Changes to Measurement of Credit Losses for Nonprofit Organizations
By Rosangela Nicholson, Director, Assurance Services
This article covers Accounting Standards Update (ASU) 2016-13, Financial Instruments – Credit Losses (ASC Topic 326): Measurement of Credit Losses on Financial Instruments, for nonprofit organizations. The update is effective for years beginning after December 15, 2022.
ASU 2016-13 is the first of several ASUs that created and amended ASC Topic 326 (ASC 326). ASC 326 is designed to address the disconnect between the reporting under U.S. GAAP and the market’s expectations regarding credit losses (this disconnect was highlighted during the global financial crisis of 2007 and 2008). The update changes U.S. GAAP from an “incurred loss” methodology, which delays recognition of a credit loss until it is probable a credit loss has occurred, to a current expected credit loss (CECL) model. To estimate credit losses, the CECL model requires reasonable and supportable information with a broader range of inputs, including forward-looking information.
Financial Assets in ASC 326
This guidance applies to all industries and entities that hold financial assets and net investments in sales-type leases and direct financing leases. Of financial assets impacted by ASC 326, nonprofit organizations typically hold the following:
- Notes receivable (excludes related party notes);
- Accounts receivable for exchange transactions, such as membership dues or tuition under ASC Topic 606;
- Off-balance-sheet credit exposure, such as guarantees, commitments, or letters of credit;
- Capital or financing leases held by the lessor; and
- Any other financial asset not excluded from the scope that the entity has the contractual right to receive cash.
Financial Assets Excluded From ASC 326
The following assets are excluded from this pronouncement:
- Financial assets reported at fair value with changes flowing through net income or change in net assets, such as investments;
- Participant loans made through a defined contribution plan;
- Promises to give covered under ASC Topic 985;
- Intercompany notes or receivables;
- Notes or receivables between entities under common control;
- Derivatives and hedging instruments covered under ASC Topic 815; and
- Operating leases held by the lessor.
CECL Measurement Model
The CECL model requires entities to measure all expected credit losses for financial instruments they hold on the reporting date based on historical experience; current conditions; and reasonable and supportable forecasts.
Under ASC 326, initial measurement for financial assets will now be reported based on the net amount the entity expects to collect over the life of the asset. This requires entities to use an allowance for credit losses (contra-asset account) that serves as a valuation account. Estimated credit losses for off-balance-sheet credit exposures are recorded as a liability and not a contra-asset.
Entities should recognize an allowance for credit losses even if the risk of loss is remote. If the risk of loss is nonexistent, then a credit loss allowance is not necessary. When ASC 326 is adopted, the estimated credit loss will take a modified retrospective approach (with some exceptions). The modified retrospective approach will require a cumulative effect adjustment to beginning net assets.
Receivables — loans or debt with purchased credit deteriorated (PCD) and certain beneficial interests — will require a prospective transition approach. There are also special measurement and reporting requirements for these financial assets (not detailed within this document).
Calculation of Credit Losses
The entity should estimate the expected credit losses over the contractual term of financial assets. Nonprofit managers must consider all relevant available information to determine the collectability of cash flows, including historical and current conditions and supportable forecasts. The allowance for credit losses can be estimated using a broad range of methods, including:
- Discount cash flow methods;
- Loss rate methods;
- Roll rate methods;
- Probability of default methods; and
- Aging schedule methods.
On each reporting date, entities must update the allowance for credit losses on all financial assets covered by ASC 326. Partial or full financial asset write-offs must be deducted from the credit allowance.
Disclosures should include enough information to enable financial statement users to understand the portfolio’s inherent credit risk and how management monitors the portfolio’s credit quality. Management’s estimate of expected credit losses should also be outlined — including any changes to the estimate that occurred during the reporting period.
Below are some of the main disclosure requirements under ASC 326:
- Credit quality monitoring information, including qualitative and quantitative elements.
- Required disclosures regarding accrued interest elections.
- Financial assets should be disaggregated to the level used when assessing and monitoring the risk.
- Disclosures clearly convey the risks inherent in the financial asset.
- Concentrations of credit risks.
- Details regarding the method of allowance for credit losses and inputs.
- Details regarding circumstances that caused changes in allowance for credit losses.
- Rollforward of the allowance for credit losses.
- Aging analysis of the amortized costs basis for certain financial assets that are past due.
This is a general overview of ASC 326. There are other required disclosures and special provisions regarding accrued interest, practical expedients, and other issues within ASC 326 that may apply to your entity. Consult your Marcum professional for assistance in adopting this pronouncement.