Chapter 5 — Application of the CECL Model to Off-Balance-Sheet Commitments, Trade and Lease Receivables, and Reinsurance Receivables
Chapter 5 — Application of the CECL Model to Off-Balance-Sheet Commitments, Trade and Lease Receivables, and Reinsurance Receivables
5.1 Off-Balance-Sheet Arrangements
ASC 326-20
30-11 In estimating expected credit
losses for off-balance-sheet credit exposures, an entity shall
estimate expected credit losses on the basis of the guidance in
this Subtopic over the contractual period in which the entity is
exposed to credit risk via a present contractual obligation to
extend credit, unless that obligation is unconditionally
cancellable by the issuer. At the reporting date, an entity
shall record a liability for credit losses on off-balance-sheet
credit exposures within the scope of this Subtopic. An entity
shall report in net income (as a credit loss expense) the amount
necessary to adjust the liability for credit losses for
management’s current estimate of expected credit losses on
off-balance-sheet credit exposures. For that period of exposure,
the estimate of expected credit losses should consider both the
likelihood that funding will occur (which may be affected by,
for example, a material adverse change clause) and an estimate
of expected credit losses on commitments expected to be funded
over its estimated life. If an entity uses a discounted cash
flow method to estimate expected credit losses on
off-balance-sheet credit exposures, the discount rate used
should be consistent with the guidance in Section 310-20-35.
Off-balance-sheet arrangements, such as commitments to extend credit, guarantees, and
standby letters of credit, are subject to credit risk; therefore, arrangements that are
not considered derivatives under ASC 815 are within the scope of the CECL model.
Accordingly, under ASC 326, an entity’s method for determining the estimate of expected
credit losses on the funded portion of a loan commitment must be similar to its method
for determining the estimate for other loans. For an unfunded portion of a loan
commitment, an entity must estimate expected credit losses over the full contractual
period over which it is exposed to credit risk under an unconditional present legal
obligation to extend credit. Such an estimate takes into account both the likelihood
that funding will occur and the expected credit losses on commitments to be funded.
5.1.1 Allowances for Credit Card Loans
An allowance for expected credit losses on credit card loans
would only be required for the funded portion, not for the unfunded portion for
which the issuer has an unconditional right to cancel the commitment.
ASC 326-20-30-11 states that an entity must “estimate expected
credit losses . . . over the contractual period in which the entity is exposed
to credit risk via a present contractual obligation to extend credit, unless
that obligation is unconditionally cancellable by the issuer.” Therefore, if an
entity has the unconditional ability to cancel the unfunded portion of a loan
commitment, it would not be required to estimate expected credit losses on that
portion, even if it historically has never exercised its cancellation right. In
other words, if the issuer has the unconditional right to cancel the commitment
at any time, it should not record an allowance for unfunded commitments
because it does not have a present contractual obligation to extend credit on
the unfunded commitments.
The example in ASC 326-20-55-55 and 55-56 illustrates
application of this guidance:
55-55 Bank M has a significant credit card
portfolio, including funded balances on existing cards and unfunded
commitments (available credit) on credit cards. Bank M’s card holder
agreements stipulate that the available credit may be unconditionally
cancelled at any time.
55-56 When determining the allowance for credit
losses, Bank M estimates the expected credit losses over the remaining
lives of the funded credit card loans. Bank M does not record an
allowance for unfunded commitments on the unfunded credit cards because
it has the ability to unconditionally cancel the available lines of
credit. Even though Bank M has had a past practice of extending credit
on credit cards before it has detected a borrower’s default event, it does not have a present contractual obligation to
extend credit. Therefore, an allowance for unfunded commitments
should not be established because credit risk on commitments that
are unconditionally cancellable by the issuer are not considered to
be a liability. [Emphasis added]
In addition, an entity should not recognize a contingent
liability under ASC 450 for the operational risk associated with extending loans
in the future under unconditionally cancelable credit commitments related to
accounts that are performing or are in default.
5.1.2 Effect of a Required Cancellation Notice Period on a Commitment to Extend Credit
When the issuer has the unconditional right to cancel a
commitment but only after a specific notice period is given, allowances for
credit losses should be provided on the unfunded portion of lines of credit or
expected losses related to estimated fundings during the notice period. In
estimating expected credit losses, an entity should report its credit loss
exposure for the period of exposure, which would include a specific notice
period if applicable. ASC 326-20-30-11 states, in part:
[A]n
entity shall estimate expected credit losses . . . over the contractual
period in which the entity is exposed to credit risk via a present
contractual obligation to extend credit, unless that obligation is
unconditionally cancellable by the issuer. . . . For that period of
exposure, the estimate of expected credit losses should consider both the
likelihood that funding will occur . . . and an estimate of expected credit
losses on commitments expected to be funded over its estimated
life.
Since a contractual period of exposure includes the notice
period, the estimate of expected credit losses should include expected credit
losses related to expected future borrowings during the notice period. The
entity is not required to estimate losses for any expected borrowings that would
occur beyond the period when the issuer has an unconditional right to cancel the
commitment (i.e., after the notice period).
5.1.3 Recognition of the Allowance for Credit Losses Related to Unfunded Loan Commitments Assumed in a Business Combination
Unfunded loan commitments assumed by an acquirer in a business
combination must be measured and recognized at fair value as of the acquisition
date in accordance with ASC 805.
We believe that an acquirer should recognize
a separate liability under ASC 326-20 for expected credit losses related
to an unfunded portion of a loan commitment acquired if that commitment is
noncancelable by the acquirer. In a manner consistent with how other unfunded
loan commitments are accounted for under ASC 326-20, the acquirer must estimate
expected credit losses over the full contractual period in which it is exposed
to credit risk under an unconditional present legal obligation to extend the
credit. Such an estimate takes into account both the likelihood that funding
will occur and the expected credit losses on commitments to be funded.
5.1.4 Accounting for the Off-Balance-Sheet Credit Exposure Related to a Forward Commitment to Purchase Loans
As stated in Section
2.1.2, a forward commitment to purchase loans from a third party is
within the scope of ASC 326-20 because it exposes the purchaser to the credit
risk associated with the underlying loans to be purchased if it is neither (1)
unconditionally cancelable by the issuer nor (2) accounted for as a derivative
under ASC 815.
The accounting for off-balance-sheet credit exposure related to
a forward commitment to purchase loans depends on whether the loans are
determined to be PCD as of the date on which the forward commitment is entered
into. If the loans are not determined to be PCD, the entity would recognize a
liability at inception of the commitment and would reflect the credit losses
expected over the loans’ contractual term.
If the loans are determined to be PCD as of the date on which
the forward commitment is entered into, the entity would not recognize a
liability for the credit exposure related to a forward commitment to purchase
the loans. Instead, it would recognize an allowance for expected credit losses
by applying the gross-up approach upon acquiring the assets, as discussed in
Chapter 6. That
is, when the entity acquires the PCD assets, it would recognize the allowance
for expected credit losses as an adjustment that increases the assets’ cost
bases. If the entity applies the gross-up approach when the loans are acquired
(and does not recognize a liability at inception of the commitment), the entity
would recognize credit exposure on PCD loans and credit exposure on forward
commitments to acquired PCD loans in a similar manner.
We generally believe that an entity should measure and recognize
a liability for off-balance-sheet credit exposure related to a forward
commitment to purchase loans from a third party as of the commitment inception
date even if the specific loans to be purchased are not specifically identified.
In such an arrangement, the entity has entered into a noncancelable commitment
to purchase loans for which it is exposed to credit losses and therefore should
recognize a liability for expected credit losses upon inception of the
commitment. We believe that the entity should analyze all facts and
circumstances related to the forward commitment to assess the type and quality
of loans expected to be purchased. In addition, the entity should use judgment
to (1) identify those loans that are expected to be accounted for as PCD and (2)
measure and recognize the liability for expected credit losses.
5.1.5 Guarantees
5.1.5.1 Overview
ASC 460-10
15-4 Except as provided in
paragraph 460-10-15-7, the provisions of this Topic
apply to the following types of guarantee
contracts:
-
Contracts that contingently require a guarantor to make payments (as described in the following paragraph) to a guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party. For related implementation guidance, see paragraph 460-10-55-2.
-
Contracts that contingently require a guarantor to make payments (as described in the following paragraph) to a guaranteed party based on another entity’s failure to perform under an obligating agreement (performance guarantees). For related implementation guidance, see paragraph 460-10-55-12.
-
Indemnification agreements (contracts) that contingently require an indemnifying party (guarantor) to make payments to an indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party.
-
Indirect guarantees of the indebtedness of others, even though the payment to the guaranteed party may not be based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party.
Guarantee arrangements can take various forms and expose guarantors to
varying levels of obligations and risks. ASC 326-20 applies to certain
financial guarantee arrangements within the scope of ASC 460 that create
off-balance-sheet credit exposure for the guarantor. Examples of financial
guarantees that create off-balance-sheet credit exposure include financial
standby letters of credit and other types of guarantees related to the
nonpayment of a financial obligation. ASC 326-20 does not apply to financial
guarantees that create off-balance-sheet exposure and that are (1) accounted
for as insurance or (2) within the scope of ASC 815-15. See Chapter 2 for more information about the
scope of ASC 326-20.
5.1.5.2 Initial Recognition and Measurement
ASC 460-10
25-2 The issuance of a
guarantee obligates the guarantor (the issuer) in
two respects:
-
The guarantor undertakes an obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur (the noncontingent aspect).
-
The guarantor undertakes a contingent obligation to make future payments if those triggering events or conditions occur (the contingent aspect).
For guarantees that are not within
the scope of Subtopic 326-20 on financial
instruments measured at amortized cost, no
bifurcation and no separate accounting for the
contingent and noncontingent aspects of the
guarantee are required by this Topic. For guarantees
that are within the scope of Subtopic 326-20, the
expected credit losses (the contingent aspect) shall
be measured and accounted for in addition to and
separately from the fair value of the guarantee (the
noncontingent aspect) in accordance with paragraph
460-10-30-5.
25-3 Because the
issuance of a guarantee imposes a noncontingent
obligation to stand ready to perform in the event
that the specified triggering events or conditions
occur, the provisions of Section 450-20-25 regarding
a guarantor’s contingent obligation under a
guarantee should not be interpreted as prohibiting a
guarantor from initially recognizing a liability for
a guarantee even though it is not probable that
payments will be required under that guarantee.
Similarly, for guarantees within the scope of
Subtopic 326-20, the requirement to measure a
guarantor’s expected credit loss on the guarantee
should not be interpreted as prohibiting a guarantor
from initially recognizing a liability for the
noncontingent aspect of a guarantee.
25-4 At the inception of a
guarantee, a guarantor shall recognize in its
statement of financial position a liability for that
guarantee. This Subsection does not prescribe a
specific account for the guarantor’s offsetting
entry when it recognizes a liability at the
inception of a guarantee. That offsetting entry
depends on the circumstances in which the guarantee
was issued. See paragraph 460-10-55-23 for
implementation guidance.
30-2 Except as indicated
in paragraphs 460-10-30-3 through 30-5, the
objective of the initial measurement of a guarantee
liability is the fair value of the guarantee at its
inception. For example:
-
If a guarantee is issued in a standalone arm’s-length transaction with an unrelated party, the liability recognized at the inception of the guarantee shall be the premium received or receivable by the guarantor as a practical expedient.
-
If a guarantee is issued as part of a transaction with multiple elements with an unrelated party (such as in conjunction with selling an asset), the liability recognized at the inception of the guarantee should be an estimate of the guarantee’s fair value. In that circumstance, a guarantor shall consider what premium would be required by the guarantor to issue the same guarantee in a standalone arm’s-length transaction with an unrelated party as a practical expedient.
-
If a guarantee is issued as a contribution to an unrelated party, the liability recognized at the inception of the guarantee shall be measured at its fair value, consistent with the requirement to measure the contribution made at fair value, as prescribed in Section 720-25-30. For related implementation guidance, see paragraph 460-10-55-14.
30-5 At the inception of a
guarantee within the scope of Subtopic 326-20 on
financial instruments measured at amortized cost,
the guarantor is required to recognize both of the
following as liabilities:
-
The amount that satisfies the fair value objective in accordance with paragraph 460-10-30-2
-
The contingent liability related to the expected credit loss for the guarantee measured under Subtopic 326-20.
ASC 460-10-25-2 states that a guarantee comprises a
noncontingent obligation and a contingent obligation. The noncontingent
obligation is the “obligation to stand ready to perform over the
term of the guarantee” if certain events or conditions occur, while the
contingent obligation is the “obligation to make future payments”
if certain events or conditions occur.
For financial guarantees not within the scope of ASC 326-20,
ASC 460 requires the guarantor to initially recognize at fair value a
guarantee liability comprising both the noncontingent obligation and the
contingent obligation (i.e., the guarantor is not required to separately
recognize at fair value a liability for the noncontingent and contingent
aspects of the guarantee). However, for financial guarantees within the
scope of ASC 326-20, the guarantor must also recognize a liability related
to the expected credit losses on the guarantee, estimated in accordance with
ASC 326-20.
A guarantor’s estimation of expected credit losses related to the contingent
element of the financial guarantee should take into account both (1) the
likelihood that the guarantor will have to fulfill its obligation and (2) an
estimate of expected credit losses related to the guarantee obligation.
Example 5-1
Accounting for a Financial Guarantee Within the
Scope of ASC 326-20
Entity X is a guarantor of debt incurred by Entity Y.
The guarantee arrangement stipulates that X must
guarantee payment of 100 percent of Y’s debt
obligations owed to a third-party debtor for a
specified time frame. Entity X is not an insurance
entity, and the guarantee is not within the scope of
ASC 815.
On July 1, 20X1, Y borrows $5
million from a third-party debtor for which X is
obligated to guarantee repayment under the guarantee
arrangement. Entity X receives an up-front cash
premium payment of $250,000 for the guarantee and
the cash premium is considered to be at arm’s
length. Entity X measures the fair value of its
stand-ready obligation (i.e., the noncontingent
obligation) to guarantee Y’s repayment under the
debt arrangement to be $250,000 on the basis of the
arm’s-length premium it received. Entity X applies
ASC 326-20 and measures its estimate of expected
credit losses related to the guarantee to be
$100,000 (i.e., the contingent obligation). Entity X
would record the following journal entry for the
guarantee arrangement:
Journal
Entry: July 1, 20X1
Connecting the Dots
Changes to Guarantee
Liability Recognition Under the CECL Model
Before the adoption of ASU 2016-13, a guarantor was not required to
bifurcate and separately account for the contingent and
noncontingent aspects of a financial guarantee under ASC 460.
Rather, the guarantor was required to initially recognize the
guarantee liability at the greater of the following:
-
The noncontingent liability stand-ready obligation of the guarantee measured at fair value in accordance with ASC 460-10-30-2.
-
The contingent liability measured in accordance with ASC 450-20-30.
However, ASU 2016-13 amended ASC 460-10-30-5 to
remove the entity’s ability to initially and subsequently recognize
the “greater of” the unamortized noncontingent obligation (ASC 460)
or the contingent obligation (ASC 450) for financial guarantees
within the scope of ASC 326-20. In other words, a guarantor must
measure and recognize a liability for the contingent element of the
guarantee obligation in accordance with ASC 326-20 in addition
to the liability for the noncontingent element under ASC
460. See Chapter
9 for transition guidance related to guarantees
within the scope of ASC 326-20. In certain circumstances,
application of the guidance in ASC 460-10-30-5 may result in a
scenario in which the sum of the noncontingent and contingent
liabilities exceeds the total amount that the guarantor is obligated
to pay. Consider the example below.
Example 5-2
Accounting for a Financial Guarantee Within
the Scope of ASC 326-20
Entity X is a guarantor for debt incurred by
Entity Y. The guarantee arrangement stipulates
that X must guarantee payment of 30 percent of Y’s
debt obligations owed to a third-party debtor for
a specified time frame. The other 70 percent of
Y’s debt obligations is guaranteed by an
independent third-party entity. Entity X is not an
insurance entity and the guarantee is not within
the scope of ASC 815.
On July 1, 20X1, Y borrows $10
million from a third-party debtor with a term of
three years for which X is obligated to guarantee
repayment of $3 million ($10 million multiplied by
X’s 30 percent guarantee obligation). Entity X
receives an up-front cash premium payment of
$300,000 for the guarantee, and the cash premium
is considered to be at arm’s length. Entity X
measures the fair value of its stand-ready
obligation (i.e., the noncontingent obligation) to
guarantee Y’s repayment under the debt arrangement
to be $300,000 on the basis of the arm’s-length
premium it received. At inception, X applies ASC
326-20 and measures its estimate of expected
credit losses related to the guarantee to be
$100,000 (i.e., the contingent element). On July
1, 20X1, X would record the following journal
entry for the guarantee arrangement:
Journal
Entry: July 1, 20X1
In the latter half of 20X1,
there is a significant macroeconomic decline in
key input factors affecting Y’s business that is
expected to persist over the contractual term of
the debt. As a result, Y experiences significant
credit deterioration and there is general concern
that Y will not be able to service the entire debt
obligation. Entity X applies ASC 326-20 and
remeasures its estimate of expected credit losses
related to the guarantee as of December 31, 20X1,
to be $2.8 million. Entity X’s
subsequent-measurement accounting policy for the
noncontingent guarantee liability is to amortize
the obligation on a straight-line basis over the
life of the guarantee, which is equal to the term
of the debt (i.e., three years). As of December
31, 20X1, the unamortized noncontingent guarantee
obligation is $250,000. Entity X would record the
following journal entry on December 31, 20X1, to
reflect the change in the liability for
off-balance-sheet credit losses:
Journal
Entry: December 31, 20X1
In this example, X’s total liability under the
guarantee as of December 31, 20X1, is $3.05
million,1 which exceeds the total amount of debt of $3
million that X is obligated to pay. While this
example is meant to portray extreme facts and
circumstances, it illustrates a potential outcome
of applying the conceptual framework of measuring
and recognizing the noncontingent and contingent
obligations of guarantees within the scope of ASC
326-20.
5.1.5.2.1 Credit Guarantee Between Entities Under Common Control
As discussed in Chapter 2, we generally believe
that guarantee arrangements between common-control entities that are
related to third-party credit exposure are within the scope of ASC
326-20. Consider the example below.
Example 5-3
Entity X and Entity Y are wholly
owned subsidiaries of Parent. As a result, X and Y
are entities under common control. Entity X
originates loans to third-party entities. Entity Y
enters into a credit guarantee with X under which
Y must reimburse X in the event that the
third-party loans were to default. Entity Y cannot
unconditionally cancel the guarantee arrangement,
and the guarantee is not within the scope of ASC
815. Entity Y prepares separate, stand-alone
financial statements.
In its separate, stand-alone
financial statements, Y should separately measure
and recognize the expected credit losses related
to the contingent element of its guarantee
obligation with X. Entity Y is exposed to the
credit risk of the third-party entities through
its guarantee arrangement with X. Therefore, Y
must measure and recognize the contingent element
(i.e., the expected credit losses) separately from
the noncontingent element (i.e., the stand-ready
obligation) of the guarantee.
5.1.5.3 Subsequent Measurement
ASC 460-10
35-1 This Subsection does
not describe in detail how the guarantor’s liability
for its obligations under the guarantee would be
measured after its initial recognition. The
liability that the guarantor initially recognized
under paragraph 460-10-25-4 would typically be
reduced (by a credit to earnings) as the guarantor
is released from risk under the guarantee.
35-2 Depending on the
nature of the guarantee, the guarantor’s release
from risk has typically been recognized over the
term of the guarantee using one of the following
three methods:
-
Only upon either expiration or settlement of the guarantee.
-
By a systematic and rational amortization method.
-
As the fair value of the guarantee changes.
Although those three methods are
currently being used in practice for subsequent
accounting, this Subsection does not provide
comprehensive guidance regarding the circumstances
in which each of those methods would be appropriate.
A guarantor is not free to choose any of the three
methods in deciding how the liability for its
obligations under the guarantee is measured
subsequent to the initial recognition of that
liability. A guarantor shall not use fair value in
subsequently accounting for the liability for its
obligations under a previously issued guarantee
unless the use of that method can be justified under
generally accepted accounting principles (GAAP). For
example, fair value is used to subsequently measure
guarantees accounted for as derivative instruments
under Topic 815.
35-4 The discussion in
paragraph 460-10-35-2 about how a guarantor
typically reduces the liability that it initially
recognized does not encompass the recognition and
subsequent adjustment of the contingent liability
related to the contingent loss for the guarantee.
The contingent aspect of the guarantee shall be
accounted for in accordance with Subtopic 450-20
unless the guarantee is accounted for as a
derivative instrument under Topic 815 or the
guarantee is within the scope of Subtopic 326-20 on
financial instruments measured at amortized cost.
For guarantees within the scope of Subtopic 326-20,
the expected credit losses (the contingent aspect)
of the guarantee shall be accounted for in
accordance with that Subtopic in addition to and
separately from the fair value of the guarantee
liability (the noncontingent aspect) accounted for
in accordance with paragraph 460-10-30-5.
A guarantor subsequently measures the noncontingent and contingent elements
of financial guarantees within the scope of ASC 326-20 differently because
the noncontingent obligation is measured under ASC 460 and the contingent
obligation is measured under ASC 326-20.
The guidance in ASC 460 does not specifically prescribe how a guarantor
subsequently measures the noncontingent element of the guarantee obligation.
Instead, ASC 460 indicates that the liability is typically reduced through
the income statement as the guarantor is released from risk under the
guarantee and cites three methods for making such a reduction:
-
Upon either expiration or settlement of the guarantee.
-
Using a systematic and rational amortization method.
-
Through changes in the fair value of the guarantee liability.
Entities cannot freely choose to elect one of the above subsequent-accounting
alternatives. Often, a systematic and rational amortization method is
appropriate. At the 2003 AICPA Conference on Current SEC Developments, the
SEC staff stated that “[i]t would seem a systematic and rational
amortization method would most likely be the appropriate [subsequent]
accounting” for the obligation to stand ready. For some guarantees, an
entity is required or permitted by U.S. GAAP to use a fair value model for
subsequent measurement as follows:
-
A fair value model is required for a guarantee that meets the definition of a derivative and is within the scope of the derivative accounting guidance in ASC 815-10.
-
For a guarantee that meets the definition of a financial instrument or is otherwise within the scope of the guidance in ASC 825-10 on the fair value option (e.g., a warranty that permits the warrantor to settle by paying a third party to provide goods or services), an entity is permitted to elect a fair value model unless the guarantee is specifically exempted from the scope of that guidance under ASC 825-10-15-5.
A fair value model cannot be justified solely on the basis
of the statement in ASC 460-10-35-2 that for some guarantees, the
guarantor’s release from risk is recognized as the fair value of the
guarantee changes. ASC 460-10-35-2 states, in part, that a “guarantor shall
not use fair value in subsequently accounting for the liability for its
obligations under a previously issued guarantee unless the use of that
method can be justified under generally accepted accounting principles
(GAAP).”
The contingent element (i.e., the expected credit losses) of the guarantee
within the scope of ASC 326-20 is subsequently measured in accordance with
ASC 326-20.
Footnotes
1
The sum of the unamortized noncontingent
guarantee obligation of $250,000 and the liability
for off-balance-sheet credit losses of $2.8
million.
5.2 Trade Receivables and Contract Assets
5.2.1 Trade Receivables
Receivables that result from revenue transactions under ASC 606 are subject to
the CECL model. ASC 606-10-25-1(e) requires an entity to perform an evaluation
at contract inception to determine whether it is “probable that the entity will
collect substantially all of the consideration to which it will be entitled” for
goods or services transferred to the customer (the “collectibility threshold”).
This evaluation takes into account “the customer’s ability and intention to pay
[the] consideration when it is due.” The purpose of the assessment is to
determine whether there is a substantive transaction between the entity and the
customer, which is a necessary condition for the contract to be accounted for
under ASC 606. Although a customer’s credit risk associated with trade
receivables that will be recorded under a contract with a customer is considered
as part of the collectibility threshold, the entity’s conclusion that the
collectibility threshold is reached does not imply that all receivables that
result from the revenue transaction are collectible. That is, once a receivable
is recorded, it is unlikely that the entity will be able to assert that there
are no expected losses on the trade receivable. The entity must calculate its
expected credit losses to determine whether it should recognize an impairment
loss related to the trade receivable and, if so, in what amount. The likely
result is that the entity will record an allowance for expected credit losses on
trade receivables earlier under a CECL model than it would under existing
accounting requirements.
ASU 2016-13 includes the following example illustrating how an
entity could use a provision matrix to apply the guidance to trade receivables.
ASC 326-20
Example 5:
Estimating Expected Credit Losses for Trade
Receivables Using an Aging Schedule
55-37 This Example illustrates
one way an entity may estimate expected credit losses
for trade receivables using an aging schedule.
55-38 Entity E manufactures and
sells products to a broad range of customers, primarily
retail stores. Customers typically are provided with
payment terms of 90 days with a 2 percent discount if
payments are received within 60 days. Entity E has
tracked historical loss information for its trade
receivables and compiled the following historical credit
loss percentages:
- 0.3 percent for receivables that are current
- 8 percent for receivables that are 1–30 days past due
- 26 percent for receivables that are 31–60 days past due
- 58 percent for receivables that are 61–90 days past due
- 82 percent for receivables that are more than 90 days past due.
55-39 Entity E believes that
this historical loss information is a reasonable base on
which to determine expected credit losses for trade
receivables held at the reporting date because the
composition of the trade receivables at the reporting
date is consistent with that used in developing the
historical credit-loss percentages (that is, the similar
risk characteristics of its customers and its lending
practices have not changed significantly over time).
However, Entity E has determined that the current and
reasonable and supportable forecasted economic
conditions have improved as compared with the economic
conditions included in the historical information.
Specifically, Entity E has observed that unemployment
has decreased as of the current reporting date, and
Entity E expects there will be an additional decrease in
unemployment over the next year. To adjust the
historical loss rates to reflect the effects of those
differences in current conditions and forecasted
changes, Entity E estimates the loss rate to decrease by
approximately 10 percent in each age bucket. Entity E
developed this estimate based on its knowledge of past
experience for which there were similar improvements in
the economy.
55-40 At the reporting date,
Entity E develops the following aging schedule to
estimate expected credit losses.
The example above illustrates that an entity’s use of a provision matrix to apply
the CECL model to trade receivables may not differ significantly from its
current methods for determining the allowance for doubtful accounts. However,
the example also shows that when using such a matrix, the entity is required to
consider the following:
- Whether expected credit losses should be recognized for trade receivables that are considered “current” (i.e., not past due). In the example above, a historical loss rate of 0.3 percent is applied to the trade receivables that are classified as current.
- When using historical loss rates in a provision matrix, the entity must assess whether and, if so, how the historical loss rates differ from what is currently expected over the life of the trade receivables (on the basis of current conditions and reasonable and supportable forecasts).
Connecting the Dots
Unit of Account
As discussed in Section 3.2, an entity is required to evaluate financial
assets within the scope of the model on a collective (i.e., pool) basis
when assets share similar risk characteristics. If a financial asset’s
risk characteristics are not similar to those of any of the entity’s
other financial assets, the entity would evaluate that asset
individually.
As a result, although an entity may be able to continue using a provision
matrix to estimate credit losses, it may need to apply the matrix to a
more disaggregated level of trade receivables because it is required to
estimate expected credit losses collectively only when assets share
similar risk characteristics. That is, instead of applying a single
provision matrix to all of its trade receivables, the entity may need to
establish pools of such receivables on the basis of risk characteristics
and then apply a provision matrix to each pool.
Although the CECL model requires entities to perform a different evaluation for
trade receivables, we generally do not expect that most entities will see a
significant change in the impairment losses recognized on trade receivables.
However, entities with long-term trade receivables (e.g., those with due dates
that extend beyond one year) may experience more of a change than those with
short-term receivables because entities with long-term receivables may need to
consider additional adjustments to historical loss experience to reflect their
expectations about macroeconomic conditions that could exist past one year.
5.2.1.1 Credit Risk Versus Variable Consideration
ASC 606-10-45-4 states, in part, that “[u]pon initial
recognition of a receivable from a contract with a customer, any difference
between the measurement of the receivable in accordance with Subtopic 326-20
and the corresponding amount of revenue recognized shall be presented as a
credit loss expense.” However, the amount of revenue recognized in a
contract with a customer can change as a result of changes in the
transaction price. This is because the amount of consideration to which an
entity expects to be entitled for promised goods or services that have been
transferred to a customer may vary depending on the occurrence or
nonoccurrence of future events, including potential price concessions that
an entity might grant. That is, an entity may accept (and is expected to
accept) less than the contractually stated amount of consideration in
exchange for promised goods or services. Concessions might be granted as a
result of product obsolescence but might also be granted because of credit
risk assumed by the vendor in the transaction. Consider the example below
reproduced from ASC 606.
ASC 606-10
Example 3 — Implicit Price
Concession
55-102 An entity, a hospital,
provides medical services to an uninsured patient in
the emergency room. The entity has not previously
provided medical services to this patient but is
required by law to provide medical services to all
emergency room patients. Because of the patient’s
condition upon arrival at the hospital, the entity
provides the services immediately and, therefore,
before the entity can determine whether the patient
is committed to perform its obligations under the
contract in exchange for the medical services
provided. Consequently, the contract does not meet
the criteria in paragraph 606-10-25-1, and in
accordance with paragraph 606-10-25-6, the entity
will continue to assess its conclusion based on
updated facts and circumstances.
55-103 After providing
services, the entity obtains additional information
about the patient including a review of the services
provided, standard rates for such services, and the
patient’s ability and intention to pay the entity
for the services provided. During the review, the
entity notes its standard rate for the services
provided in the emergency room is $10,000. The
entity also reviews the patient’s information and to
be consistent with its policies designates the
patient to a customer class based on the entity’s
assessment of the patient’s ability and intention to
pay. The entity determines that the services
provided are not charity care based on the entity’s
internal policy and the patient’s income level. In
addition, the patient does not qualify for
governmental subsidies.
55-104 Before reassessing
whether the criteria in paragraph 606-10-25-1 have
been met, the entity considers paragraphs
606-10-32-2 and 606-10-32-7(b). Although the
standard rate for the services is $10,000 (which may
be the amount invoiced to the patient), the entity
expects to accept a lower amount of consideration in
exchange for the services. Accordingly, the entity
concludes that the transaction price is not $10,000
and, therefore, the promised consideration is
variable. The entity reviews its historical cash
collections from this customer class and other
relevant information about the patient. The entity
estimates the variable consideration and determines
that it expects to be entitled to $1,000.
55-105 In accordance with
paragraph 606-10-25-1(e), the entity evaluates the
patient’s ability and intention to pay (that is, the
credit risk of the patient). On the basis of its
collection history from patients in this customer
class, the entity concludes it is probable that the
entity will collect $1,000 (which is the estimate of
variable consideration). In addition, on the basis
of an assessment of the contract terms and other
facts and circumstances, the entity concludes that
the other criteria in paragraph 606-10-25-1 also are
met. Consequently, the entity accounts for the
contract with the patient in accordance with the
guidance in this Topic.
As noted in the example above, the entity believes that it is probable that
it will collect $1,000 from the patient, which is less than the contractual
price of $10,000. Accordingly, the entity records a receivable of $1,000
when it renders services to the patient. Under ASC 326-20, the entity is
required to evaluate financial assets on a collective (i.e., pool) basis
when assets share similar risk characteristics. Therefore, in this example,
the entity would need to consider its portfolio of similar trade receivables
to determine whether it would have to record an additional allowance. This
is because, although it is probable that the entity will collect $1,000, it
is not certain that the entity will collect $1,000 from all similarly
situated patients. Accordingly, the entity would most likely need to record
an additional allowance for further expected credit losses on the basis of
the expected collections across its portfolio of trade receivables.
Entities will need to use significant judgment in determining whether
recorded receivables are not collectible because the entities have provided
an implicit price concession or because there is incremental credit risk
beyond what was contemplated when the transaction price was established.
This is particularly true of entities in highly regulated industries, such
as health care and consumer energy, which may be required by law to provide
certain goods and services to their customers regardless of the customers’
ability to pay. Therefore, entities will need to evaluate all of the
relevant facts and circumstances of their arrangements to determine whether
they have provided implicit price concessions or whether the anticipated
receipt of less than the total contractual consideration represents
additional credit risk, as a result of which they may be required to record
additional credit losses upon adopting ASC 326-20. These credit losses are
measured on the basis of the losses that would be expected to be incurred
over the entire contractual term (i.e., the period over which the
receivables recorded will be collected).
5.2.1.2 Measuring Expected Credit Losses on Trade Receivables When the Corresponding Revenue Has Not Been Recognized
In limited circumstances, an entity may have an
unconditional right to consideration (i.e., a receivable) before it
transfers goods or services to a customer. In those situations, the
entity would recognize the receivable as well as a contract liability
representing its obligation to transfer goods or services to a customer.
This contract liability is commonly referred to as deferred revenue.
Questions have arisen about whether an entity that is
determining the receivable balance on which to estimate expected credit
losses is allowed to reduce the receivable by the associated contract
liability (i.e., deferred revenue). We generally believe that the entity
should only estimate expected credit losses on receivables for which the
associated revenue has been recognized. This belief is premised on the
fact that the entity does not have credit loss exposure related to goods
or services yet to be transferred because if the customer were to
default before recognizing revenue, the entity could simply no longer
deliver the goods or services and avoid a credit loss. In this case, the
entity could use the deferred revenue balance to reduce or “offset” the
exposure related to the receivable balance for which the estimate of
expected credit losses is being determined.
However, we acknowledge that there may be situations in
which an entity is prohibited from recognizing revenue because of
certain requirements in ASC 606, even though it has transferred the
related goods or services. In this case, it would not be appropriate to
reduce the exposure related to the receivable by some or all of the
deferred revenue recognized by the entity because it has already
delivered the goods or services and therefore cannot reduce its exposure
to credit losses by not performing under the terms of the arrangement.
5.2.1.3 Recognition of Expected Credit Losses on Sales Tax Receivables From Customers
A receivable from a customer that is recognized as part
of a revenue transaction may include an amount collected from the
customer related to a sales tax imposed by a tax authority. The seller
will generally have a corresponding payable for the sales tax amount it
is required to remit to the tax authority. In limited circumstances, the
seller may not be obligated to pay the sales tax amount to the tax
authority if the customer defaults on the receivable.
We believe that if the entity is required to pay the
sales tax amount to a tax authority regardless of whether the customer
defaults on the sales tax receivable, the entity is exposed to credit
losses and an allowance for expected losses should be recognized in
accordance with ASC 326-20. However, if an entity is not obligated to
pay the sales tax amount to the tax authority if the customer defaults
on the receivable, the entity has no exposure to credit losses and would
not be required to recognize an allowance for credit losses.
5.2.2 Contract Assets
Contract assets arise when an entity recognizes revenue but the entity’s right to
consideration depends on something other than the mere passage of time (e.g., the
satisfaction of additional performance obligations in the contract). Contract assets
are commonly referred to as unbilled receivables. ASC 606-10-45-3 states that an
entity should assess whether a contract asset is impaired in accordance with ASC 310
(before the adoption of ASU 2016-13) or ASC 326-20 (after the adoption of ASU 2016-13).
Because the collection of unbilled receivables depends on something other than just
the passage of time (e.g., future performance under the contract), contract assets
may take longer to recover than trade receivables. Consequently, an entity that has
contract asset balances may be more exposed to expected credit losses for recorded
amounts than an entity that has only short-term trade receivables. If the entity’s
policy for determining incurred losses on trade receivables (e.g., a matrix
approach) does not contemplate contract assets, it may need to implement additional
policies and procedures to reflect such assets in its allowance for expected credit
losses.
The example below illustrates how a
contract asset is recorded under ASC 606 and is recovered over a contract period.
Example 5-4
On January 1, 20X1, Entity X enters into an
arrangement to license its software to Customer Y for five
years. As part of the arrangement, X also agrees to provide
coterminous postcontract customer support (PCS). In exchange
for the license to X’s software and PCS, Y agrees to pay X
an annual fee of $500, invoiced at the beginning of each
year (total transaction price of $2,500), with payments due
within 60 days of invoice (i.e., 60 days after the first of
each year).
Entity X concludes the following about its
arrangement with Y:
- The promises to deliver the software license and PCS represent distinct performance obligations. Using a stand-alone selling price allocation method, X allocates 60 percent of the total transaction price to the software license and 40 percent to the PCS.
- Entity X’s software is a form of functional intellectual property; therefore, the license grants Y the right to use its intellectual property for the five-year contract term. As a result, X satisfies its performance obligation to transfer the software license at a point in time (i.e., contract inception).
- Entity X’s promise to provide PCS is satisfied over time by using a time-based measure of progress (i.e., ratably over the five-year contract term).
- Entity X concludes that the contract does not contain a significant financing component.2
In accordance with ASC 606, X recognizes
revenue as follows:3
Journal Entry: January 1, 20X1
Each year, X provides PCS under the contract
and bills the customer $500. Of that $500, $300 effectively
is applied against the contract asset recorded when the
license was transferred to the customer while the other $200
is related to PCS provided each year. Consequently, the
contract asset would have a four-year contractual term (the
period over which X will collect the contract asset). Upon
adopting ASU 2016-13, X will need to estimate the losses
that it will incur over the contractual term (i.e., four
years) when determining the loss allowance to record on the
contract asset.
Footnotes
2
Entities may need to apply
significant judgment to determine whether the
transaction price should be adjusted to account
for a significant financing component. See ASC
606-10-32-15 through 32-20 for more
information.
3
For simplicity, only the journal
entries at contract inception and for annual
reporting periods are provided.
5.3 Lease Receivables
Unlike receivables arising from operating leases (see Section 2.2 for more information), net investments
resulting from sales-type or direct financing leases are within the scope of ASC 326 and
lessors will therefore need to determine expected credit losses for such instruments.
Under ASC 840, a lessor was required to assess the net investment in a lease for
impairments by assessing (1) the lease receivable in accordance with ASC 310 and (2) the
unguaranteed residual asset in accordance with ASC 360. However, ASC 842 did not carry
forward the dual model for assessing impairment of the net investment in the lease.
In the Background Information and Basis for Conclusions of
ASU 2016-02, the FASB noted that
including two impairment models would be overly complex and that the benefits of the
resulting financial statement information would not justify its costs. Moreover, the
Board indicated that the net investment in a lease primarily comprises a financial lease
receivable (i.e., the unguaranteed residual asset is often insignificant) and therefore
should be accounted for as a financial asset under ASC 310. Thus, although the
unguaranteed residual asset included in a lessor’s net investment in a lease does not
meet the definition of a financial asset, a lessor that adopts ASU 2016-13 will be
required to apply the CECL model to the net investment in the lease, including both the
lease receivable and the unguaranteed residual asset.
5.3.1 Measuring Expected Credit Losses on a Net Investment in a Lease
ASC 842-30-35-3 provides guidance on how a lessor should
determine an impairment related to a net investment in a lease. According to
that guidance, when a lessor performs its evaluation, the collateral it
considers should include the cash flows that the lessor would expect to derive
from the underlying asset after the end of the lease term. Specifically, ASC
842-30-35-3 states:
A lessor shall determine the loss
allowance related to the net investment in the lease and shall record any
loss allowance in accordance with Subtopic 326-20 on financial instruments
measured at amortized cost. When determining the loss allowance for a net
investment in the lease, a lessor shall take into consideration the
collateral relating to the net investment in the lease. The collateral
relating to the net investment in the lease represents the cash flows that the lessor would expect to receive (or
derive) from the lease receivable and the unguaranteed residual
asset during and following the end of the remaining lease term. [Emphasis
added]
The unit of account used when the impairment model is applied
from the lessor’s perspective is meant to encompass the amounts related to the
entire net investment in the lease, including the residual asset. Therefore,
when evaluating the net investment in a sales-type or direct financing lease for
impairment, a lessor should use the cash flows it expects to derive from the
underlying asset during the remaining lease term as well as those it expects to
derive from the underlying asset at the end of the lease term (i.e., cash flows
expected to be derived from the residual asset). When determining the cash flows
to be derived from the residual asset, the lessor should consider the amounts it
would receive for releasing or selling the underlying asset to a third party but
should not consider the expected credit risk of the potential future lessee or
buyer of the underlying asset (i.e., it would not be appropriate for the lessor
to include a credit risk assumption in its analysis since it does not know the
identity of the theoretical future lessee or buyer).
5.3.2 Gains and Losses on Subsequent Dispositions of Leased Assets
When measuring expected credit losses on a portfolio of net
investment in leases, an entity should consider gains arising from the
subsequent disposition of leased assets.
At the June 2018 TRG meeting, the FASB staff
stated that “entities should estimate expected cash flows from the subsequent
disposition of leased assets (whether those result in expected gains or losses
on disposal) when calculating expected credit losses on a portfolio of net
investments in leases under the guidance in Subtopic 326-20 if that estimate is
reasonable and supportable consistent with the treatment of other inputs to the
calculation of expected credit losses.” That is, the FASB staff does not view
the pool-level assessment required under ASC 326-20 as precluding the inclusion
of “cash flows from the subsequent disposition of leased assets expected to
result in gains on disposal from the calculation of expected credit losses.”4
However, we believe that the inclusion of expected gains on the
disposal of leased assets should not, by itself, cause an entity’s allowance for
expected credit losses to be negative. That is, while an entity should include
in its estimate of expected credit losses the cash flows expected upon the
disposition of the leased assets, we believe that the amount of cash flows
related to gains on the disposal of such assets should be limited to the amount
necessary to offset any expected credit losses on the lease payments.
Example 5-5
Lessor’s portfolio of sales-type leases
has a net investment balance of $6 million. On the basis
of its historical experience and its reasonable and
supportable forecasts, Lessor estimates that 4 percent
will default. Given the projected net investment balance
at the time of the defaults and the estimated proceeds
from the disposition of the leased assets, Lessor
expects $200,000 of credit losses. In addition, it
expects to recover $50,000 from the sale of the assets
included in its performing leases (i.e., those that will
not default during the lease term). On the basis of the
FASB staff’s response at the TRG meeting, Lessor would
estimate its expected credit losses as the sum of (1)
its expected credit losses resulting from expected
defaults plus (2) the gains it expects to recover from
the disposition of assets on the leases that do not
default. That is, Lessor’s expected credit losses would
be $150,000, calculated as the net amount expected to be
collected at the pool level.
Footnotes
4
See TRG Memo 7.
5.4 Reinsurance Receivables
A reinsurance transaction is one in which a reinsurer (an assuming entity) assumes all or
part of a risk undertaken originally by another insurer (a ceding entity) for
consideration. As noted in Chapter 2, ASC 326-20
applies to all reinsurance receivables that result from insurance transactions within
the scope of ASC 944 regardless of the underlying measurement basis of the receivables
(i.e., measured at amortized cost or on a discounted basis). The CECL model does not
have any special provisions or guidance that specifically applies to reinsurance
receivables. However, we believe that an entity will need to carefully consider the
following when applying the CECL model to reinsurance receivables:
- Isolating credit risk — Determining what portion of the collectibility concerns about reinsurance receivables is related to credit risk versus other risks (e.g., dispute risk, legal risk).
- Unit of account — ASC 326-20 requires entities to perform a collective assessment if the reinsurance receivables share similar risk characteristics.
5.4.1 Isolating Credit Risk
Before being amended by ASU 2016-13, ASC 944-310-35-4 stated, in part, that “the
ceding entity shall assess the collectibility of those [reinsurance]
recoverables in accordance with Subtopic 450-20.” Accordingly, under current
U.S. GAAP, an entity is not required to consider the reasons why collectibility
concerns exist. Rather, ASC 944 requires entities to evaluate such concerns in
accordance with ASC 450-20, even if they result from a combination of different
risks associated with the asset.
However, ASU 2016-13 amended ASC 944-310-35-4 to state that although “[a]n entity
shall measure contingent losses relating to disputed amounts in
accordance with Subtopic 450-20 on loss contingencies[,] the ceding entity shall
measure expected credit losses relating to reinsurance recoverables in
accordance with Subtopic 326-20 on financial instruments measured at amortized
cost” (emphasis added). Consequently, under ASU 2016-13, an entity is required
to isolate the collectibility concerns that are related only to credit risk and
measure the expected credit losses in accordance with ASC 326. The requirement
to bifurcate risks to isolate credit risk may be challenging for entities that
have reinsurance receivables.
5.4.2 Unit of Account
As described in Chapter 3, the CECL model does
not prescribe a unit of account (e.g., an individual asset or a group of financial
assets) in the measurement of expected credit losses. However, an entity is required
to evaluate financial assets within the scope of the model on a collective (i.e.,
pool) basis when assets share similar risk characteristics. If a financial asset’s
risk characteristics are not similar to those of any of the entity’s other financial
assets, the entity would evaluate that asset individually.
Although entities will be required to use judgment when evaluating the risk
characteristics of all financial assets, they will need to pay particular attention
to the specific risk characteristics of reinsurance receivables. Example 17 in ASC
326-20 illustrates the evaluation of different types of risks related to reinsurance
receivables.
ASC 326-20
Example 17:
Identifying Similar Risk Characteristics in
Reinsurance Recoverables
55-81 Reinsurance recoverables may
comprise a variety of risks that affect collectibility
including:
- Credit risk of the reinsurer/assuming company
- Contractual coverage disputes between the reinsurer/assuming company and the insurer/ceding company including contract administration issues
- Other noncontractual, noncoverage issues including reinsurance billing and allocation issues.
55-82 This Subtopic only requires
measurement of expected losses related to the credit risk of
the reinsurer/assuming company.
55-83 In situations in which
similar risk characteristics are not present in the
reinsurance recoverables, the ceding insurer should measure
expected credit losses on an individual basis. Similar risk
characteristics may not exist because any one or a
combination of the following factors exists, including, but
not limited to:
- Customized reinsurance agreements associated with individual risk geographies
- Different size and financial conditions of reinsurers that may be either domestic or international
- Different attachment points among reinsurance agreements
- Different collateral terms of the reinsurance agreements (such as collateral trusts or letters of credit)
- The existence of state-sponsored reinsurance programs.
55-84 However, similar risk
characteristics may exist for certain reinsurance
recoverables because any one or combination of the following
exists:
- Reinsurance agreements that have standardized terms
- Reinsurance agreements that involve similar insured risks and underwriting practices
- Reinsurance counterparties that have similar financial characteristics and face similar economic conditions.
55-85 Judgment should be applied by
ceding insurers in determining if and when similar risks
exist within their reinsurance recoverables.