Navigating Change: ASU 2016-13 Financial Instruments—Credit Losses
In 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13 Financial Instruments—Credit Losses. ASU 2016-13, also known as the Current Expected Credit Loss (CECL) model, replaces the existing incurred loss model with a more proactive methodology. The CECL standard is effective for private companies (and smaller reporting companies) for fiscal years beginning after December 15, 2022. While the adoption date was the beginning of 2023, many private companies put off adoption until their year-end close process. Private companies have the advantage of learning from the challenges that public companies (that are not smaller reporting companies) faced upon adoption since this standard was effective for public companies for fiscal years beginning after December 15, 2019.
Is this Change in Accounting Applicable to You?
Entities in most industries are expected to be impacted by this change in accounting. All organizations that have financial instruments or net investments in leases that aren’t accounted for at fair value through net income are impacted by this standard. Common examples of financial instruments that are within the scope of the CECL standard include (but are not limited to):
- Trade receivables, that result from ASC 606 revenue transactions
- Contract receivables
- Loan receivables
- Financial guarantees
- Reinsurance recoverables
- Held-to-maturity debt securities
- Loan commitments
- Lease receivables
Understanding ASU 2016-13
Traditionally, entities recognized credit losses only when evidence of a loss event emerged. The CECL model, however, requires organizations to consider historical information, current conditions, and reasonable forecasts to estimate expected credit losses over the contractual life of a financial instrument.
Key Changes and Implications
- Forward-Looking Perspective: ASU 2016-13 challenges businesses to adopt a forward-looking perspective. By incorporating reasonable and supportable forecasts, entities can better anticipate potential credit losses, allowing for more timely and accurate financial reporting.
- Broader Scope: The new standard expands its scope to include not only loans but also debt securities, trade receivables, and other financial instruments. This comprehensive approach ensures a more holistic view of an organization's credit risk exposure.
- Increased Documentation and Disclosures: ASU 2016-13 places a greater emphasis on documentation and disclosures. Companies are now required to provide more detailed information about the methods and assumptions used in estimating credit losses, offering stakeholders a clearer understanding of the decision-making process.
Implementation Assistance and Considerations
While ASU 2016-13 aims to enhance the quality and relevance of financial information, its implementation comes with challenges. Additionally, the transition may impact financial ratios and loan loss reserves, potentially influencing capital adequacy considerations.
Practical Steps for Implementation:
- Identification of Financial Instruments: Identify and assess the significance of in-scope financial assets. Specific attention may need to be given to financial statement line items that are often catch-all captions like “other assets”.
- Model Selection and Calibration: Choose an appropriate model for estimating credit losses and calibrate it to reflect the organization's historical experience and future expectations.
- Organization of Historical Information: Obtain and organize historical data, primarily data related to trade receivables and write-offs, in a readily accessible format. The extent of this analysis may vary depending on how many years of data the organization deems is appropriate to develop historical loss rates.
- Documentation and Disclosure: Develop robust documentation processes to support the estimation of credit losses and enhance disclosures to comply with the increased transparency requirements.
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