Chapter 4 — Measurement of Expected Credit Losses

4.2 Contractual Life

ASC 326-20

30-6 An entity shall estimate expected credit losses over the contractual term of the financial asset(s) when using the methods in accordance with paragraph 326-20-30-5. An entity shall consider prepayments as a separate input in the method or prepayments may be embedded in the credit loss information in accordance with paragraph 326-20-30-5. An entity shall consider estimated prepayments in the future principal and interest cash flows when utilizing a method in accordance with paragraph 326-20-30-4. An entity shall not extend the contractual term for expected extensions, renewals, and modifications unless either of the following applies:

The entity has a reasonable expectation at the reporting date that it will execute a troubled debt restructuring with the borrower.
The extension or renewal options (excluding those that are accounted for as derivatives in accordance with Topic 815) are included in the original or modified contract at the reporting date and are not unconditionally cancellable by the entity.

Pending Content (Transition Guidance: ASC 326-10-65-5)

Subparagraph superseded by Accounting Standards Update No. 2022-02.
The extension or renewal options (excluding those that are accounted for as derivatives in accordance with Topic 815) are included in the original or modified contract at the reporting date and are not unconditionally cancellable by the entity.

ASC 326-20-30-1 describes the impairment allowance as 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.” An entity can use various measurement approaches to determine the impairment allowance. Some approaches project future principal and interest cash flows (i.e., a DCF method), while others project only future principal losses. Regardless of the measurement method used, an entity’s estimate of expected credit losses should reflect the losses that occur over the contractual life of the financial asset.

An entity is required to consider expected prepayments either as a separate input in the method used to estimate expected credit losses or as an amount embedded in the credit loss experience that it uses to estimate such losses. Before adopting ASU 2022-02, the entity is not allowed to consider expected extensions of the contractual life unless (1) extensions are a contractual right of the borrower or (2) the entity has a reasonable expectation as of the reporting date that it will execute a TDR with the borrower. After adopting ASU 2022-02, an entity is only allowed to consider expected extensions of the contractual life if those extensions are a contractual right of the borrower.

Connecting the Dots

Contractual Life

Although paragraph BC40 of ASU 2016-13 states that the FASB believes that credit losses occur at a rapid rate early in a financial asset’s life and then taper off to a lower rate before maturity, the CECL model requires an entity to consider expected credit losses over the contractual life of an asset rather than a shorter period. The primary rationale for this requirement is that an allowance for credit losses that does not include some expected losses (e.g., those that are expected to occur after a prescribed forecast period) would fail to reflect the net amount expected to be collected on the financial asset. In addition, such an allowance could make expected credit losses noncomparable from instrument to instrument, period to period, and entity to entity. Moreover, the Board believes that an approach in which an entity is required to measure expected credit losses over the financial asset’s contractual life has the added benefit of removing the need to articulate the length of time over which entities should have to estimate credit losses.

4.2.1 Prepayments

Although an entity is required to estimate expected credit losses over the contractual life of an asset, it must consider how prepayment expectations will reduce the term of a financial asset, which is likely to lead to a reduction in the entity’s exposure to credit losses. Therefore, prepayments could have a significant effect on the estimate of expected credit losses, and that impact will vary on the basis of whether the entity is estimating such losses by using a DCF method or another measurement method. When an entity uses a DCF method to project expected future cash flows, expected prepayments will affect the amount and timing of cash flows expected to be collected. When a loss estimation method other than a DCF method is used, prepayments will be either reflected in the entity’s historical loss information or considered as a separate input to the estimate of expected credit losses.

Changing Lanes

Determining Whether a Refinancing Is a Prepayment in the Measurement of Expected Credit Losses

Although ASC 326-20 requires entities to consider the effect of estimated prepayments on the measurement of expected credit losses, expected prepayments have not been a significant input into allowance calculations under the incurred loss model in current U.S. GAAP. Accordingly, practice has not been established regarding what constitutes a “prepayment” for the measurement of expected credit losses. The lack of a generally accepted definition of prepayment has led to different views on how an entity should consider certain transactions or events in estimating prepayments under ASC 326.

Such an evaluation is particularly difficult for lenders that are determining whether to consider refinancings of an existing loan to be prepayments when measuring expected credit losses. Loans are commonly refinanced with lenders before maturity (through a contractual modification or the creation of a new loan), and the proceeds are used to repay the existing loan. The current guidance in ASC 310-20-35-9 through 35-12 contains a framework for entities to use in assessing whether refinancings are new loans so that they can determine recognition of fees and other costs. However, ASC 326 does not provide similar guidance.

At an August 2018 meeting,1 the FASB indicated that an entity should not be prohibited from defining prepayments in the manner that best reflects management’s expectation of credit losses; however, the Board decided not to amend ASC 326 to reflect this discussion. Because the guidance does not define a specific framework for considering prepayments, we believe that, as with other elements of the CECL model, an entity should use judgment in determining whether a loan refinancing or restructuring transaction should be considered a prepayment in the measurement of expected credit losses. Accordingly, the guidance on loan refinancing and restructuring in ASC 310-20-35-9 through 35-12 may provide one, but not the only, approach to the consideration of prepayments.

4.2.1.1 Consideration of Prepayments in the Estimation of Expected Credit Losses Under a Method Other Than a DCF Method

Under ASC 326, an entity that is using an approach other than a DCF method to estimate expected credit losses is not required to explicitly take into account discounting and the timing of payments and defaults. However, such timing could affect the exposure to loss and the entity may need to consider this when applying other methods. For example, if an entity acquired loans at a premium and is estimating credit losses on the unpaid principal balance and the premium separately, as permitted by ASC 326-20-30-5, an increase in estimated prepayments would decrease the credit exposure related to the premium. Prepayments result in an acceleration of the amortization of premiums on a pool of loans, so there would be fewer unamortized premiums remaining at the time of credit losses for the related pool of loans if estimated prepayments increased.

It is not appropriate to estimate expected credit losses by applying a loss rate over the weighted-average estimated life of a pool of prepayable financial assets (or, under another method, to calculate expected credit losses only through the weighted-average estimated life of the entire pool). Rather, the estimate of expected credit losses must take into account all credit losses over the entire life of a pool of financial assets (i.e., an entity should also recognize credit losses related to certain assets within the pool when these losses occur after the weighted-average life of the pool). However, note that the FASB staff issued a Q&A that discusses how an entity can use the weighted-average remaining maturity (WARM) method when estimating expected credit losses. Under the WARM method, the entity estimates such losses over the remaining contractual maturity. This method inherently differs from a method in which a loss rate is applied over the weighted-average estimated life of a pool of assets. See Section 4.4.8 for more information about the WARM method.

4.2.2 Expected Extensions, Renewals, and Modifications

ASC 326-20-30-6 requires an entity that is measuring expected credit losses to consider prepayments that result in a shortening of the financial asset’s contractual life. However, before the adoption of ASU 2022-02, this paragraph also states that an entity is not permitted to extend the contractual term unless it “has a reasonable expectation at the reporting date that it will execute a troubled debt restructuring” or the contract contains extension or renewal options that are not “unconditionally cancellable by the entity.” After adopting ASU 2022-02, an entity may only extend the contractual term for expected extensions related to renewal options that are not unconditionally cancelable by the entity.

An economic concession granted by a lender in a TDR reflects the lender’s effort to maximize its recovery on existing credit rather than to extend new credit. Since many TDRs involve deferring payments (e.g., by extending the maturity date), a lender could reasonably expect to grant an economic concession to an existing borrower as part of its efforts to maximize the recovery of existing credit that was extended as of the balance sheet date. Before the adoption of ASU 2022-02, as long as the lender reasonably expects to execute a TDR on an individual financial asset with the borrower, the lender may use its estimate of expected cash flows (which may include payments made for years beyond the current contractual term) in estimating expected credit losses as of the balance sheet date. Such an estimate provides the most representationally faithful depiction of the expected credit losses that the lender has extended as of the balance sheet date. If lenders were prohibited from using such an approach, they might be required to artificially assume that a borrower would refinance externally (which could prove impossible and result in an unrealistic depiction of the actual economic credit loss expected by the lender). Keep in mind, however, that although an entity may conclude that a TDR is not reasonably expected, it is not allowed to ignore deterioration in credit quality that has occurred in the current reporting period. For more information about the accounting for TDRs under the CECL model, see Section 4.7.

Changing Lanes

Effects of Loss Mitigation Activities

ASU 2022-02 removes the concept of a TDR for financial reporting purposes and amends ASC 326-20-30-6 to eliminate an entity’s ability to extend the contractual term of the financial asset when it reasonably expects, as of the reporting date, that it will execute a TDR. However, we do not believe that the FASB intended to ignore the effects of loss mitigation activities on calculating the expected credit losses for financial assets associated with borrowers that are experiencing financial difficulties. In fact, paragraph BC24 of ASU 2022-02 states, in part, that “it is not the Board’s intent to require that an entity reverse the effect of any extensions, renewals, and modifications on receivables with borrowers experiencing financial difficulty in considering historical loss data used in estimating the allowance for credit losses.”

ASC 326-20-30-6 requires entities to “estimate expected credit losses over the contractual term of the financial asset(s).” Although the guidance does not define contractual term, it specifies certain elements that entities should consider in determining this term. For instance, the guidance indicates that, in certain circumstances, it is consistent with the overall objective of ASC 326 for entities to consider extensions in determining the contractual term. ASC 326-20-30-6 clarifies that an entity should consider extension and renewal options that “are included in the original or modified contract at the reporting date and are not unconditionally cancellable by the entity.” Extension and renewal options that are not unconditionally cancelable by the entity would include those in which (1) the ability to exercise renewal options is outside the lender’s control and (2) the lender would have a present obligation to extend credit. However, options accounted for as derivatives in accordance with ASC 815 should not be considered.

Arrangements in which an entity should include extension options in the contractual term when determining expected credit losses include, but are not limited to, those that contain a contractual extension option that gives the borrower either the unilateral or conditional ability to extend the arrangement’s term. If the borrower’s ability is conditional, it may or may not be within the borrower’s control to satisfy the condition (e.g., the borrower may be subject to financial covenants).

An entity should also consider how “prepayments” would affect the estimate of credit losses for loans with an extension option that is not unconditionally cancelable by the entity. In other words, if such loans are not extended, they would be considered prepaid before the end of the contractual term.

ASC 326 requires a lessor to use the lease term (as defined in ASC 842) as the contractual term when measuring expected credit losses on a net investment in a lease.

Connecting the Dots

Prepayments Versus Extension and Renewal Options

It may seem conceptually inconsistent to require an entity to consider the effect of prepayments while allowing it to ignore the effects of renewals, extensions, and modifications on an asset’s expected life. However, the FASB believes that the estimate of cash flows not expected to be collected should be limited to the current legal terms of the contractual arrangement between the borrower and the lender. Specifically, the estimate of expected credit losses is intended to quantify expected losses on credit that the lender has extended as of the balance sheet date (i.e., in the form of either a recognized financial asset or the present legal obligation to extend credit). Credit losses that could result from the future renewal, modification, extension, or expansion of a credit facility that is not addressed in the current contractual terms therefore would not be considered in the estimation of expected credit losses because the lender has not yet exposed itself to such losses (i.e., at a future date, the lender can choose to avoid that credit exposure by not renewing, modifying, extending, or expanding the credit facility). Accordingly, an entity should consider expected credit losses that could result from future extensions or renewal options only if those options were in the original or modified contract as of the reporting date and cannot be unconditionally canceled by the entity.

4.2.2.1 Demand Loans

As its name implies, a demand loan is a loan for which the full and immediate payment of principal and accrued interest is required upon the lender’s demand. In certain situations, the demand for payment is unconditional (i.e., the lender can make the demand at any time, with or without cause). Such a loan does not have a contractual maturity and therefore remains outstanding until it is called by the lender or paid off by the borrower. The loan is implicitly renewed every day until it is called or paid.

In determining the life of a loan that is immediately and unconditionally payable upon demand by the lender, an entity should consider the guidance in ASC 326. ASC 326 requires an entity to estimate expected credit losses over the life of the financial asset. Specifically, ASC 326-20-30-6 states, in part:

An entity shall estimate expected credit losses over the contractual term of the financial asset(s) when using the methods in accordance with paragraph 326-20-30-5. An entity shall consider prepayments as a separate input in the method or prepayments may be embedded in the credit loss information in accordance with paragraph 326-20-30-5. An entity shall consider estimated prepayments in the future principal and interest cash flows when utilizing a method in accordance with paragraph 326-20-30-4.

In the absence of a reasonable expectation of a TDR before the adoption of ASU 2022-02, the contractual terms of the asset, rather than the business practices of the lender, govern the asset’s life (e.g., an entity would ignore the fact that the lender has historically renewed the demand loan). As a result, the contractual life of a loan that is unconditionally payable upon demand by the lender is the period for which the borrower must repay the loan once it is demanded by the lender. In this case, because the demand loan is unconditionally and immediately payable by the borrower, the contractual term of the loan would be one day.

However, even though the life of the demand loan discussed above is one day, the lender does not necessarily have to individually assess the borrower’s ability to repay on that date. ASC 326-20-30-2 requires an entity to pool assets that share similar risk characteristics when calculating expected credit losses. Therefore, the lender is required to pool assets (including demand loans) that share similar risk characteristics when assessing the borrower’s ability to repay. If the risk characteristics of the demand loan are not similar to those of other financial assets, the entity would individually assess the borrower’s ability to repay the loan.

The lender would need to consider various outcomes when assessing the borrower’s ability to repay upon demand. Upon the demand for payment of the loan, the borrower can:

Pay the lender with available funds.
Pay the lender by refinancing the loan with another bank.
Modify the loan.
Default.

Therefore, as of the balance sheet date, the lender would need to determine which outcome would occur. For example, if the lender refinances the demand loan on the basis of the borrower’s current credit profile, the lender may also assume that the borrower could refinance with another bank within a reasonable amount of time and therefore pay the loan off in full.

In addition, the expected payment does not have to be on the date of the demand if the refinance is reasonably expected to take place in the event that payment is demanded. The FASB staff discussed this issue at the November 2018 TRG meeting. Specifically, paragraph 47 of TRG Memo 15 states:

The staff believes that considering future economic and other conditions beyond the contractual term of the financial assets does not, in and of itself, result in an extension of the contractual term. The staff believes that entities should consider available information that is relevant for assessing the collectibility of cash flows during the contractual term, which may include information from periods beyond the contractual term. Future economic and other conditions may inform an entity’s analysis of determining the inputs in developing expected credit losses over the contractual term of the financial asset.

As a result, the lender should consider conditions beyond the contractual term of the demand loan if the conditions would affect the expected credit losses on the loan.

4.2.3 Considerations Related to the Life of Credit Card Receivables

ASC 326 requires entities to determine the allowance for loan losses on financial assets on the basis of management’s current estimate of expected credit losses on financial assets that exist as of the measurement date. Regardless of the method that entities use to estimate such losses, they must carefully consider all amounts expected to be collected (or not collected) over the life of the financial asset. Given the revolving nature of credit card lending arrangements, stakeholders have questioned how credit card issuers should determine the life of a credit card account balance so that they can estimate expected credit losses.

Under the CECL model, an allowance must not include expected losses on unconditionally cancelable loan commitments. Because credit card lines are generally unconditionally cancelable, expected losses on future draws should not be accrued before such amounts are drawn. Accordingly, some believe that an entity should apply a customer’s expected payments only to the funded portion of outstanding commitments as of the measurement date when modeling the repayment period of the measurement-date receivable. That is, an entity would estimate the life of a credit card receivable without considering the impact of future draws that are unconditionally cancelable and how that would affect payment history or whether a portion of future payments would be related to future draws and not the current outstanding balance of the credit card line.

On the basis of these questions (and the recommendations made at the June 2017 TRG meeting), the FASB has agreed that it would be acceptable for an entity to use one of the following two methods to estimate future payments on credit card receivables:

Include all payments expected to be collected from the borrower.
Include only a portion of payments expected to be collected from the borrower.

However, the Board has acknowledged that an entity may also use other methods to estimate future payments. The method an entity selects should be applied consistently to similar facts and circumstances. Further, the entity’s determination of the appropriate method to use in estimating the amount of expected future payments is separate from the determination of how to allocate the future payments to credit card balances.

Footnotes

The TRG originally discussed this issue at its June 2018 meeting. At that meeting, the TRG agreed with the FASB staff’s recommendation that an entity should not be prohibited from defining prepayments in a manner that best reflects management’s expectation of credit losses.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.