trade receivables, understanding the full scope of financial assets impacted is important for companies to prepare for a successful transition to the new standard.
Healthcare companies should begin the scoping process as early as possible and develop an adoption plan to address each class of financial asset. During this process, companies should focus on the following financial assets as they consider the adoption of the new standard.
- Trade receivables: Trade receivables are generally the largest financial asset for healthcare companies and include amounts due from clients, third-party payers, federal government programs, customers, and pharmaceutical manufacturers, and are reported net of allowances for contractual adjustments and doubtful accounts.
- Reinsurance receivables: Reinsurance receivables are amounts due from reinsurers for both paid and unpaid claims of the company’s insurance businesses. These receivables are presented net of allowances for uncollectible reinsurance, which are typically based on the number of days outstanding.
- Sales and Financing Leases: These lease receivables are for buildings including any unguaranteed residual value. Sales and financing leases are accounted for at the present value of future expected payments.
- Future Investment Commitments: These commitments represent future investment obligations in limited and real estate limited partnerships; direct investments in real estate through joint ventures; and future commitments for research and development. These investments are carried at cost plus the company’s ownership percentage of reported income or loss.
- Commercial Mortgage Loans (CMLs): CMLS are mortgage loans held by the company and made to commercial borrowers. The loans are generally secured by high quality commercial properties and made at a discount to the property’s value at loan origination. CMLs are carried at unpaid principal balances and evaluated for impairment annually or on an as needed basis and are typically seen on insurance and hospital companies’ financial statements. Impaired CMLs have been immaterial in recent years.
While it remains to be seen how CECL will affect each entity based on the mix of financial assets, healthcare companies can prepare for the change by leveraging several practical expedients that are available to streamline application of the new standard.
- Collateral maintenance provision: In situations where a borrower is required to continually adjust the amount of collateral securing a financial asset, an entity may compare the difference between the amortized cost basis and fair value of the collateral to record the loss. Companies should consider if their current contracts and collateral processes qualify for this expedient.
- Zero expected credit losses: This practical expedient can be used in cases where historical and current information, in conjunction with reasonable and supportable forecasts, conclude that expectation of non-payment is zero. Companies should consider if they have any investment securities carried at cost that would qualify for this expedient (e.g., US Treasuries) or receivables from the US government or a US government program.
- Collateral-dependent financial assets: If repayment is expected to be provided substantially by the collateral and the borrower is experiencing financial difficulty, an entity’s losses can be based on the fair value of the collateral. Companies should consider applying this expedient to reinsurance receivables and mortgage commercial loans.
After considering all available practical expedients, companies may find that certain financial assets are within scope of CECL but not eligible for a practical expedient (e.g., trade receivables and sales and financing leases). In this case, companies must measure the expected credit loss, if material. If the new standard does not result in a material impact, companies should still analyze and document existing contracts and processes to satisfy requirements from management, auditors, and regulators.
Take action now
Last July, the FASB voted to delay CECL implementation for many companies. Calendar year-end SEC filers—excluding smaller reporting companies— are required to adopt the new standard as of January 2020 while non-public entities have until January 2023 to comply with the changes. For all entities, early adoption is permitted.
Healthcare companies should take advantage of the deferred effective date to understand the potential impact of the new standard to their business and build an effective implementation plan. Companies required to adopt CECL on January 1, 2020, should finalize the loss methodology and estimate the quantitative impact of CECL for disclosure in their year-end financial statements. While there likely will not be drastic changes to the modeling of trade receivables—other than recording an allowance for current receivables—the other financial instruments mentioned above will require extensive effort prior to adoption.