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Accounting for loan receivables by corporates · PwC's accounting podcast

0:00
SPEAKER_00: Thought leadership from PWC's National Office.
0:07
SPEAKER_04: Hello, and welcome to PWC's Accounting Podcast.
0:11
SPEAKER_04: I'm Heather Horn.
0:12
SPEAKER_04: In today's episode, we continue our series on trending topics from our loans and investment guide, discussing the accounting for loans and receivables with the focus on the types of instruments a non-financial services entity may hold, such as trade accounts receivable, loans to customers and suppliers, and more.
0:31
SPEAKER_04: And you'll hear us bridge some of the differences in terminology between FS and non-FS entities for similar assets.
0:39
SPEAKER_03: So when you think about that definition, there's a lot of things that fall under there.
0:43
SPEAKER_03: And so as an example for, you know, non-banks, trade accounts receivable.
0:47
SPEAKER_03: So kind of the normal course of business, you're recognizing accounts receivable for sales to customers.
0:53
SPEAKER_03: You may have loans to suppliers or vendors or loans to your customers.
0:57
SPEAKER_03: And then any other type of financing receivable, right, would fall within that definition.
1:02
SPEAKER_03: So again, you may not have realized it, but certainly a lot of different types of loans and receivables that you likely have and will be uh accounted for under the loan accounting guidance.
1:16
SPEAKER_04: That was Catherine Espino, who's joined by Chip Curry, both partners in our national office.
1:22
SPEAKER_04: They've both seen it all on this topic and have lots of great insights to share.
1:27
SPEAKER_04: So let's go ahead and start the episode.
1:30
SPEAKER_04: Chip, Catherine, welcome to the podcast.
1:32
SPEAKER_04: So nice to have you both on for our second episode in our series this month about our loans and investments guide.
1:38
SPEAKER_04: And today our focus is going to be all about loans.
1:43
SPEAKER_04: And for our listeners who were told that this is really a podcast focused on corporates, they may be thinking, okay, but I'm not a bank, I'm not a financial institution.
1:52
SPEAKER_04: So I don't really have loans.
1:53
SPEAKER_04: Uh, but that's not actually the case.
1:55
SPEAKER_04: So, Catherine?
1:56
SPEAKER_03: Yeah, definitely, other than that, that's probably not the case, right?
1:59
SPEAKER_03: So I think typically when we think about a loan or we hear about a loan, we probably immediately think about banks or financial institutions, things like mortgage loans, commercial real estate loans.
2:09
SPEAKER_03: Um, but there's lots of other types of loans, right, that are subject to the same accounting guidance.
2:14
SPEAKER_03: Um maybe just I'll give the quick definition of how FASB defines what a loan is.
2:19
SPEAKER_03: So they define a loan, and I'm paraphrasing here, but as a recognized asset related to a contractual right to receive cash on demand or on a defined date that are not accounted for as debt securities.
2:31
SPEAKER_03: So when you think about that definition, there's a lot of things that fall under there.
2:34
SPEAKER_03: And so as an example for you know, non-banks, trade accounts receivable.
2:39
SPEAKER_03: So kind of the normal course of business, you're recognizing accounts receivable for sales to customers.
2:44
SPEAKER_03: You may have loans to suppliers or vendors or loans to your customers.
2:48
SPEAKER_03: Um, and then any other type of financing receivable, right, would fall within that definition.
2:53
SPEAKER_03: Um, so again, you you may not have realized it, but certainly a lot of different types of loans and receivables that you likely have and will be uh accounted for under the loan accounting guidance.
3:03
SPEAKER_04: All right, I think that's helpful.
3:04
SPEAKER_04: And then just for our listeners' benefit, Catherine mentioned that these are items that are not accounted for as debt securities.
3:09
SPEAKER_04: If you do have debt securities, listen to last week's podcast because uh Chris Gerot and Brett Julie talked on that episode about the accounting for those debt securities.
3:18
SPEAKER_04: All right, so we know we're talking about loans and investments, so let's walk through some of the accounting models here, starting with initial recognition.
3:26
SPEAKER_04: So, Chip, how do I record it?
3:28
SPEAKER_01: So, Heather, I've been on a bunch of these podcasts.
3:30
SPEAKER_01: How do I answer any question you ask?
3:32
SPEAKER_04: Of course, it depends.
3:34
SPEAKER_01: It depends.
3:34
SPEAKER_01: Uh so yeah.
3:35
SPEAKER_04: So then, Catherine, I know this is your first one.
3:37
SPEAKER_04: Stock answer.
3:38
SPEAKER_04: If you don't know, just say it depends.
3:41
SPEAKER_04: It depends.
3:41
SPEAKER_04: Yes.
3:42
SPEAKER_01: So let's start easy.
3:44
SPEAKER_01: Like if if uh if an entity kind of originates a loan and gives cash, the loan has a market rate of interest.
3:50
SPEAKER_01: We're generally going to measure it at proceeds.
3:53
SPEAKER_01: So we're gonna measure the loan at initial recognition at the proceeds that were lent.
3:56
SPEAKER_01: Um, we'll sometimes have like some issuance costs or issuance fees, it'll get deferred and they'll be part of the cost basis of the loan.
4:05
SPEAKER_01: So that's like your base case.
4:07
SPEAKER_04: And I guess, Chip, to be clear, because again, since you're talking, um, this is directed to non-corporate, when you say in this case, like a loan and lending cash, would this also be the case then like if I sold something and it becomes accounts receivable, or that is a different scenario?
4:23
SPEAKER_01: So that might be a different scenario.
4:25
SPEAKER_01: Um so let's let's jump to that one.
4:27
SPEAKER_01: Okay.
4:27
SPEAKER_01: So let's say that what you might have is you might originate a loan where it's not just simple loan for cash.
4:33
SPEAKER_01: So there may be other things going on.
4:35
SPEAKER_01: There may be other sort of rights or privileges or obligations to get incurred as part of the same sort of transaction.
4:42
SPEAKER_01: Um so for example, uh let's take the one that you just said.
4:46
SPEAKER_01: You might sell a product and you might originate a receivable as part of that.
4:50
SPEAKER_04: I love this language because no corporate entity would say they're originating a receivable.
4:55
SPEAKER_04: And they would say, I sold a product and I recorded a receivable.
4:59
SPEAKER_01: This is what happens when you invite the FS guy to talk about it.
5:02
SPEAKER_01: Yeah.
5:03
SPEAKER_04: So I'm here to try to keep it to our um plain English language.
5:07
SPEAKER_04: But anyway, okay, so now we have originated a receivable.
5:10
SPEAKER_01: Okay, we've created a receivable via the sale of the product.
5:13
SPEAKER_01: And so we have a specific gap that talks about that.
5:16
SPEAKER_01: So if you go look at 606, 606 would say, well, hold on a second.
5:19
SPEAKER_01: If there's sort of an other than insignificant element of financing that's part of that transaction, you can't just record the receivable at its stated amount, and you can't record a revenue equal to that amount.
5:30
SPEAKER_01: You have to discount it.
5:32
SPEAKER_01: So that would be an example of where we have a receivable that gets originated or created, and we're not putting it on the balance sheet at proceeds lent, because in that case there's no cash proceeds, and we're not putting it on the balance sheet at its stated amount.
5:46
SPEAKER_01: Another good example would be let's say you lent money to one of your employees, and you the loan had like a zero interest rate or a below market interest rate, and you're doing that as sort of incentive for the employee to remain employed.
6:00
SPEAKER_01: That would be another example where there's multiple elements there.
6:03
SPEAKER_01: There's a compensation element, and the loan's probably not gonna go on the balance sheet at the amount of the proceeds that you lend.
6:09
SPEAKER_01: Um, supplier loans.
6:11
SPEAKER_01: You lend money to a supplier, you do it again at a 0% rate or a below market interest rate.
6:17
SPEAKER_01: And you're doing that because that's gonna enable you to purchase product from that supplier.
6:22
SPEAKER_01: Well, that might be a multiple element arrangement.
6:25
SPEAKER_01: Part of that loan might be sort of a payment to a supplier for the future purchases of goods or services.
6:30
SPEAKER_01: And and generally, what GAAP's gonna require us to do is it's gonna require us to account for that other element, that other component of the transaction.
6:40
SPEAKER_01: And that'll countly dependent on will depend on exactly what that component is.
6:44
SPEAKER_01: Sometimes you see companies get loans or AR through purchases.
6:49
SPEAKER_01: Um, either they purchase the loans or they they purchase a business and as part of the assets that come over our loans.
6:56
SPEAKER_01: So in that case, what instead of it being an origination at a cost model or at a present value model, it's going to be recorded at fair value in that case, just in accordance with like the BizCom or the purchase guidance.
7:07
SPEAKER_01: So so it really does depend, you know, on what exactly, how did that loan or receivable get created or originated and what were the facts and circumstances around it.
7:17
SPEAKER_01: Um and we'll talk about this a little bit more, but when a loan ends up on the or receivable ends up on the balance sheet, it's something other than its stated amount, the amount that's due at maturity, you'll sometimes hear people refer to that as the loan is either recorded at a premium or a discount.
7:31
SPEAKER_01: A premium is it's it'll record at an amount above the amount that's contractual due, or discount would be it's recorded at an amount less than what's contractually due.
7:39
SPEAKER_04: All right.
7:39
SPEAKER_04: That's very helpful.
7:40
SPEAKER_04: So then now we've recognized it.
7:44
SPEAKER_04: Then what comes next, Catherine?
7:46
SPEAKER_03: Yep.
7:46
SPEAKER_03: So there's that loan will have to be classified, right?
7:49
SPEAKER_03: And there's two classification categories.
7:52
SPEAKER_03: And where the loan ends up is based on management's intent.
7:55
SPEAKER_03: And so what I mean by that is if management intends to hold that loan until for the foreseeable future or until it's maturity or payoff, it's classified as uh held for investment or HFI.
8:06
SPEAKER_03: But if management's intent is to sell that loan, then that loan should be classified as held for sale or HFS.
8:13
SPEAKER_03: Um so there's no default classification, it's really based on management's intent, and that intent will need to be reevaluated over time as well.
8:21
SPEAKER_03: In addition to those two classification models, you can also elect the fair value option.
8:26
SPEAKER_03: And so under the fair value option, right, that loan would be initially recognized at fair value, and then any subsequent changes in fair value would be recognized through earnings.
8:35
SPEAKER_03: But of course, you know, both of those HFI and HFS uh classifications require a different accounting model.
8:41
SPEAKER_03: Um so I can maybe I'll go through the held for investment accounting model to start.
8:46
SPEAKER_03: And so under HFI, uh the loans are recorded at amortized cost.
8:51
SPEAKER_03: And there's a few things that could be included in your amortized costs, and so I'll touch on a few of them.
8:56
SPEAKER_03: First is accrued interest.
8:57
SPEAKER_03: So any interest that you've uh earned but not yet received is part of your amortized cost basis.
9:03
SPEAKER_03: And as Chip mentioned, you may have premiums or discounts, which are also part of your amortized cost basis.
9:09
SPEAKER_03: Um, and and they can be created, those premiums and discounts from a number of different things.
9:13
SPEAKER_03: And I think as Chip you mentioned, right, deferred fees and costs is is one.
9:17
SPEAKER_03: Um and the other is when you purchase a loan at a premium or a discount.
9:21
SPEAKER_03: You could also uh your amortized cost basis will be impacted by write-offs.
9:25
SPEAKER_03: So anytime you've determined that an amount is uncollectible, that would reduce your amortized cost basis.
9:30
SPEAKER_03: And then another couple, you know, potential adjustments are foreign exchange adjustments or fair value hedge accounting adjustments where you're in a designated hedging relationship.
9:40
SPEAKER_04: All right, that's helpful.
9:40
SPEAKER_04: And then just a reminder from a listener point of view, if we're just thinking of our straight accounts receivable, I would think of whether or not this is a significant financing component.
9:50
SPEAKER_04: And otherwise likely it would be held for investment, although I guess we can get to some scenarios where it wouldn't be.
9:56
SPEAKER_04: But then now, again, sticking with this held for investment uh model, then so I know we still need to talk about Cecil and how we recognize um that those allowances.
10:07
SPEAKER_04: But before we get into that, let's talk about then what I would do for loans that are held for sale.
10:12
SPEAKER_03: Yeah, sure.
10:13
SPEAKER_03: So the accounting model for loans held for sale is what we a lot of times call the low-com model, right?
10:19
SPEAKER_03: Those loans are carried at the lower of their amortized cost or fair value.
10:23
SPEAKER_03: Um so when the fair value of a loan is below its amortized costs, you'll create a valuation allowance that reflects the difference between those two amounts.
10:31
SPEAKER_03: And so again, because these loans are intended to be sold, that valuation allowance really represents what you may expect to lose on a sale of that of that loan.
10:40
SPEAKER_04: And then would that take into account then if I was, for example, going to securitize receivables, or is that something different?
10:46
SPEAKER_01: Yeah.
10:47
SPEAKER_01: So the um if your intent changes, so a good example if you're not in the financial services space, is you might originate um account receivables or create account receivables through sales.
10:58
SPEAKER_01: Yes.
10:58
SPEAKER_01: Um, sales of products.
11:00
SPEAKER_01: And you might decide that it's cheaper instead of holding those receivables until they collect and incurring the financing charges for those.
11:08
SPEAKER_01: So that you know, you basically have to finance yourself to wait for the way for the cash collection.
11:12
SPEAKER_01: Sometimes it's cheaper to sell those receivables at a slight discount to someone else.
11:17
SPEAKER_01: And in this space, it's it's not atypical that you would sell it to like you heard about these commercial paper conduits or these accounts receivable securitization entity uh uh transactions.
11:26
SPEAKER_01: So you're absolutely right.
11:27
SPEAKER_01: If if if you're intending to sell it, then what you would do is you would reclassify it from held for investment to held for sale.
11:34
SPEAKER_01: So that would probably be the most common time where we would see, you know, non-financial services companies have some sort of held for sale or held for sale accounting or held for sale questions is when they're originating receivables with the intent to sell them.
11:48
SPEAKER_04: All right, very interesting.
11:49
SPEAKER_04: So then in this case, and Chip briefly mentioned it, but maybe we should run through it a little slower, Catherine.
11:55
SPEAKER_04: So you have accounts receivable that you originally classified as held for investment, but now you determine you are going to move them to held for sale because you are going to sell them in in some way.
12:09
SPEAKER_04: Then what are some of the accounting implications?
12:11
SPEAKER_03: Yeah, sure.
12:12
SPEAKER_03: We can kind of build on the example that that Chip just went through.
12:15
SPEAKER_03: So if you have a bunch of past due receivables that you're looking to sell and you had originally had them as held for investment, you've now changed your intent, you're planning to sell.
12:24
SPEAKER_03: There's certain accounting that we'll have to go through.
12:26
SPEAKER_03: So first we want to think about uh that the loan needs to be recorded now at its amortized cost.
12:31
SPEAKER_03: Uh, and we need to reduce that by any write-offs that are recognized prior to the transfer.
12:35
SPEAKER_03: So in this example, right, we have a bunch of past due receivables.
12:38
SPEAKER_03: There may be write-offs that need to take in just prior to that transfer to HFS.
12:43
SPEAKER_03: And then we also need to reverse the allowance for credit losses.
12:47
SPEAKER_03: And I know we'll we'll talk about that a little bit later, but if you've had a receivable or a loan classified as held for investment, you've likely recorded an allowance for credit losses.
12:55
SPEAKER_03: When you transfer the loan to held for sale, you need to reverse that allowance for credit losses through your credit loss expense.
13:01
SPEAKER_03: And then under the HFS model, we may need to establish a valuation allowance.
13:05
SPEAKER_03: So again, under that model, if the fair value is less than your amortized cost basis, you'll need to record a valuation allowance for the difference between those two amounts.
13:14
SPEAKER_03: And just to make a point that we talked about the allowance for credit losses is reverse through credit loss expense.
13:19
SPEAKER_03: If you do establish a new valuation allowance under the HFS model, that will not go through credit loss expense, right?
13:25
SPEAKER_03: That'll go through a separate line item on your PL.
13:28
SPEAKER_03: And then maybe a more nuanced point.
13:29
SPEAKER_03: Um, for any loans that are hedged in an active portfolio layer method hedge, um, the amortized cost basis should not reflect any basis adjustments associated with that hedge.
13:39
SPEAKER_04: So you are you getting a lot of questions about corporates that have active portfolio layer method hedge in place?
13:46
SPEAKER_04: No.
13:47
SPEAKER_04: Okay.
13:47
unknown: Thank you.
13:48
SPEAKER_01: We just threw that in there as a fun fact.
13:50
SPEAKER_04: Fun fact.
13:50
SPEAKER_04: And to see if I could pronounce what you're apparently.
13:54
SPEAKER_04: All right.
13:55
SPEAKER_03: Yep.
13:55
SPEAKER_03: So that's those are the steps that you'll have to go through really in probably the most common scenario for corporates of HFI to HFS transfers.
14:02
SPEAKER_03: But maybe Chip, you could take us through, you know, one of the maybe less likely scenarios of HFS to HFI transfer.
14:08
SPEAKER_01: Yeah.
14:09
SPEAKER_01: And if you if you reflect upon the model that that Catherine just walked through, what we almost do is reverse the accounting model that we were following, which was held for investment, Cecil.
14:21
SPEAKER_01: And then we reapply the new model so it can create this income statement gross-up.
14:27
SPEAKER_01: Um the other thing it can do is a lot of times if we stick with securitizing receivables, and let's let's go with like securitizing performing receivables.
14:37
SPEAKER_04: And that means receivables that I expect to collect might be.
14:41
SPEAKER_01: That are current, that they're paying, you know, that that we have all expectation for paying, in all likelihood, those will be on the balance sheet at par, at an amount that's close to par if they're short-term receivables.
14:50
SPEAKER_01: They'll be at the amount that you know you they owe.
14:53
SPEAKER_01: So they'll be at 100 bucks if they owe you 100 bucks.
14:56
SPEAKER_01: But when you're gonna sell it, you're not gonna sell it at 100 bucks.
14:58
SPEAKER_01: You're gonna sell it at a discount because the person wants to buy it at a discount, earn a little money, and and so that's why they're in the game.
15:04
SPEAKER_01: So if you think about what the low-com model does, is the minute you put it to low-com, you're gonna say, well, I think the fair value, it's not 100, it's 98, because that's what I'm gonna sell it for.
15:14
SPEAKER_01: So you effectively pull the loss on sale, like Catherine was mentioning, forward.
15:20
SPEAKER_01: And you don't wait until the sale actually happens.
15:22
SPEAKER_01: You move it into the, it happens when you reclassify the low.
15:26
SPEAKER_01: But again, it's this model of reverse what you were doing before and do apply the new model.
15:32
SPEAKER_01: And the same thing's true if you're going backwards.
15:36
SPEAKER_01: So if so if we're going from held for sale to held for investment.
15:40
SPEAKER_01: Now, now, when would that happen in a corporate space?
15:42
SPEAKER_01: Where it might happen is if you have a bunch of receivables and you're looking to sell them, so you think you're gonna sell them, you move them to held for sale, but ultimately you can't find a buyer, or you can't find a buyer at a price that's attractive to you.
15:54
SPEAKER_01: So you decide you're not gonna sell them.
15:56
SPEAKER_01: Okay, well, we would then move them into or back into held for investment.
16:01
SPEAKER_01: So, so what do we do?
16:02
SPEAKER_01: We we do the same thing of gross reversal of the accounting model.
16:06
SPEAKER_01: So any valuation allowance that we have under from applying the low-comm accounting model, we reverse it.
16:12
SPEAKER_01: And we reverse it gross, you know, like through the through the income statement.
16:16
SPEAKER_01: So whatever line item in the income statement you took the valuation through, we credit that income statement line item.
16:22
SPEAKER_01: And then we apply Cecil.
16:24
SPEAKER_01: And the initial CESL measurement, the initial credit loss measure, is a debit to credit loss expense.
16:30
SPEAKER_01: So that's an example of where you'll have, like you might have within a period, like an income statement gross up where you're crediting through a reversal of a lower of cost or market adjustment through one line item and taking a credit loss through another line item.
16:44
SPEAKER_04: All right, that's very helpful example.
16:45
SPEAKER_04: And this is definitely not uh a podcast about the nuances of moving things between uh held for investment and held for sale.
16:53
SPEAKER_04: But Chip, I do have a question because you mentioned this scenario where I'm gonna sell or I want to sell my receivables, so they're classified as um held for sale.
17:03
SPEAKER_04: And I guess the question that immediately came to my mind is at what point do you say, oh, I've decided to sell these receivables?
17:11
SPEAKER_04: Is this like, oh, I started talking to the CFO, we might do it.
17:14
SPEAKER_04: So that's the point in time.
17:15
SPEAKER_04: Is it I got approval from the board?
17:18
SPEAKER_04: And again, I know it's much more complex than we'd cover here, but at least some general ways you would think about that.
17:23
SPEAKER_01: Yeah, I mean, it's it's it's very judgmental.
17:26
SPEAKER_01: Um, and you know, as Catherine said from from at the beginning of the podcast, there's no default category.
17:31
SPEAKER_01: So you have to evaluate your receivables and say, is your intent to hold or is your intent to sell?
17:37
SPEAKER_01: Um a lot of it actually depends too on where within the organization the decision to sell receivables is is vested.
17:46
SPEAKER_01: So for example, you might have accounts receivable where they've vested the Treasury Department the ability to sell those accounts receivable.
17:55
SPEAKER_01: And so you wouldn't necessarily be looking for board approval or anything.
17:58
SPEAKER_04: Right, because the Treasury could approve it themselves.
18:01
SPEAKER_04: Exactly.
18:01
SPEAKER_01: Now, in contrast, the same organization may have loans to suppliers or loans to vendors or loans to employees, but the approval process for selling those is very different.
18:14
SPEAKER_01: And so that's why this question of when to flip between held for investment and held for sale can be complicated.
18:20
SPEAKER_01: There isn't a tremendous amount of guidance in the actual codification.
18:25
SPEAKER_01: Um, what a lot of organizations do is they they look to guidance that's put out by the banking regulators on when that should be moved and why do you look to something with banking regulators?
18:36
SPEAKER_01: It's out there, it's public, people can see it and people can find it.
18:39
SPEAKER_01: And obviously it's an issue that comes up you know more frequently at banks.
18:42
SPEAKER_01: And so that's a touch point where you can look for more guidance.
18:45
SPEAKER_04: All right.
18:46
SPEAKER_04: Well, and obviously, you know, if a company is dealing with that issue, this podcast is not intended to answer that question, but I think at least having some general understanding is helpful.
18:54
SPEAKER_04: So, Chip, I'm gonna stick with you then.
18:56
SPEAKER_04: And one of the other things that I know comes up once we have loans recorded is in some cases we may need to record interest income.
19:04
SPEAKER_04: So what are some of the considerations?
19:07
SPEAKER_01: Yeah.
19:07
SPEAKER_01: So I mean, obviously at a high level, interest is sort of compensation that's earned by the creditor, the lender, the investor, or you know, whatever word you want to use, the person that holds receivable as an asset for providing financing.
19:20
SPEAKER_01: And interest is designed to compensate you both for time value of money as well as any credit risk that you have for extending that receivable.
19:28
SPEAKER_01: Um interest can come in many forms.
19:31
SPEAKER_01: So the way the accountants think about interest is we don't necessarily pick up the contract and read and say, this is interest, this is this is principal.
19:39
SPEAKER_01: What we look for, we look at it on a more sort of economic perspective.
19:44
SPEAKER_01: So you interest can come in the form of like a periodic interest payment.
19:48
SPEAKER_01: So I owe you an interest payment once a month, or it can come from the difference between the amount that I lent or I effectively lent and the amount that's contractually required to be prepaid.
19:59
SPEAKER_01: Um, either one of those, the accountants sort of look at that and say it's a it's a form of interest.
20:05
SPEAKER_01: Um the interest income accounting model depends on a couple of things.
20:08
SPEAKER_01: It could depend on the nature of the financial instrument.
20:11
SPEAKER_01: So receivables and more plain vanilla loans have a different interest income model than complicated interests and beneficial interests or securitization entities.
20:21
SPEAKER_01: Um there's sometimes there's industry-specific guidance you need to think about.
20:25
SPEAKER_01: Um, and the accounting model you're actually applying to the instrument might matter.
20:29
SPEAKER_01: Um many of the instruments that we're talking about that corporates will have, uh, they'll fall under 310, which is the sort of receivables guidance that applies to both loans and debt securities.
20:40
SPEAKER_01: Um and it talks about how to deal with premiums and discounts, which we talked about how those can get created, created earlier.
20:46
SPEAKER_01: And it deals with both loans and debt securities.
20:50
SPEAKER_01: Um, the one thing it doesn't cover is if you're doing fair value through PL accounting, then that that model doesn't, it specifically scopes those instruments out.
20:59
SPEAKER_04: All right.
20:59
SPEAKER_04: So then, Catherine, if I am going to recognize interest income on loan or debt security, what should I think about?
21:06
SPEAKER_03: Yep.
21:06
SPEAKER_03: So the first thing I'll say, which may not be intuitive, is that interest income is not necessarily recognized on your contractual rate of interest.
21:14
SPEAKER_03: Um, but what the guidance requires is that it's more on an economic rate of return, and that's based on an effective interest rate.
21:21
SPEAKER_03: And your contractual rate may be the same as your effective interest rate, but it may not be.
21:26
SPEAKER_03: And what creates the difference between those two amounts are these premiums and discounts that we've been talking about.
21:32
SPEAKER_03: So how do you determine your effective interest rate, right?
21:34
SPEAKER_03: And hopefully this can make sense, but this is the way I think about it, right?
21:37
SPEAKER_03: Is that your effective interest rate is the discount rate that would be used to equate the present value of your contractual cash flows under your loan or receivable with the initial carrying value of that loan or receivable.
21:51
SPEAKER_03: And so what that does when you then recognize interest through using the effective interest rate, you'll not only recognize your interest, you'll also amortize any premiums or discounts.
22:00
SPEAKER_03: Through interest income, resulting in that kind of economic rate of return on your asset.
22:04
SPEAKER_01: So if you think about like what might happen, like take for example that we sell product and we create a receivable associated with that.
22:12
SPEAKER_01: And the receivables on the books for 100 bucks, they're going to pay 100 bucks.
22:16
SPEAKER_01: There's probably going to be no interest income, you know, associated with that.
22:20
SPEAKER_01: But let's say you sold product, you created a receivable, and 606 tells you the receivable can't go on the books at 100.
22:28
SPEAKER_01: It's got to go on at the, you know, to reflect the fact that you provided some level of financing.
22:33
SPEAKER_01: So in that case, the receivable is going to go on the books at 90.
22:36
SPEAKER_01: And what we're going to do is we're going to show interest income at a rate to get you from 90 up to 100 over the contractual life.
22:44
SPEAKER_01: So when there's a discount, the interest is always going to be, interest income is always going to be higher than what the contractual rate is.
22:52
SPEAKER_01: So in my example, the contractual rate was zero, but I'm still showing interest income.
22:56
SPEAKER_01: When you create a premium, the interest income is going to be lower than the contractual rate because we have to amortize this sort of premium that we created.
23:07
SPEAKER_04: All right.
23:08
SPEAKER_04: I think that's helpful.
23:08
SPEAKER_04: Although I'm sure many of our listeners feel like they're back in their like 301 finance class or 301 accounting class, trying to remember how to use their calculators.
23:18
SPEAKER_04: But I definitely think it intuitively makes sense then there, and it's very similar to what companies are doing with their debt.
23:25
SPEAKER_04: So basically the opposite side of these entries.
23:28
SPEAKER_04: So then we have taught mentioned this a few times in this podcast.
23:32
SPEAKER_04: And Chipp, I was trying to remember how many podcasts we've done on this topic that I've had you on.
23:38
SPEAKER_04: But at this point, I think everyone listening should have adopted ASC 326, which is financial instruments credit losses, or more affectionately referred to as Cecil, to, you know, for use of estimating the allowance for credit losses for expected uncollectible amounts.
23:56
SPEAKER_04: But can you just give us a quick high-level summary?
24:00
SPEAKER_01: Well, yeah, I mean, the only thing better to talk about other than Cecil would be derivatives.
24:04
SPEAKER_01: So, but I get I'm not allowed to do that.
24:06
SPEAKER_01: That's next year.
24:06
SPEAKER_04: I'm gonna have you on.
24:07
SPEAKER_04: We'll do like a whole month, Chip.
24:09
SPEAKER_04: Just you, a derivative.
24:10
SPEAKER_04: Derivative month.
24:10
SPEAKER_04: Yeah.
24:11
SPEAKER_01: I'll be wildly popular.
24:12
SPEAKER_04: Um especially commodity derivatives.
24:14
SPEAKER_01: Yeah.
24:15
SPEAKER_01: Yeah.
24:16
SPEAKER_01: Um so just as a reminder, a high level, the Cecil model requires you to sort of estimate credit losses over the entire life of the financial asset.
24:25
SPEAKER_01: Um, and financial assets that are within the scope, as we've talked about, include trade receivables, loans to suppliers, vendors, and customers, you know, in addition to the the more traditional banking and other loan products.
24:37
SPEAKER_01: Um when you do the estimate, you generally start with your historic loss data, then you sort of think about how current conditions are different from historical loss data.
24:47
SPEAKER_01: And then what you would do is you would also incorporate sort of the language's reasonable and supportable forecasts sort of over the life of the of the asset.
24:56
SPEAKER_01: Um when you you should measure them on a collective basis.
24:59
SPEAKER_01: So credit losses on a collective basis when you've got similar risk characteristics.
25:03
SPEAKER_01: So if you think about like trade AR, for example, generally credit losses are estimated based upon pools of risks of receivables with similar risks.
25:12
SPEAKER_01: So you might group people together based upon their your customers' credit rating, you know, how aged the receivable is, like how far past due it is, the industry that your customer is in, perhaps the product line, but you know, really any characteristic that would kind of serve as a driver of what you think is a, you know, will impact credit risk.
25:31
SPEAKER_01: Um, if the loan or receivable does not have similar risk characteristics, then obviously we don't pool it and we would look at it on an individual basis.
25:39
SPEAKER_01: Um your pools aren't static, they get constantly reassessed.
25:43
SPEAKER_01: So you might have a bunch of receivables that look similar and so they're assessed at a pool level, but then something happens to an individual customer that makes that now the credit risk is different from the pool.
25:54
SPEAKER_01: So we would pull it out of the pool and we would assess it differently.
25:58
SPEAKER_01: There's a lot of flexibility in in the accounting standard on how you calculate credit losses.
26:04
SPEAKER_01: You can do it using like a discounted cash flow approach, but more commonly in corporates for like trade IR, you'll see something like a like a loss rate or sort of a probability of default and loss given default model.
26:16
SPEAKER_01: Um, your ultimate choice really depends on the complexity of the instrument that you're dealing with.
26:21
SPEAKER_01: Um But yeah, I mean, irrespective of what method you use, the goal is still the same.
26:26
SPEAKER_01: It's all about your your recoverability of the amortized cost basis, thinking about current conditions and reasonable and supportable forecasts.
26:34
SPEAKER_04: So then, Catherine, if you're thinking about like a non-financial service company that's maybe evaluating, you know, AR, trade AR, what are some of the like key things we'd be thinking about?
26:45
SPEAKER_03: Yeah, I think as Chip mentioned, right?
26:46
SPEAKER_03: So to take trade AR, these are generally pretty short-term receivables.
26:51
SPEAKER_03: Um, and you're likely, as Chip mentioned, to group a number of the receivables together because they're generally small balances.
26:57
SPEAKER_03: You would group together, you know, however you consider kind of similar credit risk with those uh receivables.
27:02
SPEAKER_03: But alternatively, and I think Chip mentioned this, right?
27:05
SPEAKER_03: You may have a loan to a supplier.
27:06
SPEAKER_03: And so that may be a more bespoke loan, it may be very unique.
27:11
SPEAKER_03: You may not have any history related to loans with that supplier.
27:13
SPEAKER_03: So in this case, you would probably evaluate that loan on its own.
27:17
SPEAKER_03: And you may have to look to external information to really estimate expected credit losses.
27:22
SPEAKER_04: All right, that's very helpful.
27:24
SPEAKER_04: So, Chip, I have a question for you because if I think back to some of our earlier podcasts on this topic, you know, one of the things that came up was when CISEL was first adopted for large public companies, it was right after the start of the pandemic.
27:38
SPEAKER_04: And so you had this like intersection of the pandemic along with this new accounting model, which I know is challenging for banks, definitely also challenging for corporates, because I think even getting your head around the model was a bit complicated.
27:50
SPEAKER_04: So now, fast forward four years later, things look a lot different.
27:54
SPEAKER_04: Do you are you seeing then in terms of the types of questions and the way companies are thinking about it, that it's it has also stabilized, like people kind of know how to do this now, and we're not seeing the same level of uncertainty that we were.
28:09
SPEAKER_01: The good thing about CSOL is when people call me, they're asking the accounting model.
28:13
SPEAKER_01: The accounting model is easy.
28:14
SPEAKER_01: Lifetime credit losses, debit PL, credit allowance.
28:18
SPEAKER_01: But to your point, like from modeling methodology and things like that, when when the pandemic happened, the models that people had created leading up to the adoption of CSOL, they they were not really fit for purpose because they weren't really designed to operate in an environment that you know, like we were in with a global bigger.
28:37
SPEAKER_04: Yeah, so much uncertainty.
28:38
SPEAKER_04: Yeah.
28:39
SPEAKER_01: I mean, they they weren't the bottles were not trained to deal with the data that we had, um, or the the the macroeconomic environment that we had.
28:46
SPEAKER_01: I think what we've seen is there's there's not been quite the return to normal yet.
28:51
SPEAKER_01: We've gone through many, many different phases.
28:54
SPEAKER_01: So we sort of had the pandemic, and then we had an incredible amount of government stimulus, which kind of then said, well, credit losses are now not a lot lower than we expected in a global pandemic, but they're even lower than they would have been absent that because there's so much stimulus and there's so much money in.
29:14
SPEAKER_01: Then we transferred into a world of where there's inflation.
29:17
SPEAKER_01: Yes.
29:18
SPEAKER_01: And so what's the impact of inflation on credit losses, people's ability to pay?
29:22
SPEAKER_01: Because all else being equal, usually when rates go up, credit losses go up because you have to pay more and and you know things are things are more expensive.
29:30
SPEAKER_01: Um now we're moving into a different world where rates are coming down, inflation is is coming down.
29:36
SPEAKER_01: And so I think I think the questions and sort of the factors that people think about have continued to change and evolve.
29:43
SPEAKER_01: Um, you know, I think the other big thing is people have gotten to see how these models actually work, you know, in in different environments and different things and and have, you know, try to double click on their their things, better pooling, better segregation.
29:57
SPEAKER_01: So, yeah, I definitely think the pace of changes to the models and the questions have slowed, but they're they haven't completely disappeared, you know, and and you know, it hasn't gone back to complete, like, okay, you know, we're yeah, are we each are really at a price of long-term stability.
30:13
SPEAKER_04: So then, Chip, this might be an unfair question, so you can decline to answer.
30:17
SPEAKER_04: But do you think after like you did mention like a number of different stress points on the model, in retrospect, then obviously the Fast B did not anticipate all of these different circumstances.
30:30
SPEAKER_04: But has the model been flexible enough to deal with all of these different changes we've seen in the world?
30:36
SPEAKER_01: So this might be the point of the podcast where I should say these are the views of Chip Curry and Fair enough.
30:41
SPEAKER_01: I should have said that.
30:43
SPEAKER_04: Yes, and I should have said that too.
30:44
SPEAKER_01: Well, usually, if it's like a webcast, you could have that flashing across the bottom when I talk, but like it's harder to do on a podcast.
30:49
SPEAKER_04: Yeah.
30:50
SPEAKER_01: Um, my own personal opinion is I I think the models worked.
30:55
SPEAKER_01: Like it's given, I think it's better than what we had before, which is a reminder was like an incurred loss model where if you saw changes in the macroeconomic variable you environment, you couldn't deal with it.
31:07
SPEAKER_01: Yeah, you couldn't deal with it.
31:08
SPEAKER_01: And now now you can.
31:10
SPEAKER_04: Yeah.
31:10
SPEAKER_01: Um, you know, so I think that's been a big benefit of of the of of the standard.
31:16
SPEAKER_01: I mean, yeah, it's it's created some PL volatility, maybe not so much at the corporate space, but certainly in the financial institution space when, you know, pandemic hit, credit losses went way, wide, great stimulus, all the stimulus, credit losses came back down, we were returning to normal.
31:31
SPEAKER_01: So there's been some volatility, which I think people have kind of picked up on and said, like is, you know, and and and and had some thoughts and some comments about that.
31:39
SPEAKER_01: But I think the most beneficial thing is people have been able to proactively react to give investors, hey, this is what I think is happening to me from a credit risk perspective and reflect that in the financial statements versus being shackled to like an incurred loss model.
31:54
SPEAKER_04: Yeah, that's very helpful.
31:55
SPEAKER_04: But Catherine, you were nodding.
31:57
SPEAKER_04: Do you want to give Catherine a spino's point of view?
32:00
SPEAKER_03: Uh sure.
32:01
SPEAKER_03: No, I I do largely agree with what Chip said.
32:03
SPEAKER_03: I think the model has, you know, it's been maybe difficult to deal with, or you know, there's been a lot of judgments that companies have had to make, and obviously in these kind of like unprecedented situations, but I think they've done that, and I think, you know, the result has been uh, you know, a model that's you know shown to be effective and I think and reactive to the to the environment.
32:24
SPEAKER_04: All right.
32:24
SPEAKER_04: Look, that's I appreciate you both being willing to weigh in on that.
32:27
SPEAKER_04: I know this was not a podcast about Cecil, but I think sometimes from a listener's perspective, I mean we get so focused on debits and credits, and it's helpful to take a step back and say, what are we really doing here?
32:38
SPEAKER_04: And you know, what are some thoughts on it?
32:40
SPEAKER_04: So it's optimal perspective.
32:41
SPEAKER_01: To be totally fair, the one area that continues to be identified that there hasn't been a lot of material impact result of CEABL is or of Cecil is trade AR, you know, short-term trade AR.
32:54
SPEAKER_01: So the FASBI does have a project that's working through the private company council about whether or not they should think about changing how the model gets applied for private companies to things like trade AR and short-term receivables.
33:06
SPEAKER_01: So that's been one area where people said, yeah, it's been it's been great, you can do these things, but by and large, has that resulted in a lot of material changes to like standard short-term AR?
33:16
SPEAKER_01: Probably not.
33:17
SPEAKER_04: Yeah.
33:17
SPEAKER_04: And I guess, Chip, though, the point of that is if you're a public company listening, stick with CSOL because it's not changing.
33:24
SPEAKER_04: This is potentially for private companies at some point in the future.
33:27
SPEAKER_04: All right, that's helpful.
33:28
SPEAKER_04: So this has been very helpful running through, and I appreciate you adopting some corporate, more corporate terminology here, although maybe we should have said recorded instead of creative, but that's fine.
33:39
SPEAKER_01: Well, well, well, Catherine said bespoke.
33:42
SPEAKER_04: I know, but that is not unique to financial services.
33:46
SPEAKER_04: Do you think?
33:47
SPEAKER_01: I don't know.
33:47
SPEAKER_04: Corporate companies can do bespoke things too.
33:50
SPEAKER_01: I don't know.
33:50
SPEAKER_01: I got in trouble for using originate.
33:52
SPEAKER_01: She used like a SAT word like bespoke.
33:55
SPEAKER_01: And like Well, there you go.
33:57
SPEAKER_04: That's you know, there you go.
33:58
SPEAKER_04: First time guests gets a little extra.
34:00
SPEAKER_04: Yeah.
34:01
SPEAKER_04: So anyway, you guys have done this before, Chip and Catherine.
34:05
SPEAKER_04: I think they warned you this question was coming.
34:07
SPEAKER_04: But um, I always like to wrap things up to understand what you know, at your point of view and from your um perspective and experience, some of the things uh companies should be thinking about.
34:19
SPEAKER_04: Uh a word of advice in accounting for loans receivables.
34:22
SPEAKER_04: So, Catherine, I'll go to you first.
34:24
SPEAKER_03: Yeah, so I I guess I would just uh reiterate, you know, that again, what we've been talking about, that even the you know, corporate entities, non-bank entities have a lot of things to consider when they're you know originating, creating recording loans uh and receivables.
34:39
SPEAKER_03: So I think you know, make sure that you're prepared for that, right?
34:42
SPEAKER_03: In terms of the accounting models and processes and procedures.
34:45
SPEAKER_03: And so that's I think what I would say in terms of a takeaway.
34:48
SPEAKER_03: And Chip?
34:49
SPEAKER_01: Yeah, I agree with you.
34:50
SPEAKER_01: I mean, particularly, Catherine, we're particularly if you're pivoting into a new type of lending you haven't done before.
34:55
SPEAKER_01: So if you've always been doing trade AR, and that's sort of been where your loans are, and you move into, well, now I'm going to be extending loans to employees, I'm expending loans to suppliers or vendors, that might be of the model you have for AR may not fit well.
35:11
SPEAKER_01: And so being prepared to pivot, I think is good.
35:13
SPEAKER_01: And then we talked a couple of areas of financial instruments accounting, but you know, trade AR, where you have the right to receive cash, those are financial instruments.
35:21
SPEAKER_01: So if you are looking at like selling it or transferring it, things, the financial instruments, the recognition and other guidance applies.
35:27
SPEAKER_01: So, you know, that would be the other thing I would remind people.
35:30
SPEAKER_04: Yeah, and I think the other great reminder I got from this uh podcast was just the fact that just because it's AR doesn't mean there's not some financing or other elements.
35:40
SPEAKER_04: So just because I'm selling, you know, you're my customer, there still could be, quote, more to it.
35:44
SPEAKER_04: And so definitely keep that in mind, particularly as companies are customizing or changing their approaches.
35:50
SPEAKER_04: So, well, one last question, Catherine, I'll go to you for just as a reminder where companies should go look if they want to know more.
35:57
SPEAKER_03: Yep.
35:58
SPEAKER_03: So our again, Loans and Investments Guide is a great resource for all of these topics and more.
36:03
SPEAKER_03: Um, if you're looking for some additional guidance.
36:05
SPEAKER_04: Okay, perfect.
36:06
SPEAKER_04: Well, uh Catherine Chips, such a pleasure to talk to you.
36:09
SPEAKER_04: Thanks so much for joining me today.
36:10
SPEAKER_04: Thanks, Heather.
36:12
SPEAKER_04: That's our show for today.
36:14
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36:34
SPEAKER_04: From Thought Leadership at PWC, I'm Heather Horn.
36:39
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36:50
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