CECL, which stands for Current Expected Credit Loss, is an accounting standard that helps entities determine when to record losses from financial assets and other credit they extend. It was developed in response to the financial downturn of 2008/2009 to encourage entities to report more accurate loss allowances and so that users of the financial statements had more decision-useful information.
CECL replaced the prior standard in 2020 for SEC filers and was effective for all other entities — including nonprofits — by 2023. Both the legacy standard and the “new” CECL standard help organizations estimate allowances for credit losses, but each standard does it a bit differently.
What did CECL change?
Under the incurred loss model, entities could only recognize credit losses when it was probable that a loss had been incurred. The CECL standard takes a more forward-thinking approach. Under CECL, entities can record allowances by estimating the amount of credit losses that will occur over the life of the financial instrument, not just what is likely to be uncollectible at year end. CECL also expanded the methodology for estimating those uncollectible accounts, allowing management to use more inputs in their estimates and to use more judgment.
In both instances, the estimated loss allowances should be recorded on the nonprofit’s statement of financial position as a contra-asset account to reduce the value of the associated financial asset. Actual losses that occur will then reverse this contra-asset account rather than the financial asset balance itself.
How does CECL affect nonprofits?
Like many other entities, CECL requires nonprofits to evaluate its financial instruments for potential credit losses. Some financial instruments that may be in the scope of CECL include:
- Trade receivables
- Loan receivables, including programmatic loans
- Repurchase agreement receivables
- Reinsurance receivables
- Financial guarantees
- Loan commitments/guarantees
For nonprofits, pledges/promises to give are specifically excluded from the CECL standard, but nearly all receivables resulting from exchange transactions would be within scope. Here is an example.
Hospital Setting: Patient Receivables
Receivables for patient services are often uncollectible. Not only do many patients face barriers to paying, but insurance companies and government involvement can alter the transaction price, even after the service has been performed. Hospitals will first need to determine what uncollectible amounts are related to implicit price concessions, which should be accounted for using the ASC 606, Revenue Recognition protocols. From there, the organization can apply CECL to estimate the amounts that will be uncollectible and may result in credit losses.
How does the CECL methodology work?
The CECL methodology should estimate future credit losses over the life of the loan financial instrument using a combination of current conditions, reasonable forecasts, and historical loss data. This requires more judgement from management than ever before. Some things management will need to consider are:
- How the regulatory environment could change in the future
- Whether historical losses are a good estimate of future losses
- What macroeconomic forecasts are relevant to their industry
- What regulatory shifts could impact their financial instruments
- How covenants and collateral could play a part
- How their organization manages its collections process
Management may even decide that these qualitative factors (q-factors) are more relevant than the quantitative data. While historical loss data is still relevant, management may not rely on those numbers as strongly as they once had. For example, if the composition of their trade receivables has changed or if macroeconomic conditions are vastly different, prior loss data might not accurately reflect their current risk of loss.
Estimating losses over the entire contractual life of the financial instrument is also new under CECL. Such estimates requires more judgement, which means that q-factors like the ones listed above will play a bigger role.
Under CECL, there is no prescriptive method for determining estimated losses, and methods may vary for each type of asset. Management should develop written policies and procedures for calculating credit losses and maintain detailed records supporting their calculations.
What should nonprofits do to implement CECL?
Nonprofits should work with an advisor to develop a CECL framework if they haven’t already. A few steps in that process should be:
Identify areas where credit losses may occur.
Review the organization’s financial instruments to determine which may be applicable under the CECL model.
Select a methodology for measuring expected credit losses.
Estimation methods can be different for each type or class of asset, but some common measurement models are:
- Discounted cash flows —The current value of projected future cash flows (and associated losses) is estimated using a discount rate.
- Aging schedule analysis — Accounts have a higher or lower risk of loss based on how long the receivable has been outstanding.
- Rate-roll method — Future losses are estimated according to the percentage of delinquent accounts that move from one delinquency bucket to another (e.g., from 60-days delinquent to 90-days delinquent).
Gather data and perform calculation.
Gather the data you need, finalize your assumptions, and perform the calculation. Not all data will be relevant, but use what data you have and employ sound judgement for unknown variables.
Post estimated losses to your books.
Post the resulting estimated credit losses to the appropriate contra-asset accounts. Craft footnote disclosures when needed.
Available-for-Sale Debt Securities
While available for sale (AFS) debt securities are not within the scope of CECL, amendments have been made to existing impairment model that changes to how to account for these securities. In general, if a nonprofit intends to hold its AFS debt securities to maturity, it should be evaluate if there is impairment (i.e. its fair value is less than its amortized cost) and record an allowance for expected credit losses using a discounted cash flow approach. With the amendment covering more not discussed here, we recommend you reach out to your advisor if you have any of these securities on your books.
Don’t be afraid to ask for help.
Your nonprofit may have financial instruments within the scope of CECL. If you haven’t implemented this new framework, contact your team of LaPorte advisors. We can help you implement this new standard or work with you to update your existing framework so that your future estimated credit losses are as accurate as they can be.