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How Does the New CECL Model Affect Your Financial Statements?

How Does the New CECL Model Affect Your Financial Statements?

Service Businesses  |  Healthcare  |  Manufacturing & Distribution  |  Government Contractors  |  Construction & Real Estate

Non-public entities will need to adopt the new Current Expected Credit Loss (CECL) model starting with 2023 calendar year-end financial statements. What does this mean for your company and your financial statements?

For context, CECL is a financial accounting standard that was introduced by the Financial Accounting Standards Board (FASB) several years ago. The standard, already in effect for public companies, introduces the current expected credit losses methodology for estimating allowances for credit losses.

While this requirement may not change the numbers on your financial statements, it does require additional scrutiny for certain types of assets. The new CECL model will also require additional informational disclosures for your financial statements.

As you are closing out 2023, you should ensure you are taking the proper steps in evaluating your financial assets.

You will hear two key terms throughout the discussion of CECL:

1. “Financial Asset”

Although several things fall into this category, we will look at enforceable transactions, which allow an asset to be recorded on one entity’s books and a liability to be recorded on another entity’s books.

2. “Credit Risk” or “Credit Loss”

The concept of credit risk is the same as the allowance we have historically used for receivables, which is accounting for the likelihood that you may not get paid the full value of your financial asset.

Which Financial Assets Are Affected?

Assets common in all manufacturing companies and for-profit companies in general, such as trade receivables, unbilled receivables and note receivables, fall into this category. The new model relates to the evaluation of the allowance for credit losses. Companies will also need to evaluate off-balance sheet items such as commitments and financial guarantees. Investments held to maturity and net investment in leases are less commonly found in manufacturers but are also included.

Change in Valuation

Whether you evaluate your receivable allowance for credit losses on the discounted cash flow method or the aging schedule method, both, or any of the commonly used methods, you are headed in the right direction for the implementation of the CECL model. The intended goal is not to require companies to follow a specific methodology. The goal is to change the inputs that are used in the elected methodology.

Generally speaking, each financial asset should be evaluated individually unless they share similar credit risk characteristics. So, the first step to make this process more manageable is pooling your receivables into groups with similar risk exposures. This will look different for each company but could include product types, customer geography or size, or contract terms. Like many things, not every receivable is created equal, and the volatility of your receivables could take many shapes. Pooling will allow segregation of more risky receivables in the evaluation process.

The second big change is to include the need to look at current and future conditions and make a judgement as to how they will affect the risk of those pooled groups. Management is now tasked with identifying qualitative and/or quantitative linkages between external or internal factors and their effects on financial assets. These factors should be limited to specific pooled groups and relevant industry environments. Since no one knows what the future holds, management only needs to consider reasonably supportable forecasts for future projections.

Relief to These New Requirements

There is some relief to these requirements. If you are thinking to yourself “there are endless avenues that may need to be followed to implement this,” you are not alone. With that in mind, management can evaluate the cost-benefit of going down various avenues. You are allowed to use professional judgement and are only required to use reasonably available information without expending undue cost and effort.

If through management’s efforts no linkages are established, the company may revert to their historical information in determination of an allowance for credit losses. If after all the effort you have gone through there have been changes to the forecasts used, you will not have to go back and re-evaluate those assets. Any significant changes between the end of the year and the date of your financial statements will be included in the financial statement as a subsequent event disclosure.

Changes to Your Financial Statements

Outside of any possible change to your allowance calculation, the first obvious change to your financial statements will be the verbiage. Allowance for doubtful accounts will be replaced with allowance for credit losses. Bad debt expense will be replaced with credit loss expense.

The second change to the financial statements will be the additional disclosure information. Management’s methodology and evaluation techniques will need to be disclosed. This includes the information identified in coming up with the allowance for credit losses, how accounts were pooled and the inherent risks of the financial assets. Management will have to detail their procedures for monitoring credit losses.

Finally, the disclosure will need to discuss what effects, if any, the new CECL model had on the allowance for credit losses after adoption.

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Published on February 02, 2024