3.1 Recognition
ASC 326-20
30-1 The
allowance for credit losses is a valuation account that is
deducted from, or added to, the amortized cost basis of the
financial asset(s) to present the net amount expected to be
collected on the financial asset. Expected recoveries of
amounts previously written off and expected to be written
off shall be included in the valuation account and shall not
exceed the aggregate of amounts previously written off and
expected to be written off by an entity. At the reporting
date, an entity shall record an allowance for credit losses
on financial assets within the scope of this Subtopic. An
entity shall report in net income (as a credit loss expense)
the amount necessary to adjust the allowance for credit
losses for management’s current estimate of expected credit
losses on financial asset(s).
Unlike the incurred loss models in existing U.S. GAAP, the CECL model does not
specify a threshold for the recognition of an impairment allowance. Rather, an
entity will recognize its estimate of expected credit losses for financial assets as
of the end of the reporting period. Credit impairment will be recognized as an
allowance — or contra-asset — rather than as a direct write-down of a financial
asset’s amortized cost basis.
Financial assets within the scope of the CECL model are generally measured at
amortized cost. Such assets, including loans and HTM debt securities, are recorded
at their amortized cost basis because an entity expects to realize the total value
of the financial asset by collecting this basis. Consequently, in paragraph BC48 of
ASU 2016-13, the Board reasons
that for assets measured at amortized cost, “an entity should not wait for an event
of default or other actual shortfall of cash flows to conclude that a credit
impairment exists.” Accordingly, the Board believes that “[r]emoving the probable
threshold would result in a more timely measurement of expected credit losses
because losses can be expected before they are probable (as that term is used in
Topic 450) of occurring (or have occurred).”
Changing Lanes
Allowance Approach Used for HTM Debt
Securities
Because the CECL model requires the use of an allowance
approach for all financial assets measured at amortized cost, an entity will
no longer adjust the cost basis of an HTM debt security to reflect an
expected credit loss.1 Paragraph BC75 of ASU 2016-13 explains the Board’s rationale for this
decision:
[S]takeholders expressed concerns that the
requirement to adjust the amortized cost basis of a security when an
entity recorded an other-than-temporary impairment distorted yields
because those amounts are recognized as interest income in future
periods. As a result, the Board decided that expected credit losses
should be recorded through an allowance for credit losses for all
financial assets that are held for the collection of contractual cash
flows and the allowance (as opposed to the yield) should be adjusted if
credit loss expectations subsequently improve. This decision was
supported by both preparers and users. Preparers often cited the
complexity of continually adjusting the yield on those securities on a
prospective basis.
Although preparers may welcome this change given the concerns expressed about
the current accounting for credit losses on HTM debt securities (i.e.,
prospective yield adjustments after a recognized credit loss), the new
requirements may present other challenges for preparers. For example, an
entity will now be required to recognize expected credit losses upon initial
recognition of an HTM debt security without regard to the security’s fair
value. That is, the entity will no longer be allowed to avoid recognizing a
credit loss simply because the fair value of the HTM debt security equals or
exceeds its amortized cost basis. Accordingly, an entity may need to modify
its existing credit risk management and financial reporting systems because
the entity will now be required to continually update the underlying cash
flows expected at the end of the financial reporting period when measuring
its expected credit losses, irrespective of the HTM debt security’s fair
value.
In addition, because the CECL model does not have a minimum
threshold for recognition of impairment losses, entities will need to
measure expected credit losses on assets for which there is a low risk of
loss (e.g., investment-grade HTM debt securities). However, ASC 326-20-30-10
states, in part, that “an entity is not required to measure expected credit
losses on a financial asset . . . in which historical credit loss
information adjusted for current conditions and reasonable and supportable
forecasts results in an expectation that nonpayment of the [financial
asset’s] amortized cost basis is zero.” While the FASB may have been
thinking of U.S. Treasury securities and certain highly rated debt
securities when it decided to allow an entity to recognize zero credit
losses on an asset, ASC 326 does not indicate that this is the case.
Regardless, challenges will most likely be associated with measuring
expected credit losses on financial assets whose risk of loss is low. For
more information about the measurement of expected credit losses on U.S.
Treasury securities and other highly rated debt instruments, see Section 4.4.10.
Footnotes
1
In accordance with ASC 326-20-35-8, an entity would
write off the HTM debt security if it is “deemed uncollectible.”