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New method of accounting for credit losses

credit losses, accountingA number of Accounting Standards Updates (“ASU”) will become effective in the next few years, and perhaps most notable among them are the new lease and revenue recognition standards. ASU 2016-13, which introduces ASC 326 to the codification, will also be impactful and is worth taking note of. While the new standard will not be effective for a few years, it is helpful to develop a basic understanding of what changes will take place. The premise of ASU 2016-13 is a new method of accounting for credit losses. Most relevantly, this will affect accounting for trade receivables, held-to-maturity securities and notes receivable. Under current accounting standards (ASC 310-10-35), these assets are impaired using the incurred loss model. The focal point of the incurred loss model is that impairment is only appropriate once it is probable that a loss has been incurred. Per ASC 310-10-35B”

“Losses shall not be recognized before it is probable that they have been incurred, even though it may be probable based on past experience that losses will be incurred in the future.”

As such, some have described the incurred loss model as backward-looking. The new impairment model featured in ASC 326, commonly known as CECL (Current Expected Credit Loss), emphasizes forward-looking impairment. Under ASC 326, an allowance for credit losses is established to represent management’s estimate of future credit losses. Accordingly, financial assets are presented as net of this allowance in the financial statements. As circumstances and variables change, management may adjust this allowance to better represent their estimate of future credit losses.

FASB is deliberately flexible in prescribing guidance for estimating future credit losses. Yet, ASC 326 does give some general guidance. Since it is usually implausible to estimate credit losses on an individual asset basis, FASB does require that, when possible, assets of similar risk characteristics be pooled together for evaluation. Furthermore, it is required that historical data as well as future expectations be used for estimation purposes. Lenders and other businesses that extend credit will be chiefly impacted by ASU 2016-13. Implementation is the largest concern for smaller entities which do not have the sophistication and data necessary to implement the new standard. To some extent, some of the analysis necessary to estimate credit losses is already being done. For example, lenders perform risk assessment and credit analysis before lending, and some of this analysis may be reused to develop estimates.

ASC 326 is effective for public and private entities for fiscal years beginning after December 15, 2019 and 2020, respectively.

Michael Veldhuizen