Banks, credit unions, insurers and other financial institutions have been focused on the current expected credit loss accounting standard and its potential impact for several years, and with good reason, as it will substantially impact the tops of their balance sheets. Banks continue to actively participate in interpreting the standard, with larger institutions well into parallel runs. Insurers are focused on CECL’s impact on investment portfolios and reinsurance receivables. Credit unions – while subject to a later implementation deadline – are largely in the throes of gearing up for the new standard.
However, that still leaves covered non-financial institutions, a group that now appears underprepared for the implications of the standard. While CECL was being finalized and implementation issues investigated, non-financial institutions were dealing with their own significant accounting changes, including revisions to revenue recognition, hedge accounting, and lease accounting. Now, as CECL nears its implementation deadline, these companies are trying to catch up, understand the impact, and determine how all of these changes will fit together and affect their bottom line.
CECL’s focus is on the details of how contracts and transactions are structured. A good example of the importance of transaction details in relation to CECL can be seen in trade receivables. At first glance, there does not appear to be a significant change to the allowance for uncollectible trade receivables due to CECL. Examples from the Financial Accounting Standards Board typically advocate the use of aging schedules to determine the allowance, and that method can still be utilized.
However, CECL will bring broad changes to the allowance calculation regardless of the methodology chosen. For example, all receivables must be considered, regardless of where they are in the aging process. Therefore, as soon as a receivable has been recorded, an allowance must be calculated and allocated to it. This mirrors CECL’s sea change in the financial services industry, where a new loan must receive an allowance at the point of origination; trade receivables are subject to an analogous requirement. A second example of a more obvious change driven by the new standard is the requirement to consider future economic conditions in the determination of the allowance.
Beyond these overt changes, there are more nuanced implications that may be even more impactful if they are not considered within contracts from the beginning. For example, contracts with customers may have been set up to include short-term milestones for revenue-recognition purposes, and that may cause receivables to appear as short term and low risk for CECL.
However, CECL also requires one to review a contract’s off-balance-sheet exposure, and if not structured with this in mind, a company may inadvertently be offering credit terms to customers that might require consideration far beyond the short-term receivable. This could occur if the deal includes terms with the ability to extend the receivable in conjunction with further purchases, or guaranteed delivery of future purchases regardless of the status of the customer’s other receivables (albeit typically to a certain threshold). Or, as is common within the energy and commodities industries, contracts are often established for future purchases well in advance and extend credit terms for those purchases to the customer well before the receivable is recognized.
While neither of these situations necessarily fall into the scope of CECL, the details of the contract mean they could. If they do, an allowance will be necessary and will alter the financial impact of the contract. At the very least, the risk of these types of impacts will require contract-level analysis.
Another common way in which non-financial institutions might feel the impact of CECL is in regard to off-balance-sheet exposure stemming from subsidiary transactions with third parties. While CECL does not apply to intercompany transactions, it may apply to exposures that exist for those subsidiaries. Has the subsidiary made guarantees to third parties that might impact the parent institution? This can become a significant challenge with foreign subsidiaries whose contracts with third parties may not be appropriately scrutinized for CECL ramifications.
These are just a few examples of the impact of CECL on non-financial institutions. Other cases include net investments in leases, other non-trade receivables (for example, loans to employees) and certain guarantees. For leases, the structure of the transaction is particularly important in relation to the impact CECL will have. Leases, particularly in the case of large industrial equipment, can be for lengthy durations and for assets that are hard to value. Therefore, establishment of salvage values, extension terms, and potential third-party guarantees can all drive material changes in the allowance required by CECL.
What is consistent among all of these examples is that the structure and contractual obligations within a deal can greatly impact its required CECL reserve, but unlike financial organizations – where there is certainty that investments in loans and held-to-maturity securities will be impacted – there is far more ambiguity in these corporate line items. Corporations should quickly begin to review how they have structured deals and consider how they will account for CECL before the approaching implementation dates. While a complicated process may not ultimately be needed, it is critical to be prepared and understand how the calculations will be performed.
