How will CECL impact nonfinancial services companies? Watch our latest video for a quick summary.
Financial services companies will be broadly impacted by the FASB’s new CECL impairment model for financial assets. Further, nonfinancial services companies also hold financial assets that will be subject to the new model. In this video we cover how the new CECL model would be applied to (1) trade receivables, (2) lease receivables, (3) other financial instruments, as well as (4) updates to the impairment guidance for available-for-sale securities.
Hi! I’m Victoria Miretti, a director in PwC’s national office. Today we’re continuing our series of videos discussing the new credit loss standard.
As a reminder, the standard does a couple of things. It introduces the current expected credit loss model, or CECL, and amends the available for sale debt securities impairment guidance.
Under CECL, an entity is required to estimate credit losses over the life of financial instruments within its scope and record this estimate in earnings at initial recognition of those financial instruments. Changes in this estimate are recorded in earnings. There are no triggers such as whether a loss is probable of occurring before recognizing an impairment.
Estimates of credit loss should consider relevant internal and external information, including historical loss experience, current conditions and reasonable and supportable forecasts. All of which are factors that affect the expected collectability of the amortized cost of a financial instrument.
In this video, I’ll cover how the standard impacts nonfinancial services companies in four areas.
- First, trade receivables
- Second, lease receivables
- Third, other financial instruments
- And Fourth, available for sale debt securities impairment guidance.
Let’s start with trade receivables. Currently, most nonfinancial services companies reserve for credit losses on trade receivables, primarily through judgment and the application of historical loss rates by aging category to the period-end trade receivables balance. Under CECL, companies will have to consider whether historical loss data requires adjustment for reasonable and supportable forecasts of future losses both when initially recording a trade receivable and in subsequent periods.
Further, as I mentioned earlier, under CECL there is no trigger such as whether a loss is probable of occurring before recognizing an impairment. As a result companies will be required to consider credit losses as soon as they record a receivable on their balance sheets or, on day 1, and because of that, there will be an allowance for receivables that aren’t yet past due.
Next, let’s move on to lease receivables. The FASB has amended the standard to clarify that operating lease receivables are outside the scope of the CECL guidance, however, the new leasing and credit impairment standards require recognition of an allowance for credit losses on net investments in both sales-type and direct financing leases at and after the lease commencement date.
The net investment in these leases have both financial and nonfinancial components which both need to be evaluated under CECL. There are likely different considerations in the application of the CECL model to the financial and nonfinancial components. The guidance requires the application of CECL to both components as opposed to requiring different impairment models for each.
In running the financial components of the lease through the CECL model, the lessor should consider the credit risk related to the cash flows it would expect to receive from:
- Rental payments,
- The residual value guarantee, and
- Amounts due on exercise of purchase options or lease termination options reasonably certain of being exercised, all of which are included on the balance sheet in the lease receivable component of the net investment in the lease.
In running the nonfinancial components of the lease through the CECL model, the lessor should consider:
- The portion of the net investment in the lease that is attributable to the unguaranteed residual value of the asset, and
- The difference between the current fair value of the leased asset and the residual value that is not included in the net investment in the lease. This amount is effectively collateral against the lessee’s payment obligations.
Companies should consider and document the judgments and assumptions used in determining the amount of the allowance for credit losses for these types of leases.
Now let’s switch gears and discuss other financial instruments. Companies, including nonfinancial services companies, may hold a number of financial instruments at amortized cost that are subject to CECL.
- Loans to officers or employees
- Store credit card arrangements
- Certain tax refunds
- Certain insurance settlements
- Held-to-maturity debt securities, and
- Certain guarantees, which we've discussed in an earlier video within this credit loss series
Companies should carefully review all financial instruments on their balance sheets and footnotes to determine whether, and how much, an allowance for credit losses under CECL will be required.
Lastly, I’d like to cover the new available-for-sale, or AFS, debt securities impairment guidance. While AFS securities are not within the scope of CECL, the newly issued credit loss standard does make amendments to the AFS debt securities impairment guidance. The new guidance requires companies to recognize expected credit losses through an allowance for AFS debt securities, which is a significant change from the current impairment guidance.
In addition, there are other changes to the AFS debt security impairment guidance. See our loans and investments guide for additional information.
The timing and recognition of impairment will differ between instruments classified as held-to-maturity with impairment evaluated under CECL and those instruments classified as available-for-sale with impairment evaluated under the new AFS guidance.
In addition to these four areas, nonfinancial services companies are reminded that there are also significant new disclosures that they will be required to make under the new credit standard.
So let’s wrap up. Companies have a lot of work ahead of them to get ready for the new standard. Given the impact on impairment measurement for broad classes of financial instruments, nonfinancial services companies should not delay in developing their implementation strategies.
Adoption of the new standard may require involvement of specialists and could result in significant changes to systems, processes, and controls. But the good news is there are many resources available to help.