Demystifying the Current Expected Credit Loss Model for Not-for-Profits

FASB’s Accounting Standards Update (ASU) 2016-13, Financial Instruments-Credit Losses (Topic 326), changes the estimation of credit losses from a model based on incurred loss to one based on current expected credit loss (CECL). ASU 2016-13 is effective for not-for-profit organizations’ fiscal years beginning after December 15, 2022 and interim periods within those fiscal years. Many not-for-profit organizations should be implementing the standards update for FASB ASC Topic 326, as this applies to all financial assets measured at amortized cost, with few exceptions. The following is intended to provide an overview of Topic 326 and its impact on organizations. It may not include all considerations applicable to an individual not-for-profit’s circumstances, and we strongly recommend reading the entire standard or working with an expert to properly implement the accounting requirements.

Changes under Topic 326

Trade accounts receivable, contract assets, notes or loans receivable, certain lease receivables, certain guarantees, loan commitments, and held-to-maturity debt securities are within the scope of Topic 326 and are common financial assets held by not-for-profit organizations. While this list is not all-inclusive (please refer to ASU 2016-13 for complete details, including guidance for Purchased Credit‐Deteriorated (PCD) assets), organizations will likely come across these items more regularly. Notably excluded from Topic 326 are promises to give (contributions or pledges receivable), which are to be evaluated for collectability separately under FASB ASC 958-310-35, and loans and receivables between entities under common control.

Under Topic 326, the allowance for credit losses is a valuation (contra-asset) allowance, reported as a deduction from the amortized cost basis of the related financial asset. Adjustments to the allowance for credit losses resulting from management’s estimates are presented through the change in net assets as credit loss expense (or reversal). This is the same presentation as the allowance for doubtful accounts and bad debt expense in the statement of financial position and statement of activities under previous guidance and does not represent a significant change to the financial statement presentation.

Note that, according to FASB ASC 326-20-45-1: “An entity shall separately present on the statement of financial position, the allowance for credit losses that is deducted from the asset’s amortized cost basis.” As such, the presentation is on the face of the statement of financial position. The terminology “allowance for doubtful accounts” was removed from ASC 310-10-50-4, and “allowance for credit losses” is used in ASC 310 going forward. However, not-for-profit organizations may continue to use the term “bad debt expense” when reporting credit losses.

There are additional presentation requirements within ASC 326-20-45-2 regarding off-balance-sheet credit exposures and within ASC 326-20-45-5 about accrued interest receivable – both of which may also impact not-for-profit organizations. Aside from the presentation requirements on the statement of financial position, the most significant changes resulting from CECL are within the measurement and disclosure requirements.

Major Differences under the CECL Model

There are key differences in the measurement requirements under the CECL model. Rather than recognizing incurred losses when probable of occurring, organizations must change to an expected credit loss model that: 1) incorporates a risk of loss, even if that risk is remote; 2) estimates credit losses over the contractual life of the asset; and 3) adjusts historical losses to incorporate reasonable and supportable forecasts. Not-for-profit entities must also pool financial assets for evaluation if they share similar risk characteristics. In all other cases, expected credit losses should be evaluated on an individual basis. Examples of risk characteristics are described in detail within ASC 326-20-55-5 including credit score or ratings and financial asset type, size, and term, among other factors.

The allowance for credit losses may be determined using various methods, including the use of discounted cash flows, loss-rate methods, roll-rate methods, probability of default methods or methods that utilize an aging schedule. Under the prior guidance, the most common method for not-for-profit organizations to analyze collectability was to utilize an aging schedule. Organizations may continue to use this to perform the analysis in accordance with Topic 326.

Examples: An organization currently using an aging schedule to estimate the allowance for doubtful accounts receivable may continue to do so as a measurement approach to estimate credit losses. However, the not-for-profit would need to ensure that the pooling of accounts receivable based on age is appropriate, or if further disaggregation based upon risk characteristics is necessary.

The entity would also include all aging categories in its overall measurement of expected credit losses. If an organization’s current estimation approach only includes accounts receivable over 90 days, it would need to consider accounts receivable under 90 days in its allowance for credit losses estimate as well. The expected credit loss must include a measure of expected risk of credit loss, even if the risk is remote. The organization would generally consider its historical loss experience of each aging category as a starting point; however, management should not rely solely on historical loss information to estimate the allowance for credit losses. In addition, there may be challenges in obtaining the historical loss information by aging category in order to develop an expected loss model by aging category.

Lastly, the NFP would need to consider current conditions and reasonable and supportable forecasts over the entire term of the accounts receivable to determine the ultimate allowance for credit losses. For periods in which the not-for-profit entity is not able to make reasonable and supportable forecasts, it should revert to historical loss experience. What is “reasonable and supportable” is determined by management using the information and estimation methods deemed appropriate in the circumstances. Internal and/or external information may be used to inform the forecast.

Improvements under Topic 326

The disclosure requirements under Topic 326 are intended to provide information about credit risk and management’s process for monitoring credit quality, management’s estimate of expected credit losses, and changes to management’s estimates of expected credit losses during the period. Additional disclosure requirements apply to financing receivables similar to the expanded disclosure requirements under the incurred loss model (disclosure requirements may be found in ASC 326-20-50). Such requirements include information about management’s method for developing the allowance for credit losses, such as information used to develop the current estimate, any circumstances that caused changes to the allowance for credit losses, a roll-forward of the allowance for credit losses, and credit quality information, among other requirements. Not-for-profit organizations should review the requirements within ASC 326-20-50 to determine if its policies and current data collection support the enhanced disclosures under Topic 326.

Transition guidance, including transition disclosures, also appears within ASU 2016-13. Generally, organizations will apply the ASU by means of a cumulative-effect adjustment to the opening balance of net assets as of the beginning of the first reporting period in which ASU 2016-13 is effective. Refer to the guidance for specific transition requirements that apply to certain financial assets less commonly held by not-for-profit organizations.

Not-for-Profit Organizations’ Next Steps

There are several examples within ASU 2016-13 to assist you in implementing the standard. The complete ASU 2016-13 and related amendments may be found here. The FASB has issued two Q&As about Topic 326, as well as its Transition Resource Group Materials, here. For additional support in understanding and implementing Topic 326, please contact our not-for-profit team, who can support you with changes under the CECL method.