By Neena Shukla, CPA, CFE, CGMA, FCPA, CTP

The introduction of the Current Expected Credit Loss (CECL) model by the Financial Accounting Standards Board (FASB) in 2016 marked a significant shift in accounting practices. While traditionally targeted at financial institutions, CECL’s impact extends beyond banks, affecting companies in various non-financial sectors such as consumer and retail, manufacturing, real estate, and more. In this two-part blog series, we aim to demystify CECL for non-financial entities, providing comprehensive insights into its key aspects and offering detailed guidance on navigating this complex terrain.

1. Understanding CECL and Its Departure from the Incurred Loss Model:

CECL, as encapsulated in Accounting Standards Update (ASU) 2016-13, represents a departure from the incurred loss model. Unlike the traditional approach that recognizes losses only when they are probable, CECL mandates entities to estimate credit losses over the entire contractual term of the instrument. This means recording expected future losses from day one, challenging the status quo of waiting for losses to become probable.

2. Scope of CECL for Non-Financial Entities:

Understanding the scope of CECL is crucial for non-financial entities. While it covers most financial assets carried at amortized cost, certain instruments fall outside its purview. We delve into the types of financial assets within and outside the scope of CECL, shedding light on its applicability to trade receivables, leases, financial guarantees, and more.

3. Assets in Scope of CECL:

CECL’s reach covers a broad spectrum of financial assets. Primarily, it applies to those carried at amortized cost, including held-to-maturity debt securities, trade receivables, net investments in leases, reinsurance recoverables, and loans.

  • Held-to-maturity debt securities: These are debt securities that a company intends to hold until they mature. They are recorded at amortized cost in financial statements, making them applicable for CECL.
  • Trade receivables: These are amounts owed by customers for goods sold or services provided as part of normal business operations. They are usually due within one year and are hence considered a current asset.
  • Net investments in leases: These are the net investments in lease agreements, calculated as the gross investment in the lease minus the present value of unearned income.
  • Reinsurance recoverables: These are amounts that an insurer expects to recover from a reinsurer to cover paid losses. They are part of an insurer’s assets and come under the purview of CECL.
  • Loans: These include all types of loans, such as mortgage loans, commercial loans, and consumer loans, that are not held for sale.

4. Assets Outside the Scope of CECL:

While CECL has a broad reach, there are certain financial instruments that fall outside its scope. Notably, these include:

  • Available-for-sale debt securities: These are debt securities that a company intends to hold for an indefinite period of time but can sell in response to needs for liquidity or changes in market conditions. The potential credit losses for these securities are accounted for differently and are hence, not covered by CECL.
  • Equity method investments: These are investments where one entity holds significant influence over the operating and financial policies of another but does not have full control or joint control. The potential credit losses from these investments are not considered under CECL as they are accounted for using the equity method.
  • Financial assets measured at fair value: These include financial instruments which are valued at market prices. Since their valuation is updated regularly to reflect changes in market value, they are not subject to CECL.
  • Loans made to participants by defined contribution employee benefit plans: Loans made by employers to employees under defined benefit plans are also excluded from the purview of CECL.

Understanding which financial instruments are included and excluded from the scope of CECL is crucial for non-financial entities as it helps them make the necessary adjustments to their accounting practices.

5. Implications for Trade Receivables:

Trade receivables play a significant role for many non-financial entities. In this section, we explore how CECL impacts trade receivables, emphasizing the importance for organizations to consider these factors when estimating expected credit losses.

CECL’s implementation has a significant impact on how non-institutional entities treat trade receivables in their financial records. With the new model, entities are now required to estimate the expected credit losses for trade receivables throughout their lifetime, starting from the initial recognition and updating these estimates at each reporting date. This shift towards a more forward-looking approach compels non-institutional organizations to proactively assess potential losses and allocate more credit loss allowance. One crucial challenge is to establish robust methodologies based on data analysis, enabling accurate forecasting of future credit losses. Additionally, CECL introduces enhanced disclosure requirements, which may necessitate investments in improved data management systems and internal controls. While CECL provides a more realistic representation of a non-institutional entity’s financial health, it also requires significant changes in the accounting of trade receivables.

6. Immaterial Accounts Receivable and CECL:

While CECL fundamentally changes the approach to estimating credit losses, it is important to note that not all accounts receivable are subjected to this new model. Specifically, immaterial accounts receivable—those small enough that their effects on financial statements are considered negligible—are typically exempt from CECL. The rationale behind this is grounded in the concept of materiality in accounting, that an entity should focus its resources on items that could influence the decision-making of users of financial statements. Applying CECL to immaterial accounts receivable may lead to unnecessary complexity and disproportionate costs, without significantly enhancing the quality or utility of financial information. However, entities should carefully evaluate the cumulative materiality of these accounts, as in aggregate they can still have a significant impact on financial statements. Regular reassessment of the materiality of accounts receivable is recommended to ensure accurate and compliant financial reporting.

7. The Transition: Effective Dates and Disclosures:

CECL implementation comes with specific timelines and disclosure requirements. The effective dates for CECL are related to when the new accounting standard becomes applicable to different types of entities. The Financial Accounting Standards Board (FASB) introduced CECL through Accounting Standards Update (ASU) 2016-13, and the effective dates vary based on the type of entity:

  • Public Business Entities (PBEs):
    • For SEC filers, which are considered public business entities, CECL became effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.
  • Non-Public Business Entities:
    • For all other entities, including smaller reporting companies, CECL became effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.

These effective dates were set to allow different types of entities sufficient time to implement the necessary changes in their accounting and reporting systems. It’s important for organizations to be aware of and comply with these timelines to ensure a smooth transition to the CECL model.

CEC: is generally effective on a modified retrospective basis. To apply the guidance, entities should make a cumulative-effect adjustment to retained earnings at the start of the first reporting period when the changes take effect. However, it’s important to note that a prospective transition approach is required for certain debt securities and purchased credit impaired assets. It is crucial to consider all available data when making these adjustments.

8. Internal Controls in the CECL Era:

As non-financial entities transition to CECL, the impact on internal controls is inevitable. We discuss the importance of assessing and adjusting internal controls to meet the challenges posed by CECL and maintain robust financial reporting practices. We highlight best practices for implementing effective internal controls in the CECL era. The key aspects to consider:

  • Data Management and Quality:
    • CECL requires organizations to gather and analyze a broader set of data, including historical loss experience and forward-looking information. This necessitates robust data management processes to ensure the accuracy, completeness, and integrity of the data used for credit loss estimation.
  • Model Governance:
    • Internal controls related to model governance become critical under CECL. The model used for estimating credit losses needs to be well-documented, and there should be processes in place to validate and review the appropriateness of the model. This includes periodic model validation and governance procedures to ensure the model’s accuracy and reliability.
  • Assumptions and Forecasts:
    • CECL requires organizations to incorporate reasonable and supportable forecasts into their credit loss estimates. Internal controls need to be established to review and validate the assumptions used in these forecasts. Additionally, organizations should have processes for adjusting assumptions based on changing economic conditions.
  • Documentation and Disclosures:
    • CECL introduces new disclosure requirements, and internal controls should be in place to ensure that the organization can provide the necessary information in its financial statements. Proper documentation of the credit loss estimation process, methodologies, and the rationale behind management’s decisions is crucial.
  • Communication and Training:
    • Effective communication and training are essential components of internal controls. Staff involved in the credit loss estimation process should be well-informed and trained on the new CECL requirements. This includes educating relevant personnel on the changes in methodologies and the impact on financial reporting.
  • Monitoring and Review Processes:
    • Internal controls should include ongoing monitoring and review processes to assess the effectiveness of CECL implementation. This involves regular reviews of the credit loss estimates, the accuracy of data inputs, and compliance with accounting standards.
  • IT Systems and Infrastructure:
    • The implementation of CECL may require enhancements to IT systems to accommodate the increased data requirements and more complex modeling. Internal controls should be in place to ensure the reliability and security of IT systems supporting the credit loss estimation process.

In summary, CECL has a profound impact on internal controls, necessitating enhancements and adjustments to existing control frameworks. Organizations need to carefully assess and strengthen their internal control environment to ensure compliance with CECL requirements and maintain the integrity of financial reporting.

In Part 2, we will delve deeper into the measurement methodologies, modeling techniques, potential challenges, and industry-specific considerations for non-financial entities navigating the CECL landscape. Stay tuned for Part 2!