As companies have started implementing Accounting Standards Codification (ASC) 326 Financial Instruments—Credit Losses (also known as CECL, for Current Expected Credit Losses), many questions have come up about how ASC 606 and ASC 326 interact. The truth is, these standards do not interact directly. ASC 326 applies to all companies and affects balance sheet accounts such as accounts receivable and contract assets. Some of the accounts affected by ASC 326 are also related to ASC 606 Revenue Recognition, which is part of why there has been confusion over how the standards affect each other. After implementing ASC 326, companies will need a strong understanding of the difference between a credit loss and a price concession, as well as adequate data collection systems in place to make necessary disclosures and analyze past transactions. Creating a forecast of future expected credit losses may also require input and collaboration from multiple departments. This article gives an overview of what ASC 326 is, how ASC 606 and ASC 326 relate, and how implementation of ASC 326 will affect businesses.
ASC 326 Financial Instruments—Credit Losses (CECL)
In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13: Financial Instruments—Credit Losses, which was codified as section 326 of the accounting standards codification. Before this change was made, Generally Accepted Accounting Principles (GAAP) required entities to recognize credit losses when it was probable that a loss had already been incurred. Under this previous guidance, entities did not report expected credit losses, but instead reported losses that had been incurred. During the financial crisis of 2008, both preparers and users of financial statements were frustrated that credit loss accounting was not more forward-looking. This frustration contributed to standard-setters making this change in credit loss accounting.
Now, under ASC 326, entities must record estimates of current expected credit losses over the life of their financial assets. While forward-looking estimates of lifetime losses will require forecasts of future losses, the FASB has stated the following: “It is not the Board’s expectation that an entity will need to create an economic forecast over the entire contractual life of long-dated financial assets.” Entities can still use historical loss information to estimate losses for periods that are “beyond the time frame for which the entity can develop reasonable and supportable forecasts” (ASU 2016-13).
ASC 326 affects entities holding financial assets that are not already accounted for at fair value through net income. The standard has two main provisions: “Assets Measured at Amortized Cost” and “Available-for-Sale Debt Securities.”
ASC 326: Difference between GAAP and IFRS. According to GAAP, companies must estimate all future losses expected over the lifetime of a loan and recognize those losses currently. IFRS only requires that companies estimate and recognize future losses expected over the next twelve months when the credit risk has not increased significantly since initial recognition (IFRS 9, 5.5.5). If credit risk has increased significantly since initial recognition, companies must measure the loss allowance for the lifetime expected credit losses (IFRS 9, 5.5.3).
ASC 326: Effective Dates. According to Accounting Standards Update (ASU) 2019-10, ASC 326 becomes effective for fiscal years beginning after December 15, 2019 for public entities that are considered Securities and Exchange Commission (SEC) filers, excluding smaller reporting companies (SRCs). For all other entities (public companies that are not considered SEC filers, private entities, nonprofits, etc.), ASC 326 is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early application is permitted for fiscal years after December 15, 2018, including interim periods within those fiscal years.
The Roles of ASC 606 and ASC 326 in Contracts
First, it may be helpful to review the five steps of ASC 606: Revenue Recognition. To learn more about these steps, read The Five-Step Method.
- Identify the Contract
- Identify the Performance Obligation(s)
- Determine the Transaction Price
- Allocate Revenue to the Performance Obligations
- Recognize Revenue as Performance Obligations are Satisfied
Initial Collectibility Analysis Under ASC 606
Before an entity can record a receivable, it must first identify a contract with its customer. For a contract to exist, collectibility must be probable (in practice about 70-80% certain). If an entity enters into an agreement with its customer while at the same time not expecting that it will be able to collect on that agreement, there is no contract and ASC 606 does not apply. Entities usually won’t enter into agreements unless they think the customer will pay, so this situation is uncommon. However, an important distinction is that this initial assessment of collectibility is specifically for the purposes of ASC 606, not ASC 326. Read more about Collectibility of Consideration.
If the contract exists according to ASC 606, an entity can proceed to follow the rest of the five-step process and begin to recognize revenue. Next up, the entity must identify its performance obligations, then determine the transaction price. Determining the transaction price requires judgment to distinguish between a credit risk and an explicit or implicit price concession.
Price Concession or Credit Loss?
When evaluating the transaction price, entities must include the effect of any price concessions, whether explicit or implicit. After contract inception, subsequent price concessions must also be evaluated, so entities should use judgment to determine whether the factors affecting collectibility represent a price concession or a credit loss at that time. This issue is mentioned in a Deloitte Heads Up:
“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 as a result of 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.” (Page 4, emphasis added)
Health care is one industry mentioned in the Deloitte Heads Up. Healthcare organizations negotiate many different rates with insurance companies; these negotiated rates can be interpreted as explicit price concessions. However, if someone were to walk into a hospital in critical condition with no insurance, the hospital would still have to treat them. For these patients, healthcare organizations may recognize implicit price concessions or credit losses because the customer does not usually end up paying the entire amount. See the illustrations in this article to get a sense of the difference between price concessions and credit losses.
In its September 2019 10-Q, HCA Healthcare, Inc. explained when it uses explicit and implicit price concessions and how it estimates them:
“Revenues related to uninsured patients and uninsured copayment and deductible amounts for patients who have health care coverage may have discounts applied (uninsured discounts and contractual discounts). We also record estimated implicit price concessions (based primarily on historical collection experience) related to uninsured accounts to record these revenues at the estimated amounts we expect to collect.” (Sept. 2020 10-Q)
When HCA treats uninsured patients, the company may record an explicit price concession based on uninsured or contractual discounts. Based on its historical experience, HCA also usually records an implicit price concession because it expects to lower the price for amounts due from its uninsured patients.
SmileDirectClub, Inc. sells dental products such as aligners, whitening gel, and retainers. In its March 10-Q, SmileDirectClub explains how it assesses price concessions and reserves for credit losses:
“We offer our members the option of paying for the entire cost of their aligners upfront or enrolling in SmilePay, a convenient monthly payment plan that requires a $250 down payment, with the remaining consideration due over a period up to 24 months. Approximately 65% of our members elect to purchase our aligners using SmilePay. The amount of contract consideration we estimate to be collectible from our SmilePay members results in an implicit price concession. We estimate the amount of implicit price concession based upon our assessment of historical write-offs and expected net collections, business and economic conditions, including the uncertainty of the lasting effects of the COVID-19 pandemic, and other collection indicators. We believe our analysis provides reasonable estimates of our revenues and valuations of our accounts receivable.” (March 2020 10-Q, page 43)
“The Company provides credit to customers in the normal course of business. The Company maintains reserves for potential credit losses and such losses have been within management’s expectations.” (March 2020 10-Q, page 14)
Universal Health Services, Inc. (UHS) has recently implemented ASC 606 and ASC 326. A 10-Q released following the change includes this analysis of the company’s “Charity care, Uninsured Discounts, and Other Adjustments to Revenue”:
“Under ASC 605, our hospitals established a partial reserve for self-pay accounts in the allowance for doubtful accounts for both unbilled balances and those that have been billed and were under 90 days old. All self-pay accounts were fully reserved at 90 days from the date of discharge. Third party liability accounts were fully reserved in the allowance for doubtful accounts when the balance aged past 180 days from the date of discharge. Patients that express an inability to pay were reviewed for potential sources of financial assistance including our charity care policy. If the patient was deemed unwilling to pay, the account was written-off as bad debt and transferred to an outside collection agency for additional collection effort. Under ASC 606, while similar processes and methodologies are considered, these revenue adjustments are considered at the time the services are provided in determination of the transaction price.” (Sept. 2020 10-Q)
Under ASC 606 and 326, UHS has changed their analysis process to consider potential price concessions at the time the contract is made.
Example: Price Concession or Credit Loss?
Suppose ABC Hospital provides health care services to a patient, Mr. Gray. Mr. Gray has insurance, but still owes ABC Hospital $100 after receiving care. ABC Hospital finds it probable that the patient will pay, so the contract is valid under ASC 606. ABC Hospital then records a bad debt expense of $10, expecting the customer to actually pay $90. After 45 days, Mr. Gray pays only $75. See the journal entries below for ABC Hospital:
|Provision for Credit Losses||10|
|Allowance for Doubtful Accounts and Credit Losses||10|
As seen above, the net Accounts Receivable balance before the cash payment is $90 ($100 – $10). After the cash payment of $75, ABC Hospital still has $15 left in its net Accounts Receivable. However, Mr. Gray will not pay the full $90. Is the $15 a result of a credit loss or a price concession? The answer should reflect the reason why the patient did not pay. If the patient went bankrupt, the $15 is most likely a credit loss. However, if Mr. Gray called the customer service line to complain about his experience and was told that he could settle his debt with just $75, the $15 may be a price concession.
Initial and Subsequent Collectibility Analysis Under ASC 326
After an entity has established a contract and a receivable (adjusted for any price concessions), it can assess collectibility and create an allowance upon initial measurement of the financial asset, then reassess the allowance at reporting dates. Both assessments should be done using the guidance of ASC 326 Financial Instruments—Credit Losses. Increases and decreases are recorded as credit loss expense and reversal of credit loss expense, respectively, in the income statement. ASC 326-20-55-2 states the following:
55-2: “In determining its estimate of expected credit losses, an entity should evaluate information related to the borrower’s creditworthiness, changes in its lending strategies and underwriting practices, and the current and forecasted direction of the economic and business environment.”
The combination of these factors will help entities determine what the amount of the allowance for credit losses should be. The standard provides more detail on estimating the credit losses for both “Assets Measured at Amortized Cost” and “Available-for-Sale Debt Securities,” but assets measured at amortized cost relate more closely with ASC 606.
Assets Measured at Amortized Cost
ASC 326-20 requires assets measured at amortized cost (typically receivables, loans, etc.) to be presented at the net amount expected to be collected. ASC 606-10-45-3 also requires that contract assets be assessed for credit losses under the guidance of ASC 326-20 (Read more about Contract Assets). When disclosing the expected credit losses, an entity can create an allowance for its estimate, then deduct the allowance from the total asset value to reach the net amount shown on the balance sheet. Increases or decreases in the allowance amount will show up in the income statement. To make the estimate for the allowance account, entities can use “relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amount” (ASU 2016-13). Other factors for determining collectibility can be found in ASC 326-20-30-7 through 30-8.
Entities are not required to use any single estimation method, although a discounted cash flow method is described as acceptable (ASC 326-20-30-3). If the entity does use a discounted cash flow method, the entity should use the effective discount rate of the financial asset to discount the cash flows (ASC 326-20-30-4).
According to ASC 326-20-30-2, entities must evaluate expected credit losses for financial assets measured at amortized cost on a collective (pool) basis if the assets have similar risk characteristics. The initial allowance for credit losses for purchased financial assets with credit deterioration is determined on a collective basis, then allocated to individual assets (ASC 326-20-30-13). If a single financial asset has different risk characteristics than the rest, the entity can evaluate that asset’s expected credit losses separately. However, the asset measured on an individual basis cannot also be included when entities make evaluations for the collective group of financial assets. For a comprehensive example, see ASC 326-20-55-18 through 55-22.
Duke Energy Corporation implemented ASC 326 this year. In its September 10-Q, Duke explains how it determines its allowance for credit losses:
“Duke Energy recognizes allowances for credit losses based on management’s estimate of losses expected to be incurred over the lives of certain assets or guarantees. Management monitors credit quality, changes in expected credit losses and the appropriateness of the allowance for credit losses on a forward-looking basis. Management reviews the risk of loss periodically as part of the existing assessment of collectability of receivables.” (Sept. 2020 10-Q)
Implications for Businesses Implementing ASC 326
The changes in ASC 326 for how companies account for credit losses will have several effects on both small and large businesses.
Because ASC 326 requires forward-looking estimates, one of the main issues companies could have is the development of forecasts for future credit losses. Since these forecasts can rely on past data, at least partially, data integrity could be a problem, especially for smaller companies. Smaller companies may go through several different system implementations as they continue to grow, and data from before a newer implementation may not be easily accessible or comparable between systems. For example, write-offs may not be connected to specific past invoices. This would make it difficult to determine how long it takes for invoices to get written off and to make other similar measures. When past data is not reliable, developing forecasts based on historic trends may become complicated.
In addition, if historic trends are similar to what you expect, forecasting is much simpler. However, uncertainty caused by recessions or the recent COVID-19 pandemic make forecasting much more difficult. Pacific Premier Bancorp, Inc. said the following about its estimates:
“The Company has developed an expected credit loss estimation model in accordance with ASC 326. The Company implemented the model through a cross-functional effort steered by a CECL Committee, related sub-committees and working groups. These committees, sub-committees and working groups, collectively, were primarily comprised of senior management and staff members from our finance, credit, lending, internal audit, risk management and IT functional areas… Management leverages economic projections from a reputable and independent third party to inform its reasonable and supportable economic forecasts.” (June 2020 10-Q)
The creation of credit loss estimates is possibly one of the most difficult parts of the change to ASC 326. Pacific Premier Bancorp needed the expertise from a wide range of departments to develop a model for expected credit losses, even though it outsourced some of its forecasting. Other companies implementing these requirements will not only have to align departments that haven’t had much past interaction, but will also have to document the process well enough to satisfy external auditors. Companies will also need to make financial statement disclosures about the inputs into their forecasting process. The onset of COVID-19 has only made the forecasting process more difficult. The forecasting requirements for ASC 326 could certainly be time consuming for a business, no matter the size and no matter the industry.
One other potential implication for businesses comes from a FASB Board Meeting on December 2nd. During this meeting, the Board discussed feedback on Update 2016-13 (CECL) in a post-implementation review. In this meeting, the Board discussed the “scope of financial assets included in Update 2016-13 (including trade receivables).” No decision has been made to exclude trade receivables from the scope of ASC 326, but the staff will continue to monitor feedback from stakeholders on this topic.
For any financial assets subject to ASC 326, entities must record an allowance for future expected credit losses over the life of its financial assets. Although the allowance affects accounts that can be related to ASC 606, such as receivables or loans receivable, the allowance made according to ASC 326 is different from the initial collectibility analysis under ASC 606. Therefore, companies will need a strong understanding of the difference between a credit loss and a price concession. In addition, companies will need adequate data collection systems in place to make necessary disclosures and analyze past transactions for use in forecasts. Creating a forecast of future expected credit losses may also require information from multiple departments. If companies make the necessary changes, they will be able to implement ASC 326 successfully.
- ASC 606: Revenue from Contracts with Customers
- AICPA Revenue Guide, Chapter 7—Health Care Entities.
- ASU 2016-13: “Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.”
- ASU 2019-10: “Financial Instruments—Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842)—Effective Dates.”
- Deloitte, Heads Up: “No Free Passes: How the New Current Expected Credit Loss Standard Affects Nonbanks.” July 1, 2019.
- IFRS 9: Financial Instruments
- PwC, “Loans and Investments.” March 2020. Section 7.1 through Section 7.3.
- FASB, Board Meeting Handout: “Post-Implementation Review of Topic 326, Financial Instruments—Credit Losses.” December 2, 2020.
- FASB Tentative Board Decisions: “Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” December 2, 2020.