In June 2016, the FASB issued ASU 2016-13 Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, including subsequently issued ASUs, to clarify the implantation guidance in ASU 2016-13.
Topic 326 applies to all entities in varying degrees and the main goal is to improve financial reporting by requiring earlier recognition of credit losses on financial receivables and other financial assets in scope. Some of the reasons for the change are so that users of the financial statements are not making their own assessments and so that assets are not overstated.
The amendment requires a financial asset (or group of financial assets) to be assessed for impairment under the current expected credit loss model, rather than an incurred loss model. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions and reasonable and supportable forecasts that affect the collectability of the reported amount.
Financial assets such as trade receivables, available-for-sale debt securities, guarantee contracts, loan commitments, and contract assets under Topic 606, are within scope. It is also important to mention some assets are not within scope, such as contributions receivable, loans and receivables between entities under common control, and most grants receivable.
Implementing the new standard may be challenging for various reasons. Some things may not change such as assessing aging of receivables and history of payment. However, some things are new such as forward-looking estimates and considerations including internal and external information, and of course additional disclosures. Entities will be required to maintain historical credit loss information on an aggregate basis for financial assets, so data collection will be key. Also, entities will be required to adjust historical loss experience for current conditions to produce reasonable and supportable forecasts.
The standard does not require one specific forecasting model for measuring expected credit losses, however, suggested methods include:
- discounted cash flows
- cumulative or vintage loss-rates
- roll-rates
- probability-of-default
- aging schedule.
Disclosures include but may not be limited to accounting policies and elections, allowance for credit losses, credit quality information, how credit risk is being monitored by management, past-due or delinquency status, nonaccrual status, purchased financial assets with credit deterioration, key assumptions used to develop estimates, and more.
Start preparing now by developing polices and procedures, making sure historical data is available and accessible, considering sources used in future projections, reviewing internal controls, selecting the measuring methodology, and reading the guidance on Topic 326.
ASU 2016-13 will be effective for private companies’ fiscal years beginning after December 15, 2022. Early adoption is permitted. Entities will use the modified-retrospective approach and record the cumulative effect adjustment to opening retained earnings as of the earliest period presented.