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.