A Quick Review

In April 2021, we published a Tip covering Current Expected Credit Losses (CECL) requirements. Although implementation was delayed during the pandemic, CECL is now set to come into effect beginning January 2023. Financial Statements for periods after that date should reflect the CECL methodology for calculating AR losses. If your company has already adapted to the new requirements, the following may be validating. If you have not yet started, it will hopefully be informative and help you with an action plan.

A Disclaimer

The following is an overview of how CECL affects the loss calculation for your Accounts Receivable portfolio. It is intended only as a starting point. Since there are some things in CECL that are not well defined, it is even more important to be aware of how CECL requirements impact the Credit Department. 

Why CECL is Important to a Credit Manager

It is likely to change the way you currently calculate your allowance for bad debt losses. CECL requires a calculation of “expected future losses over the life of the financial asset,” as opposed to how you may do this now, using a historical loss calculation, or by pooling customers with a similar risk profile. 

Think Positive

Any change in a long-standing process may raise concerns. CECL does have its benefits:

• • • Analyzing future potential losses can improve the visibility of what drives your accounts receivable performance. 
    • Collaboration among the various stakeholders will help to adapt credit and collection strategies addressing existing and new customer segments, and new marketing and product initiatives. 
    • You may identify policy gaps in risk mitigation measures, the need for adjustments to customer payment terms, or collection practices.

Six Things You Need to Know About the CECL Loss Calculation:

1. The new standard applies to trade receivables.

2. Replaces former GAAP standards requiring companies to estimate and immediately recognize credit losses on day one. 

3. Removes the threshold of “probable,” generally requiring an allowance even if the risk of loss is remote. 

4. The calculation will vary between companies, but CECL requires looking forward to a “reasonable and supportable” time horizon for every exposure and then extending over their expected lives. There is no firm definition. 

5. The need for a cross-functional implementation team: If your company has not already addressed this, implementing CECL will require the participation of other internal stakeholders and your auditor. You may find it necessary and well advised, to seek out a third-party resource with the expertise needed to help work through the process. 

6. Like everything there are exceptions. Such things as US Treasury Securities, cash equivalents, and immaterial financial instruments. 

Five Steps Towards CECL Implementation:

1. Create an implementation committee:

• • • Estimating expected losses requires cross-functional cooperation. Identify other stakeholders, such as IT, Sales, senior management, and audit. Determine if qualified third-party expertise is needed to determine implementation options.
    • Set timeline milestones.
    • Perform dry runs to identify any weaknesses in the calculation, and credit policies. 

2. Gather data: Determine what data you will need to anticipate future losses. 

3. Understand what drives the calculation:

• • • Start by pooling receivables with similar risk characteristics.
    • Review historical loss rates to determine if adjustments are needed based on asset-specific characteristics within the portfolio such as Sales channel, customer type, industry, region, etc.
    • Make adjustments to the historical loss rates based on current conditions and reasonable and supportable forecasts. 
    • You can revert to historical loss rates for future periods that cannot be reasonably forecasted.
    • Apply revised loss rates to the trade receivable balance.

4. Document: CECL requires a documented & well-thought-out process to estimate credit losses.

5. Conduct ongoing reviews: Of your credit policy and risk analysis. 

Conclusion:

The information above is intended to provide you with a brief overview of what you need to know about CECL requirements, how the allowance for credit losses calculation has changed, and the actions your company needs to take to meet CECL requirements. Implementation will take a team effort, involving others in your company who are impacted by these changes, your company's auditor, and potentially third-party with the required expertise. 

Source: Are You Ready for January 2023 Current Expected Credit Losses Requirements? What You Need to Know, and What You Need to Do

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