In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016 – 13, Financial Instruments – Credit Losses (ASC Topic 326). The update requires entities holding financial assets measured at amortized cost to measure credit losses using the new Current Expected Credit Loss model (CECL). Companies will be required to estimate credit losses over the entire contractual term from the date of initial recognition. They will record the initial measurement of expected credit losses as credit loss expense as well as any change after initial recognition.
It is important to consider the impacts of this ASU to determine the overall effect on your company. While it is expected to have a lesser impact on the restaurant and franchising industries than other industries (like credit unions and banks), there will still be an impact that requires analysis. The impacts could be to the following accounts:
- Credit card receivables
- Third-party delivery receivables
- Royalty/advertising fund receivables
- Franchise fee receivables
- Tenant improvement allowance receivables
- Other trade receivables
- Notes receivable/financing receivables
- Loans to employees or officers of the Company
- Held-to-maturity debt securities
- Off-balance-sheet credit exposures (i.e., financial guarantees)
- Reinsurance recoverable
With the CECL methodology, companies will evaluate financial assets on a collective or pooled basis that share similar risk characteristics. These risk characteristics include, but are not limited to, the following:
- Credit score
- Financial asset type
- Collateral type
- Size
- Effective interest rate
- Location
- Industry
- Historical patterns
A financial asset should be evaluated individually if it does not share the same risk characteristics, though it should not be included in both the pooled basis and individual evaluation.
An example could be if a Company has royalty/advertising receivables from franchisees, initial franchise fee receivables, and credit card receivables. These three categories would need to be assessed separately based on the characteristics of the populations. They would result in at least three analyses, and possibly more depending on the breakdown of the components of those categories (i.e., if a franchisee has historical patterns of no payment or disputing payments resulting in credit memos, you may want to assess those groups of franchisees separately from the franchisees that pay timely without disputes).
Significant Shifts
The CECL model creates three significant shifts from the current incurred loss model:
- First, the forward-looking analysis requires the utilization of future information/forecasts to estimate the allowance for loan losses
- Consider if an allowance is needed for receivables that are not past due
- Second, this new standard removes the probability threshold and requires you to evaluate the possibility that a loss exists or does not
- The guidance requires recognition of credit losses when the losses are “expected”
- Lastly, this changes the loss horizon from 12-18 months to view the life of the asset
- CECL requires a loss to be recognized earlier in the asset life
This model will be applied at the origination of the financial asset and in subsequent reporting periods. It will also require a frequent re-evaluation of historical loan performance, current conditions, and expectations about future conditions.
While evaluating the adoption of this standard, we recommend management identify the items on their balance sheet that are in scope and determine the materiality of that impact. Additionally, have documentation around the assessment and a process to monitor it should it be concluded to be immaterial on a go-forward basis.
Disclosure
Additional disclosures will focus on accounting policy, description of estimates and quantitative models. The FASB added this disclosure requirement so the financial statement user can understand how management arrived at the allowance.
Adoption
This standard became effective for public business entities that meet the definition of an SEC Filer, excluding small reporting companies (SRCs) as defined by the SEC, for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. SRCs and all other non-public entities must adopt for fiscal years beginning after December 15, 2022 (2023 fiscal year).
Please contact your GBQ team for assistance with questions and the adoption of this guidance.
