The Current Expected Credit Loss (CECL) model is an accounting standard used to estimate allowances for credit losses based on expected losses rather than incurred losses that was first introduced in June of 2016.

While the new model has already been in effect for most SEC filers, the effective date for all other organizations is for fiscal years beginning after December 15, 2022 (2023 calendar year ends and 2024 fiscal year ends).

What has changed?

In essence, organizations are no longer allowed to write off bad debt as it occurs (direct write off method). Organizations are now required to evaluate receivables for expected credit loss (likelihood of collection) at each reporting period.

Once the expected credit loss is determined, at the point of implementation, the organization would post an entry to create the “allowance for credit losses” and offset the entry to “credit loss expense” for current year changes and beginning net assets for any prior year changes. Going forward, the allowance will be adjusted annually. In essence, CECL requires companies to be more proactive about recognizing potential bad debt instead of waiting until it is probable, painting a more accurate picture of an organization’s financial health.

What is included under CECL?

Receivables subject to the evaluation, which therefore require an allowance calculation, are those receivables from exchange transactions, loans and notes receivable (related party loans or notes are excluded), programmatic loans, and those from direct financing or sales-type leases (operating leases are excluded). Pledges or promises to give are not included under this standard and do not require an evaluation or allowance.

CECL Methodology

CECL is about looking ahead, not just backward. The standard requires organizations to look at factors other than historical information. The evaluation is required to look at:

• The contractual term of the receivable
• Current conditions and reasonable and supportable forecasts
• The organization’s environment
• Factors specific to the creditor.

Said more simply, organizations can no longer solely rely on what happened in previous years to predict future losses, but instead must consider a wide range of contextual factors like larger economic conditions and contract length to determine potential losses.

The method used needs to be consistent from year to year. There are various methods that can be used to evaluate a list of receivables, and in some cases, more than one method may be used.  For example, government payments on a contract that is billed monthly will be evaluated differently than amounts due from individuals for classes held or a long-term note receivable.

Examples of methods include:

Loss Rate Method

• This method looks at the likelihood of collection.
  1. Based on types of creditors (individual method) when the risk characteristics between creditors vary. For example, for an in-home care provider, private pay may have a higher percentage of expected credit loss in the calculation compared to managed care organizations or government agencies, which would have lower loss risk based on credit worthiness.
  2. Based on types of receivables (collective method) when there are similar risk characteristics between creditors. For example, rent receivable will be assessed at a certain percentage that is different than the receivables for classes held or other programmatic events.

Aging Schedule

• This method takes the aging schedule and assigns a percentage to each category, increasing as the receivables are older. For example:
  1. 0.3 percent for receivables that are current
  2. 8 percent for receivables that are 1-30 days past due
  3. 26 percent for receivables that are 31-60 days past due
  4. 58 percent for receivables that are 61-90 days past due
  5. 82 percent for receivables that are more than 90 days past due

Discounted Cash Flow Method

• This method calculates the expected cash flows estimated, and then discounts them at a rate that equates the purchase price with the present value of expected cash flows.

In many cases, organizations may find that the allowance is small. If that is the case, during an audit, the adjustment may be deemed immaterial and the direct write off method could still be used. Either way, organizations are required to evaluate and provide support for their position. Auditors will ask to see the evaluation to determine the reasonableness and materiality of the calculation.

If you have further questions on this new standard or other upcoming changes that may impact your organization, we are here to help. Reach out to us if you’re interested in learning more about CECL and its impact on your organization.