There is a new accounting standard effective during 2023 which will change how companies account for future losses on financial instruments. If this sounds abstract, then you are not alone. The standard was initially developed to change the way that banks account for losses in order to give more clarity to stakeholders into how losses are estimated and to recognize losses when expected no matter how remote. The financial instruments referred to in the standard are any assets that your company or nonprofit expects to receive; this includes trade receivables, contract assets arising from revenue recognition, net investments in leases recognized by lessors, held to maturity debt securities and many others. The only receivables to which this standard does not apply are financial assets measured at fair value through net income, pledges receivable, and certain related party loans and receivables between entities under common control. Accounting Standards Update (“ASU”) 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (CECL) became effective for most private companies and non-profits for years beginning after December 15, 2022.
It will be imperative for every company and nonprofit that holds these assets on its balance sheet to determine the impact of the new standard’s adoption on its financial statements.
The New Standard: Accounting for Expected Losses
The CECL model’s main change from previous accounting rules is a requirement to incorporate forward-looking information in estimates of credit losses, hence the word “expected” in the model’s name. Companies will be required to forecast the total expected losses on their total accounts receivable, even those that are not past due at the reporting date. The forecast is based on historical information, current information, reasonable and supportable forecasts and even external factors.
Financial assets with similar risk characteristics (e.g., all current accounts receivable from domestic entities, all past due accounts receivable from foreign entities, etc.) should be pooled to determine the estimated loss. The CECL does not require a specific methodology for developing a forecast of expected losses, the length of the forecasting period or the amount of precision required. As such, judgment will be applied in estimating the overall expected loss.
Many companies currently use a matrix of percentages to reserve for accounts receivable based on aging categories. While these matrices may still be used under CECL, the percentages used will depend on both historical loss data and reasonable and supportable forecasts of future losses. Because these forecasts should include external factors the bar for not recording any allowance is much higher. Therefore, many companies will be applying a reserve percentage for credit losses on their current receivables for the first time under the new standard.
With the potential changes to systems, processes and controls being driven by the new CECL model, companies should consider adoption challenges sooner rather than later, involving stakeholders and accounting professionals as necessary.
If you have any questions or would like additional information, please contact DMJPS.
Isaac Rowles, CPA
Isaac Rowles is a Partner at DMJPS CPAs + Advisors in Assurance Services. He has extensive experience in assurance and accounting across diverse industries, including hospitality, manufacturing, construction, real estate, and non-profit sectors. He offers a skillful approach to services like consulting, agreed-upon procedure engagements, financial statement audits, reviews, compilations, and targeted assurance and accounting solutions.