The expected impact of CECL on portfolio company valuation

In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2016-13, Financial Instruments – Credit Losses, ASC Topic 326. The ASU requires entities to measure credit losses on most financial assets carried at amortized costs and certain other instruments using an expected credit loss model. The ASU also states that entities that qualify under the definition of an SEC Filer, not including small reporting companies, are required to adopt Current Expected Credit Losses (CECL) for the years beginning after December 15, 2019, while all other entities are required to adopt CECL for the years beginning after December 15, 2022.

Allowance for credit losses is an estimate of an amount from a financial asset that a company is unlikely to recover. CECL replaces the current method for estimating the allowance for credit losses, the Incurred Loss Methodology (ILM). This replacement was deemed appropriate as the increase in allowances under ILM were occurring too late in the business cycle, with the change in timing and level of allowances.

CECL covers a broad range of financial instruments such as loans held for investments, held to maturity debt securities, available for sale debt securities, trade receivables, etc. In relation to portfolio companies, CECL will mainly affect the trading of debt securities and how those securities are valued. One of the main areas that will be affected is Trade Receivable Accounts, as under the new guidance the creation of allowance accounts and alteration to the estimation requirements for allowances will generally result in the reduction of this receivable. How this affects the company’s valuation is dependent on the designation assigned to the securities held by the portfolios, as the accounting treatment is different for each designation. See below for the effects of CECL on each security designation:

Trading securities

Securities that are designated as trading are unaffected by CECL, as these securities are accounted for monthly with credit losses being accounted for immediately.

Available-for-Sale securities

Securities that are designated as Available-for-Sale (AFS) are accounted for on a monthly book basis, with valuation changes being recorded to capital as Other Comprehensive Income (OCI). The FASB had decided that CECL will not apply to AFS Securities, but instead has released amendments that are targeted changes to GAAP that remodeled the concept of Other Than Temporary Impairment (OTTI) and require credit losses on AFS debt securities to be recorded in an allowance account. Under previous guidance, OTTI would result in the permanent write-down of the debt security, but under the remodeled guidance, instead of there being a permanent write-down, it is now put into an allowance account. This updated guidance will have multiple effects on a company, including affecting a company’s initial profits due to the timing of the recognition. Under the direct write-off method, the recognition is delayed, while under the allowance method the recognition is immediate; therefore this will result in higher initial profits under the older write-off method. Trade receivable accounts also tend to be lower under the allowance method, since a reserve is being netted against the receivable amount. The modified debt security impairment methodology also limits the amounts recorded in the allowance for credit loss to the excess of the amortized cost over the fair value of the security.