The current expected credit loss guidance, or "CECL," will have a wide variety of impacts. One such impact relates to the accounting for guarantees that are not within the scope of another standard; for example, guarantees that are accounted for as derivatives. This video discusses requirements for guarantees under the new CECL standard and how it will require an additional credit loss estimate to be recognized for the lifetime expectation of credit loss payments to be made under the guarantee.
Hi! I'm Joscelyn Carlin a Senior Manager in PwC's National office.
Today, we’re going to discuss the new current expected credit loss standard commonly referred to as CECL.
This is the first in a series of videos that will cover the accounting for CECL-related topics.
As companies have been evaluating the potential impact of CECL, many implementation questions have arisen.
Today, in this video I’ll cover:
First, how guarantors should account for guarantees of the financial performance of another party;
Second, how guarantors should apply the CECL guidance related to such guarantees.
The guidance I will discuss today applies to all companies that guarantee the financial performance of another party.
To understand the impact CECL will have on the accounting for guarantees, let's start by discussing how a guarantor currently accounts for a guarantee of the financial performance of another party.
First, a guarantor should ensure the guarantee provided does not fall under the scope of another standard.
Some examples include:
Each of which are accounted for under other standards and would need to be evaluated separately to determine if CECL applies.
If the accounting for a guarantee is determined to not be in the scope of another standard, the guarantor recognizes a guarantee liability on its balance sheet at fair value at the inception of the guarantee.
The existing guidance for guarantees provides certain practical expedients available when the guarantee is issued at arm’s-length to an unrelated party.
First, if the guarantee is issued in a standalone transaction, a practical expedient allows the fair value to be measured as the amount of the guarantee premium received.
Second, if the guarantee is issued as part of a transaction with multiple elements, a practical expedient allows the guarantor to measure fair value by considering what the premium would have been to issue the same guarantee in a standalone transaction.
The accounting for guarantees discussed up to this point will not change upon the adoption of the CECL guidance.
Now, with that background, let's talk about how CECL will impact guarantee accounting.
At inception, the CECL guidance requires an additional credit loss estimate to be recognize for the lifetime expectation of credit loss payments to be made under the guarantee.
Now, on the surface, it may seem like this interaction of guarantee accounting and CECL double-counts credit risk, since the guarantor would likely price credit risk in the up-front guarantee premium.
It’s a fair observation, however, the FASB has clearly stated that guarantees are in the scope of CECL, and that expected credit losses on a guarantee should be recognized separately from the initial fair value of the financial guarantee.
This results in income recognition of the guarantee premium not being affected by expected credit losses.
Therefore, at inception, the guarantor would recognize a guarantee liability at the fair value of the financial guarantee.
And at the same time, the guarantor would recognize a liability for the expected credit loss on the guarantee.
So, to be clear, this results in two liabilities being recorded at contract inception.
Now let's discuss subsequent measurement.
The guarantee liability represents deferred revenue and will be recognized into revenue as the guarantor is released from the risk under the guarantee; for example, systematically over the life of the guarantee.
In contrast, the estimate of expected credit losses liability would be independently assessed each reporting period over the life of the guarantee.
This results in the guarantee premium being presented separately from the credit loss allowance provision on the income statement.
It is important to note that the expected credit loss liability would not necessarily decrease proportionally with the guarantee liability.
Let talk through an example to illustrate this.
Company A provides a guarantee over the financial performance of Company B for five years.
Company A amortizes the guarantee liability on a straight line basis over the five year term.
Company A separately assesses each reporting period, the expected credit loss estimate to reflect changes in the default risk of Company B.
Lastly, let's consider another scenario where the entire guarantee premium is not paid to the guarantor at inception of the guarantee.
In this scenario, the guarantor records a receivable for the premium.
This receivable is a financial asset also subject to credit loss estimation under CECL at inception and in each subsequent reporting period.
With that said, there may be factors limiting the guarantor's exposure to credit loss.
For example, if the guaranteed party failed to pay the premium under the contract, the guarantor would cancel the guarantee, which would limit its credit loss exposure.
So let's wrap up.
Companies have a lot of work ahead of them getting ready for the new CECL standard, but the good news is there are many resources available to help.