No free passes: How the new current expected credit loss standard affects nonbanks has been saved
No free passes: How the new current expected credit loss standard affects nonbanks
This Heads Up discusses key considerations for nonbanks as they contemplate adoption of FASB Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU adds to U.S. GAAP an impairment model (known as the current expected credit loss (CECL) model) that is based on expected losses rather than incurred losses. Although the new CECL standard has a greater impact on banks, most nonbanks have financial instruments that are subject to it, and many of those nonbanks may not have started evaluating its effect even though its effective date is quickly approaching.
Background of the CECL Model
In June 2016, the FASB issued ASU 2016-13, which amends the Board’s guidance on the impairment of financial instruments. The ASU adds to U.S. GAAP an impairment model (known as the current expected credit loss (CECL) model) that is based on expected losses rather than incurred losses. Under the new guidance, an entity recognizes as an allowance its estimate of lifetime expected credit losses, which the FASB believes will result in more timely recognition of such losses. The ASU is also intended to reduce the complexity of U.S. GAAP by decreasing the number of credit impairment models that entities use to account for debt instruments. Further, the ASU makes targeted changes to the impairment model for available-for-sale debt securities. The guidance in ASU 2016-13 is codified in ASC 326.
Connecting the Dots
In late 2015, the FASB established a transition resource group (TRG) for credit losses. The credit losses TRG does not issue guidance but provides feedback to the FASB on potential implementation issues. On the basis of the TRG’s discussions, the FASB determines whether it needs to take further action (e.g., by clarifying or issuing additional guidance). The TRG met three times from 2016 to 2018 and discussed approximately 15 issues. The FASB subsequently issued three ASUs (2018-19, 2019-04, and 2019-05) to amend and clarify the guidance in ASU 2016-13, including the effective date and transition provisions.
The new CECL standard is effective for public companies that meet the U.S. GAAP definition of an SEC filer for annual reporting periods beginning after December 15, 2019, and interim periods therein. For public companies that are not SEC filers, the guidance is effective for annual reporting periods beginning after December 15, 2020, and interim periods therein. For private companies, the guidance is effective for annual reporting periods beginning after December 15, 2021, and interim periods therein. For most debt instruments, entities must use a modified retrospective approach to adopt the new CECL standard (including the guidance in the ASUs subsequently issued by the FASB), meaning entities will record a cumulative-effect adjustment to the statement of financial position as of the beginning of the first reporting period in which the guidance is effective.
Once effective, the new guidance will significantly change the accounting for credit impairment. Although the new CECL standard has a greater impact on banks, most nonbanks have financial instruments or other assets (e.g., trade receivables, contract assets, lease receivables, financial guarantees, loans and loan commitments, and held-to-maturity (HTM) debt securities) that are subject to the CECL model. While banks and other financial institutions (e.g., credit unions and certain asset portfolio companies) have been closely following standard-setting activities related to the new CECL standard, are actively engaged in the discussions with the FASB and the TRG, and are far along in the implementation process, many nonbanks may not have started evaluating the effect of the CECL model. Because the effective date of the new standard is quickly approaching, nonbanks should (1) focus on identifying which financial instruments and other assets are subject to the CECL model and (2) evaluate whether it is necessary to make changes to existing credit impairment models to comply with the new standard.
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