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A new accounting standard from the Financial Accounting Standards Board (FASB) appears at first glance to apply only to financial institutions, but it could affect nonprofits that adhere to generally accepted accounting principles (GAAP). Among others, Accounting Standards Update (ASU) No. 2016-13, Financial instruments — Credit losses (subject 326), Valuation of credit losses on financial instruments, requires advance reporting of credit losses on receivables, loans and other financial assets. It also expands the range of information taken into account in determining expected credit losses. The standard comes into force in 2023, so it’s a good idea to look into the details as soon as possible.
Under the current “incurred loss” standard, organizations only recognize a credit loss after a loss event has occurred or is probable. Before that point is reached, nonprofits record an allocation based on historical events. For example, based on past experience, you may record a provision for bad debts in anticipation of future losses on bad debts.
Critics have complained that this largely backward-looking model limits an organization’s ability to record expected credit losses that do not yet meet the “likely” threshold. In response, the FASB initiated a project to better align financial disclosures about credit losses with the need of users of financial statements for forward-looking information.
After considering various models for reporting expected credit losses, the FASB decided on the “current expected credit loss” (CECL) model. This model measures and reports expected losses over the contractual life of the asset—usually from the initial recognition of the asset. The measurement of expected credit losses will be based on relevant information, not only on past events, including historical experience and current conditions, but also on “reasonable and supportable” forecasts that affect the recoverability of the reported amount.
Several types of assets often held by nonprofits fall under the new ASU. They understand:
- Trade receivables (generally, amounts invoiced for goods or services, such as merchandise, tuition, fees, membership dues, and special event revenue);
- Debt securities held to maturity in an investment portfolio;
- Notes receivable and other loan commitments; and
- Lease receivables.
The ASU excludes pledges, loans and receivables between entities under common control and loans under defined contribution benefit plans.
The ASU does not prescribe a method for estimating specific credit losses. Rather, it allows not-for-profit organizations to exercise their judgment in determining which method is appropriate for their circumstances, including the nature of their financial assets. It also allows organizations to continue to use many of the loss estimation techniques currently in use, including loss rate methods, probability of default methods, discounted cash flow methods, and age calendars. . But the data used with these techniques will change to incorporate the full amount of expected credit losses and the use of reasonable and supportable forecasts.
Also, under CECL, credit impairment is accounted for as an allowance for credit losses, not as a direct impairment of the financial asset. The ASU does not, however, establish a threshold for recognizing an impairment allowance, so organizations must also measure expected losses on assets with a low risk of loss. This means that trade receivables that are outstanding or not yet due will have a provision. Under the current rule, these receivables may not require a provision.
The new FASB standard will become effective for most nonprofit organizations in 2023, although earlier application is permitted. To begin preparing for the implementation of the CECL model, your nonprofit will need to review all of your financial assets to identify those that fall within the scope of the standard and determine the method you will use to estimate the expected losses. ORBA can help you.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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