Kaitlyn H. Axenfeld, CPA/CFF, CFE
The CECL model’s main change from current accounting rules is a requirement to incorporate forward-looking information while estimating credit losses. Construction companies typically have several types of financial assets that are subject to the ASU, including contract receivables, contract retainage and contract assets. You will now be required to forecast the total expected credit losses of these types of financial assets over the entirety of the asset’s life rather than when the loss meets the probable threshold or when incurred. This forecast is based on a wider scope of data that includes past events, current conditions, and reasonable and supportable estimates for the future. As a result, companies will have to invest more time in reviewing past write-offs, past bad debts, creditworthiness, etc., to calculate a reasonable and fair estimate for future bad debts.
A common approach to estimating future bad debts is to review aging categories for receivables. These aging categories can then be assigned reserve percentages based on delinquency, prior bad debts, knowledge of who owes what, etc. Those values are then combined to determine an entity’s allowance or reserve for bad debts.
When estimating future bad debts for financial assets subject to ASC 326, management should also evaluate and consider consumer credit risk scores, credit ratings, credit risk grades, debt-to-value ratios, collateral, collection experience, or other internal metrics.
The new standard requires enhanced disclosures to provide transparency on credit risk management, methodology, and the impact on financial statements. This enables financial statement users to assess the credit quality of financial assets and understand changes in expected credit losses over time.
For each class of financial assets, a reporting entity should describe the credit quality indicator that it is using and then disclose the amortized cost basis of the asset, grouped by indicator.
Footnotes on an ongoing basis are required to include:
- A description of how expected loss estimates are developed.
- The entity’s accounting policies and methodology to estimate the allowance for credit losses.
- Factors that influenced management’s current estimate and relevant risk characteristics.
- Changes in the factors influencing management’s current estimate of expected credit losses and the reasons for those changes.
- Changes to the entity’s accounting policies and reasons for significant changes in the amount of write-offs, if applicable.
CECL may not have a significant impact on a company’s allowance for credit loss, but it will require management to make new judgments and calculations to comply with the new standard. Entities should also consider updating their policies and procedures to ensure the necessary data is accurately captured. Once implemented, CECL will require ongoing monitoring to ensure that the methods and assumptions used for the initial credit loss calculations continue to reflect current conditions and variables. Forecasting should be a continuous process, and those factors will continue to evolve.
It is also important to consider the impact of CECL when entering into new transactions or relationships, as well as when economic conditions change. CECL could negatively impact liquidity measures and ratios, which could affect lending, bonding, and other insurance.
Kaitlyn H. Axenfeld, CPA/CFF, CFE, is an audit partner at Dannible & McKee, LLP, a public accounting firm with offices in Syracuse, Auburn, Binghamton and Schenectady, NY, and Tampa, FL. The firm has specialized in providing tax, audit, accounting, and advisory services since its inception in 1978. For more information on this topic, you may contact Kaitlyn at (315) 472-9127 or visit online at www.dmcpas.com.