top of page

Accounting for Credit Losses

TOPC Potentia

July 25, 2024



A new accounting standard for reporting credit losses goes into effect in 2023 for small public companies, private companies and not-for-profits that extend credit. Although the changes primarily affect banks and other financial institutions, any company that has trade receivables, notes receivable, investments in held-to-maturity debt securities or contract assets must use the new standard.


Large public companies were required to adopt the updated credit loss rules by 2021 (after a one-year deferral under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Switching over to the current expected credit loss (CECL) model caused the largest financial institutions — including JPMorgan Chase, Bank of America, Wells Fargo and Citigroup — to write off billions of dollars of losses in 2022 as economic conditions faltered and credit card debt grew.


In light of ongoing economic uncertainties, credit losses were listed as a top concern for the year ahead by 84% of small financial institutions that participated in the Tenth Annual Community Bank Survey conducted by Risk Management Association. Another major concern was regulatory compliance — in particular, community banks must now start implementing updated guidance that will require earlier reporting of credit losses than under the previous incurred-loss model.



New Model Calls for Earlier Recognition


Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, requires banks and other entities that extend credit to forecast into the foreseeable future to predict losses over the life of a loan and then immediately book those losses. The updated guidance was designed to provide more-timely recording of credit losses, but measuring losses is challenging in today’s uncertain marketplace.


In a nutshell, the updated guidance requires the entity to estimate the CECL based on historical information, current conditions, and reasonable and supportable forecasts. By contrast, the previous rule relies only on historical information.


For example, before the adoption of ASU 2016-13, an entity estimated allowance for doubtful accounts for accounts receivable based on general reserve and customer specific reserve; which general reserve is calculated by multiplying the accounts receivable by the average ratio of historical write-offs, and the customer specific reserve is generally determined when a customer fails to make a payment after a long period of time (several months past due or longer), and there is no indication that the customer will pay even after the company has followed up on the past due. The customer specific reserve can also be considered when an event has arisen on or before the reporting date that causes the management to doubt the collection from a customer.


After the adoption of ASU 2016-13, to estimate the CECL for accounts receivable, in addition to the analysis of historical information as described above, the entity is also required to consider other factors such as the customer’s economic condition, credit rating, industry, and forecast that may affect the customer’s ability to pay in the future.


The guidance requires the entities which extend credit to customers, to regularly monitor their open accounts receivable to ensure that their net receivables after allowance for credit losses (‘loss reserves’) represents what is currently expected to be collected.


Loss reserves are “built up” when past-due accounts and write-offs are expected to increase; an increase in the loss reserve lowers earnings on the income statement. Conversely, loss reserves may be “released” when the economic outlook brightens; this situation boosts earnings.  



Ready, Set, Implement


The new CECL is a major change from the previous model for reporting credit losses. Thus, small public companies, private companies and not-for-profits may be unsure how to proceed. Contact your CPA for help updating your procedures and systems to implement the changes.  

Comments


© 2021 TOPC Potentia All Rights Reserved

TRAIANGL-TOP-WHT.png

© 2022 TOPC Potentia All Rights Reserved

bottom of page