February 6, 2023
By: Susan Colladay, CPA, Partner, Audit
Announced by the Financial Accounting Standards Board (FASB) in 2016, Accounting Standards Update (ASU) 2016-13: Financial Instruments – Credit Losses (Topic 326) is also referred to as Current Expected Credit Losses (CECL). The new standard improves financial reporting by requiring more timely recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. CECL is not just for banks and other for-profit companies. Nonprofits are also included in the new standard, although contributions are not included within the scope of CECL. If you have not thought about CECL yet, it is time to review and analyze it now! Implementation of this new standard is required for fiscal years ending on December 31, 2023.
CECL applies to financial instruments, such as accounts receivables related to exchange transaction revenues that fall under Topic 606 (i.e., any revenue stream that is not a contribution under Topic 958). In other words, accounts receivables that are scoped in under CECL may result from program service fees, such as conferences, membership dues, sales of publications, and tuition charges. In addition, nonprofits might have notes receivable that result from student loans or other types of loans. It should be noted that grants receivable may or may not be considered contributions under Topic 958. Again, contributions are not part of the scope of CECL.
Under current GAAP, an allowance for doubtful accounts is recorded against receivables based on past experience and/or knowledge of individual collectability from customers so that net receivables represent expected future collections. Under CECL, an impairment for potential uncollectible amounts is required to be recognized on ALL receivables as an allowance for credit losses.
Fortunately, CECL does not dictate how to determine the allowance because that will be unique to each nonprofit’s facts and circumstances. In determining its estimate of expected credit losses, a nonprofit should evaluate information related to the creditworthiness of its customers along with the current and forecasted direction of the economic and business environment. CECL recommends estimation techniques that are practical and relevant to the circumstances. The method(s) used to estimate expected credit losses may vary based on the type of receivable, the nonprofit’s ability to predict the timing of cash flows, and the information available to the nonprofit.
Below are three methods nonprofits might use to estimate the allowance for credit losses under CECL:
- Discounted Cash Flow Method
A discounted cash flow analysis is based on the present value of expected future cash flows discounted using an effective interest rate. The allowance for credit losses is the difference between the gross amount receivable and the present value of the expected cash flows.
- Aging Schedule Method
An aging schedule methodology is commonly used to estimate the allowance for doubtful accounts in accordance with current GAAP. Under this method, a historical credit loss rate is determined by age bucket or how long a receivable has been outstanding (e.g., 1-30 days past due, 31-60 days past due, etc.). The difference under CECL is that the historical loss rates for each respective age bucket are then adjusted for current conditions using reasonable and supportable forecasts. Based on the aging categorization and the adjusted loss rate per category, an allowance for credit losses is calculated by multiplying the adjusted loss rate with the gross amount receivable in the respective age category.
- Loss Rate Method
Using a loss rate approach, loss rate statistics are developed on the basis of the historical rate of loss of financial assets. When computing its loss rates, a nonprofit should segment its portfolio into appropriate groupings or sub-portfolios based on shared credit risk characteristics. These historical credit loss trends should then be adjusted for current conditions and expectations about the future. Credit losses are calculated using the estimated loss rate and multiplying it by the gross amount receivable at the balance sheet date.
For more information, visit FASB’s CECL resource page. Consult an accountant who specializes nonprofit audit and assurance for help with your organization’s implementation of (ASU) 2016-13: Financial Instruments – Credit Losses (Topic 326).