Chapter 4 — Measurement of Expected Credit Losses
Chapter 4 — Measurement of Expected Credit Losses
4.7 Considerations Related to TDRs Under ASC
326 Before the Adoption of ASU 2022-02
4.7.1
Measuring Credit Losses on a TDR
4.7.2
Measurement Approaches for TDRs
4.7.3 TDR as
a New Loan
4.7.4
Reasonable Expectation of Executing a
TDR
4.1 Introduction
For assets measured at amortized cost, the estimate of expected
credit losses will be (1) recognized immediately upon either origination or
acquisition and (2) adjusted in each subsequent reporting period. Measurement is the
most significant aspect of the CECL model. This chapter addresses the following
topics:
- Contractual life (Section 4.2).
- The information an entity needs when estimating credit losses (Section 4.3).
- Measurement methods (Section 4.4).
- Write-offs and recoveries (Section 4.5).
- Credit enhancement features (Section 4.6).
- Considerations related to postacquisition accounting for acquired loans (Section 4.7).
- Subsequent events (Section 4.8).
- Transfers to other measurement categories (Section 4.9).
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:
- Subparagraph superseded by Accounting Standards Update No. 2022-02.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. 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 stated 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, consistent 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. An entity may only extend the contractual
term for expected extensions related to renewal options that are not
unconditionally cancelable by the entity.
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.
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 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 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
1
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.
4.3 Information Set
ASC 326-20
30-7 When
developing an estimate of expected credit losses on financial
asset(s), an entity shall consider available information
relevant to assessing the collectibility of cash flows. This
information may include internal information, external
information, or a combination of both relating to past events,
current conditions, and reasonable and supportable forecasts. An
entity shall consider relevant qualitative and quantitative
factors that relate to the environment in which the entity
operates and are specific to the borrower(s). When financial
assets are evaluated on a collective or individual basis, an
entity is not required to search all possible information that
is not reasonably available without undue cost and effort.
Furthermore, an entity is not required to develop a hypothetical
pool of financial assets. An entity may find that using its
internal information is sufficient in determining
collectibility.
30-8 Historical
credit loss experience of financial assets with similar risk
characteristics generally provides a basis for an entity’s
assessment of expected credit losses. Historical loss
information can be internal or external historical loss
information (or a combination of both). An entity shall consider
adjustments to historical loss information for differences in
current asset specific risk characteristics, such as differences
in underwriting standards, portfolio mix, or asset term within a
pool at the reporting date or when an entity’s historical loss
information is not reflective of the contractual term of the
financial asset or group of financial assets.
30-9 An entity
shall not rely solely on past events to estimate expected credit
losses. When an entity uses historical loss information, it
shall consider the need to adjust historical information to
reflect the extent to which management expects current
conditions and reasonable and supportable forecasts to differ
from the conditions that existed for the period over which
historical information was evaluated. The adjustments to
historical loss information may be qualitative in nature and
should reflect changes related to relevant data (such as changes
in unemployment rates, property values, commodity values,
delinquency, or other factors that are associated with credit
losses on the financial asset or in the group of financial
assets). Some entities may be able to develop reasonable and
supportable forecasts over the contractual term of the financial
asset or a group of financial assets. However, an entity is not
required to develop forecasts over the contractual term of the
financial asset or group of financial assets. Rather, for
periods beyond which the entity is able to make or obtain
reasonable and supportable forecasts of expected credit losses,
an entity shall revert to historical loss information determined
in accordance with paragraph 326-20-30-8 that is reflective of
the contractual term of the financial asset or group of
financial assets. An entity shall not adjust historical loss
information for existing economic conditions or expectations of
future economic conditions for periods that are beyond the
reasonable and supportable period. An entity may revert to
historical loss information at the input level or based on the
entire estimate. An entity may revert to historical loss
information immediately, on a straight-line basis, or using
another rational and systematic basis.
An entity must consider all available relevant information when estimating expected
credit losses, including details about past events, current conditions, and reasonable
and supportable forecasts. That is, while an entity can use historical charge-off rates
as a starting point for determining expected credit losses, it must evaluate how
conditions that existed during the historical charge-off period may differ from its
current expectations and revise its estimate of expected credit losses accordingly.
However, the entity is not required to forecast conditions over the entire contractual
life of the asset. Rather, for the period beyond that for which the entity can make
reasonable and supportable forecasts, the entity should revert to historical credit loss
experience.
4.3.1 Historical Credit Loss Experience
ASC 326-20-30-8 states, in part, that “[h]istorical credit loss
experience of financial assets with similar risk characteristics generally provides
a basis for an entity’s assessment of expected credit losses.” Historical credit
loss experience can be used as a starting point for estimating expected credit
losses and for reversion for periods beyond which management can make reasonable and
supportable forecasts of such losses. In calculating historical credit loss
information, an entity may consider different factors depending on its policies,
asset types, and pooling of assets according to their risk characteristics.
ASC 326-20-30-8 and 30-9 require entities to adjust historical loss
information to reflect differences associated with (1) asset-specific risk
characteristics and (2) current conditions and reasonable and supportable forecasts
of future economic conditions relevant to the financial assets. ASC 326-20-30-9
states, in part, that “[f]or periods beyond which the entity is able to make or
obtain reasonable and supportable forecasts of expected credit losses, an entity
shall revert to historical loss information . . . reflective of the contractual term
of the financial asset or group of financial assets.” Further, ASC 326-20-55-6(c)
indicates that when estimating expected credit losses, an entity must use
significant judgment to decide on “[t]he approach to determine the appropriate
historical period for estimating expected credit loss statistics.”
4.3.1.1 Determining Historical Credit Loss Data
The guidance in ASC 326 on the factors that an entity should
consider in determining the appropriate historical periods to use to calculate
historical credit loss information is limited to the following:
- ASC 326-20-30-8 and 30-9 indicate that the historical loss information should reflect “the contractual term of the financial asset or group of financial assets.”
- ASC 326-20-55-3 states, in part: An entity may use historical periods that represent management’s expectations for future credit losses. An entity also may elect to use other historical loss periods, adjusted for current conditions, and other reasonable and supportable forecasts. When determining historical loss information in estimating expected credit losses, the information about historical credit loss data, after adjustments for current conditions and reasonable and supportable forecasts, should be applied to pools that are defined in a manner that is consistent with the pools for which the historical credit loss experience was observed.
To determine the appropriate historical credit loss data to use in calculating
historical loss information, management must apply professional judgment and
consider the nature of the financial assets and their risk characteristics. In
making this determination, an entity must evaluate the number of, and which,
periods to include in historical credit loss information.
4.3.1.1.1 The Number of Periods to Include in Historical Credit Loss Information
As noted above, ASC 326 only discusses the number of periods of historical
credit loss information in the context of whether such information reflects
“the contractual term of the financial asset or group of financial assets.”
Given that guidance, entities may think that the number of periods of
historical loss information must at least equal the contractual term of the
financial assets for which an allowance for credit losses is being estimated
(e.g., 10 years of historical loss information for financial assets with a
10-year contractual maturity). While such a conclusion may be appropriate,
it does not represent a requirement. Rather, ASC 326 specifies only that the
historical loss information must reflect historical defaults of similar
financial assets during the entire contractual term of those assets. For
example, if an entity is estimating expected credit losses for a group of
financial assets with a contractual maturity of 10 years, it may determine
that five years of historical loss information appropriately reflects the
entire contractual term of the financial assets being evaluated because the
composition of the financial assets within the five-year historical loss
information appropriately includes a mix of financial assets that have been
outstanding (seasoned) for periods commensurate with the remaining
contractual maturities of the financial assets being evaluated.
Since ASC 326 (1) does not specifically require that the number of periods of
historical loss information at least equal the contractual term of the
financial assets being evaluated and (2) does not prohibit an evaluation in
which the number of periods of historical loss information exceeds the
contractual term of those assets, an entity should consider the factors
discussed in the subsections below in determining the number of periods to
use in historical loss information.
4.3.1.1.1.1 Whether the Number of Periods Used Appropriately Represents the Seasoning of the Financial Assets Being Evaluated
Since the evaluation of credit losses is rarely linear, it is important
for historical loss information to appropriately reflect the specific
default patterns expected on the basis of the type of financial asset.
For example, for a group of financial assets with a 10-year contractual
maturity, the historical credit loss information should appropriately
represent the expectations regarding defaults that will occur in each
year of the assets’ contractual life on the basis of their seasoning as
of the balance sheet date.
4.3.1.1.1.2 Whether the Number of Periods Used Appropriately Represents the Asset-Specific Risk Characteristics of the Financial Assets Being Evaluated
ASC 326-20-30-8 requires an entity to adjust “historical loss information
for differences in current asset specific risk characteristics, such as
differences in underwriting standards, portfolio mix, or asset term
within a pool.” However, the differences cited in this paragraph are not
inclusive (i.e., there may be other relevant differences in
asset-specific risk characteristics to consider, such as changes in
prepayment behaviors resulting from changes in the nature of the
financial assets or the environmental conditions that affect
prepayments).
If an entity is relying on internal historical loss information and there
have been recent significant changes in asset-specific risk
characteristics, the entity may find it more appropriate to use a more
recent, shorter period of historical loss information (as opposed to
using a longer period, in which case the adjustment of such loss
information may be more complex).
4.3.1.1.1.3 Whether the Number of Periods Used Appropriately Represents How the Historical Loss Information Is Being Used in the Calculation of Expected Credit Losses
ASC 326-20-30-9 requires an entity to revert to
historical loss information, adjusted solely to reflect differences in
asset-specific risk characteristics, in calculating expected credit
losses for periods beyond which management can make reasonable and
supportable forecasts of expected credit losses. Thus, the remaining
contractual life of a group of financial assets for which an entity is
solely reverting to historical loss information will be shorter than the
full contractual maturity of such assets. Accordingly, entities should
consider the need, for reversion purposes, to use historical loss
information that reflects the seasoning of the financial assets, since
the determination of credit losses is not linear. This seasoning aspect
for reversion periods is likely to differ from the seasoning of the
financial assets on the balance sheet date.
Further, paragraph BC50 of ASU 2016-13 notes that “[s]ome entities may be
able to forecast over the entire estimated life of an asset, while other
entities may forecast over a shorter period.” For entities that are able
to forecast expected losses over the entire estimated life of a group of
financial assets, the seasoning considerations above will be reflected
in the forecasted expected losses rather than in historical loss
information used for reversion.
4.3.1.1.1.4 Whether the Number of Periods Used Appropriately Reflects a Full Economic Cycle
It is generally appropriate for the historical credit loss information to
include a full economic cycle (i.e., peaks and troughs) even if the life
of a particular financial asset is shorter than an economic cycle. The
length of the period that encompasses an economic cycle will depend on
the facts and circumstances.
The determination of whether historical credit loss information should
reflect a full economic cycle will also ultimately depend on the
particular facts and circumstances, including the extent to which an
entity is able to adjust historical loss information on the basis of (1)
reasonable and supportable assumptions of future economic conditions and
(2) the remaining period (if any) for which expected credit losses will
be determined by reverting to historical loss information. For example,
if the remaining period for reversion to historical loss information is
short and the timing of such reversion is in the near term, an entity
could reasonably conclude that historical credit loss information that
reflects the current economic conditions is more relevant than
historical credit loss information over an entire economic cycle. In all
cases, the historical loss information used to make adjustments based on
reasonable and supportable assumptions of future economic conditions
should represent where an entity is within an economic cycle.
4.3.1.1.1.5 The Number of Periods of Relevant Historical Loss Information That Are Available to the Entity
Some entities may have more historical loss data than others and
therefore may include longer periods in the calculation of historical
credit losses. Note that, as discussed below, entities that use longer
periods should not be biased in selecting such data (i.e., by including
periods with more peaks than troughs or vice versa).
For example, one entity may only have historical loss information that
starts 10 years ago and therefore may calculate historical loss
information on this basis. Another entity may, however, have historical
loss information that begins 40 years ago and therefore may use a longer
period. Under ASC 326, two entities may reasonably use different
periods. These differences may be attributable to the size and
sophistication of the entity, how long the entity has existed, and the
availability of relevant external data when sufficient internal data are
unavailable.
4.3.1.1.2 Which Historical Periods to Include in Historical Loss Information
In addition to determining the number of historical periods to use in
calculating historical loss information, management should consider which of
these periods to include. While it often may be reasonable for an entity to
start with the most recent period and work backwards consecutively, such an
approach is not necessarily required or always appropriate. In determining
which historical periods to use, an entity should consider the factors
discussed below.
4.3.1.1.2.1 Whether the Approach Is Objective and Reflects Expected Future Credit Losses
An entity should be objective, not biased, in estimating the allowance
for credit losses. Therefore, it would not be appropriate for an entity
to select historical periods that reflect either an overly aggressive or
an overly conservative level of credit losses (i.e., “cherry-picking”
historical information to achieve a desired accounting result). A biased
selection of historical information (e.g., using long-term historical
loss information that includes more peaks than troughs or vice versa)
would not be consistent with the credit loss measurement objective of
ASC 326.
4.3.1.1.2.2 Whether the Approach Is Consistent With Asset-Specific Risk Characteristics
In a manner consistent with the discussion above, an entity that is
selecting among periods of historical credit loss information should
consider how such information is aligned with the current asset-specific
risk characteristics of the financial assets being evaluated. For
example, if an entity has made changes to its underwriting to be more
consistent with an underwriting approach used in prior periods, it may
be more appropriate for the entity, if all else is held constant, to use
older historical loss information (as opposed to using more recent
historical loss information and applying more complex judgments about
how to adjust such information).
Note that management must use judgment in determining
the allowance for credit losses and should include thorough
documentation to support such judgment. While an entity is not
prohibited from changing the composition of historical credit loss data
used in this determination, any changes the entity makes in constructing
historical loss information should be justified by the facts and
circumstances and would reflect a change in accounting estimate. See
Section
4.4 for more information.
4.3.1.1.3 Effect of Accrued Interest on Historical Loss Information
An entity may have a nonaccrual policy under which it
stops accruing interest if it believes that the collection of interest
is in doubt. This is generally the case when a borrower is in default
for a specified period (e.g., 90 days past due). Many entities also
reverse the previously accrued interest if the borrower remains in
default for an extended period (e.g., 180 days). In those cases,
historical loss information would not reflect any or all interest
amounts that were not collected, because the entity had already decided
to stop accruing interest on the asset and also may have reversed any
interest that accrued before determining the ultimate amount of any loss
on the asset.
Questions have arisen about whether historical loss
information should be adjusted (increased) to reflect the amount of
accrued interest that would have been charged off if the entity had not
applied a nonaccrual accounting policy.2 ASC 326-20-55-6(b) states that one of the judgments an entity uses
in estimating credit losses is the following:
The
approach to measuring the historical loss amount for loss-rate
statistics, including whether the amount is simply based on the
amortized cost amount written off and whether
there should be adjustments to historical credit losses (if any)
to reflect the entity’s policies for recognizing accrued
interest. [Emphasis added]
In addition, as discussed in Section 4.4.5.1, ASC 326-20-30-5A states that “[a]n
entity may make an accounting policy election . . . not to measure an
allowance for credit losses for accrued interest receivables if the
entity writes off the uncollectible accrued interest receivable balance
in a timely manner.”
Accordingly, we believe that an entity should adjust
historical loss information if its loss data are not consistent with its
accounting policy election related to whether an allowance is measured
for losses on accrued interest. For example, if the entity does not
elect to measure an allowance for credit losses on accrued interest
receivables as permitted by ASC 326-2-30-5A, it should adjust the
historical loss information to reflect the amount of accrued interest
that would have been charged off if the entity had not applied a
nonaccrual accounting policy.
4.3.2 Adjustments to Historical Loss Data for Differences in Asset-Specific Risk Characteristics
While historical loss data serve as a starting point for estimating
expected credit losses, ASC 326 requires an entity to evaluate whether such data are
relevant to the financial assets for which the estimate is being made. Specifically,
ASC 326-20-30-8 states, in part, that “[a]n entity shall consider adjustments to
historical loss information for differences in current asset specific risk
characteristics, such as differences in underwriting standards, portfolio mix, or
asset term within a pool at the reporting date or when an entity’s historical loss
information is not reflective of the contractual term of the financial asset or
group of financial assets.” For example, it would not be appropriate for an entity
to use historical loss data related to subprime mortgages when estimating expected
credit losses on prime mortgages in the current financial reporting period.
4.3.3 Current Conditions and Reasonable and Supportable Forecasts
As discussed in Section 4.3.1, an entity’s historical credit loss experience with
financial assets whose risk characteristics are similar generally serves as a basis
for the entity’s assessment of expected credit losses. Further, as discussed in
Section 4.3.2,
sometimes an entity needs to adjust historical data for differences in
asset-specific risk characteristics. However, ASC 326-20-30-9 states that an entity
“shall not rely solely on past events to estimate expected credit losses.” Rather,
an entity that uses historical loss information should consider adjusting
information to appropriately reflect management’s current expectation of future
credit losses. Specifically, ASC 326-20-30-9 states that an entity “shall consider
the need to adjust historical information to reflect the extent to which management
expects current conditions and reasonable and supportable forecasts to differ from
the conditions that existed for the period over which historical information was
evaluated.”
Note that the adjustments for current conditions and reasonable and supportable
forecasts differ from (and are incremental to) the adjustments discussed in
Section 4.3.2 that are related to differences between historical
data and asset-specific risk characteristics. For example, an entity may upwardly
adjust historical loss rates to reflect that it now lends money to retail customers
with lower credit scores and is trying to estimate losses on a pool of loans to
those customers. This would be an adjustment for differences in asset-specific risk
characteristics. However, the entity may also adjust the historical loss rates again
to reflect the difference between the current economic conditions and the conditions
related to the period represented by the historical information. For example, if
current unemployment rates are lower than the rates during the period reflected in
the historical data, the loss rates may be adjusted down to reflect current
conditions. An entity may also be required to make further adjustments to reflect
reasonable and supportable forecasts.
While some entities may be able to develop reasonable and supportable forecasts over
the contractual term of a financial asset (or group of financial assets), ASC 326
does not require an entity to develop such forecasts. Furthermore, under ASC
326-20-30-7, the entity’s search for all possible information that may be relevant
to management’s expectations regarding future credit losses does not need to involve
“undue cost or effort.” ASC 326-20-30-7 and ASC 326-20-30-9 state, in part:
30-7 When developing an estimate of
expected credit losses on financial asset(s), an entity shall consider
available information relevant to assessing the collectibility of cash
flows. . . . An entity shall consider relevant qualitative and quantitative
factors that relate to the environment in which the entity operates and are
specific to the borrower(s). When financial assets are evaluated on a
collective or individual basis, an entity is not required to search all
possible information that is not reasonably available without undue cost and
effort. . . .
30-9 [F]or periods beyond which the entity is able to make or obtain
reasonable and supportable forecasts of expected credit losses, an entity
shall revert to historical loss information determined in accordance with
paragraph 326-20-30-8 that is reflective of the contractual term of the
financial asset or group of financial assets. An entity shall not adjust
historical loss information for existing economic conditions or expectations
of future economic conditions for periods that are beyond the reasonable and
supportable period. An entity may revert to historical loss information at
the input level or based on the entire estimate. An entity may revert to
historical loss information immediately, on a straight-line basis, or using
another rational and systematic basis.
It would be rare for an entity to conclude that there is no reasonable and
supportable information about current conditions and expectations for future
economic conditions and therefore for the entity to solely use historical loss
information to measure expected credit losses. Paragraph BC51 of ASU 2016-13 states
that the FASB “expects that an entity should not ignore relevant data when
considering historical experience or when considering qualitative adjustments for
current conditions and reasonable and supportable forecasts.” The Board also
acknowledges that “the adjustment for current conditions and reasonable and
supportable forecasts will be the most subjective aspect of the estimate.” Paragraph
BC53 of ASU 2016-13 further explains that the purpose of the language in ASC
326-20-30-9 on reversion to historical loss information is to “provide additional
guidance on how to measure expected credit losses as an entity moves into periods of
increasing uncertainty and decreasing precision.” This guidance is not intended to
allow an entity to merely default to historical loss information when estimating
expected credit losses.
The determination of how far into the future an entity can
reasonably adjust historical loss information to reflect projected future economic
conditions relevant to the recoverability of a particular type of financial asset
will depend on the particular facts and circumstances, including the types of
macroeconomic data that are predictive of future credit losses, and may be limited
to the periods for which future macroeconomic data may be obtained from external
sources. ASC 326-20-30-9 specifically prohibits adjustments to historical loss
information “for existing economic conditions or expectations of future economic
conditions for periods that are beyond the reasonable and supportable period.”
However, an entity is not precluded from projecting future economic conditions for
periods beyond which there is published external information if such projections are
reasonably supportable given the particular facts and circumstances.
4.3.3.1 Use of Macroeconomic Data to Make Reasonable and Supportable Forecasts
The objective of incorporating macroeconomic data into the
modeling of the allowance for credit losses is to use relevant information
about how current and projected economic conditions will affect the level of
future credit losses on financial assets (i.e., how current and future
economic conditions will affect historical loss experience). An entity would
be expected to use such macroeconomic data in estimating expected credit
losses.
ASC 326 does not require an entity to incorporate into its
credit loss estimate a certain number of macroeconomic variables, and it
does not establish a required period into the future for which macroeconomic
variables are considered reasonable and supportable information for the
entity to use in making credit loss estimates (i.e., as compared with
defaulting to historical loss information). However, we believe that, in
estimating credit losses, an entity should use macroeconomic data that are
correlated with historical losses (and are periodically revalidated) and
should not ignore macroeconomic data that are relevant to the expectation of
future cash flows.
An entity may use more than one external source of
macroeconomic data, although it is not required to do so. If an entity
evaluates more than one external source of macroeconomic data, it is not
required to apply probability weighting to the information. Rather, it could
consider multiple sources to validate the primary source of information
used. In addition, an entity could use its internal views on key economic
indicators rather than using external sources. However, the entity should
consider whether it is appropriate that its internal views are contrary to
published information.
4.3.3.2 Reasonable and Supportable Forecast Periods
ASC 326 does not require an entity’s forecast period to be
the same for all asset types or for all inputs into the models it uses for
estimating credit losses. On the contrary, ASC 326-20-30-7 states, in part,
that “[w]hen developing an estimate of expected credit losses on financial
asset(s), an entity shall consider available information relevant to
assessing the collectibility of cash flows [as well as] relevant qualitative
and quantitative factors that relate to the environment in which the entity
operates and are specific to the borrower(s).” The effects of changes in
macroeconomic data could differ depending on which of the entity’s assets
are involved, causing an entity to use different reasonable and supportable
forecast periods when estimating expected credit losses. For example, an
entity may consider macroeconomic data related to residential mortgages
differently depending on the location of borrowers or the underlying
collateral securing the loans. As a result, the entity may need to use
different reasonable and supportable forecast periods to reflect the
differences in the macroeconomic data relevant to the particular asset.
Further, in July 2019, the
FASB staff addressed this issue in the following Q&A:
FASB Staff Q&A
Topic 326, No.
2: Developing an Estimate of Expected Credit
Losses on Financial Assets
Questions and
Answers — General Questions About the CECL
Standard
Question
8
May the length of reasonable and
supportable forecast periods vary between different
portfolios, products, pools, and inputs?
Response
Yes. The duration or length of the
reasonable and supportable forecast period is a
judgment that may vary based on the entity’s ability
to estimate economic conditions and expected losses.
The reasonable and supportable forecast may vary
between portfolios, products, pools, and inputs.
However, specific inputs (such as unemployment
rates) should be applied on a consistent basis
between portfolios, products, and pools, to the
extent that the same inputs are relevant across
products and pools. It also is acceptable to have a
single reasonable and supportable period for all of
an entity’s products. An entity is to disclose
information that will enable users to understand
management’s method for developing its expected
credit losses, the information used in developing
its expected credit losses, and the circumstances
that caused changes to the expected credit losses
among other disclosures about the allowance for
credit losses.
In addition to not requiring
that an entity’s forecast period be the same, ASC 326 does not require an
entity to develop (or preclude it from developing) multiple economic
scenarios. The following FASB staff Q&A addresses this issue:
FASB Staff Q&A
Topic 326, No.
2: Developing an Estimate of Expected Credit
Losses on Financial Assets
Questions and
Answers — General Questions About the CECL
Standard
Question
12
When developing a reasonable and
supportable forecast to estimate expected credit
losses, is probability weighting of multiple
economic scenarios required?
Response
No. Topic 326 does not require an
entity to probability weight multiple economic
scenarios when developing an estimate of expected
credit losses. One entity may choose to probability
weight multiple economic scenarios when developing
its estimate of expected credit losses, while
another entity may rely on a single economic
scenario to develop reasonable and supportable
forecasts.
4.3.3.3 Assumptions Used by an Entity
The economic forecasts used to estimate expected credit
losses do not necessarily have to be the same as those used for other
forecasting purposes within the organization (e.g., budgeting, goodwill
impairment testing). ASC 326 notes that various methods for forecasting
expected credit losses are acceptable and does not outline a specific
approach to use. While the information used to forecast expected credit
losses may be consistent with the information used for other forecasting
purposes, it does not need to be the same.
4.3.3.4 Validating the Forecasting Process
Although an entity’s forecasts must be reasonable and
supportable, ASC 326 does not require an entity to substantiate its ability
to accurately predict economic conditions. In other words, when estimating
its expected credit losses, an entity is not required to evaluate in the
current reporting period whether it had “successfully” predicted economic
conditions in prior periods. Paragraph BC50 of ASU 2016-13 states that
“[e]stimates of credit losses may not precisely predict actual future events
and, therefore, subsequent events may not be indicative of the
reasonableness of those estimates.” While paragraph BC50 addresses the
overall estimate of expected credit losses more broadly, we believe that it
applies equally to reasonable and supportable forecasts about the future.
That is, inherent in any forecast of economic conditions is a level of
uncertainty and lack of precision. As a result, we do not believe that an
entity must evaluate whether existing economic conditions were accurately
predicted in its previous forecasts in earlier reporting periods. However,
paragraph 3.5.21(d) of the AICPA Audit and Accounting Guide on credit losses
states that “significantly missing near-term forecasts may be an indicator
of a deficient forecasting process.”
4.3.4 Reversion to Historical Loss Information
As mentioned previously, some entities may be able to develop reasonable and
supportable forecasts over the contractual term of a financial asset. Those that
cannot do so will need to revert to historical loss experience for the periods
beyond which they can develop reasonable and supportable forecasts. The Board
believes that it would be inappropriate to assign zero as the estimate of credit
losses during the period beyond which an entity could develop a reasonable and
supportable forecast. In paragraph BC53 of ASU 2016-13, the FASB indicates that “an
approach that does not record some expected losses (for example, those that are
expected to occur after some prescribed forecast period) would fail to reflect the
amount that an entity expects to collect, which is the Board’s measurement objective
for financial assets. . . . Therefore, the Board decided to provide additional
guidance on how to measure expected credit losses as an entity moves into periods of
increasing uncertainty and decreasing precision.”
In a manner consistent with its objective not to prescribe or
prohibit specific approaches or assumptions that management uses to develop its
expectations about the future, the FASB has given entities flexibility related to
choosing how to revert to historical loss experience. ASC 326-20-30-9, in part,
states that “[a]n entity may revert to historical loss information at the input
level or based on the entire estimate [and] may revert to [such] information
immediately, on a straight-line basis, or using another rational and systematic
basis.” While such use of reversion is not an accounting policy election, the entity
is required to disclose the reversion method (e.g., the level at which it reverts
and the period over which it chooses to revert) as a significant judgment used by
management when determining the cash flows it expects to collect.
Further, how an entity reverts to historical loss experience could
be affected by whether it has a single reasonable and supportable forecast period
covering all financial assets and inputs used in estimating losses or whether it
uses multiple forecast periods for different financial assets and inputs (see
Section 4.3.3.2 for more information about
determining the reasonable and supportable forecast period). In other words, an
entity may believe that reversion on a straight-line basis is appropriate for
certain assets or inputs but may decide to use a different rational and systematic
reversion method for other assets and inputs if it believes that such a method would
result in a better representation of its expected credit losses in such
circumstances.
It is important to highlight two points regarding an entity’s ability to revert to
historical loss information as discussed in ASC 326-20-30-9. First, the historical
loss information used for reversion must be adjusted (to the extent necessary given
the particular facts and circumstances) for differences in asset-specific risk
characteristics (see Section 4.3.2). Second, such reversion is appropriate (and required)
only for periods beyond which management can reasonably adjust historical loss
information “for current conditions and reasonable and supportable forecasts,” as
discussed in ASC 326-20-30-10. That is, an entity may not default solely to
historical loss information to estimate expected credit losses.
While ASC 326-20-30-9 allows an entity to revert to historical loss
experience on “a straight-line basis, or using another rational and systematic
basis,” it does not require that the reversion occur over the remaining contractual
life of the financial asset. As a result, an entity can choose to revert to
historical loss experience over a period shorter than the asset’s remaining
contractual life if it believes that such reversion would result in a better
estimate of its expected credit losses.
Footnotes
2
Note that such questions are not relevant when
expected credit losses are calculated by using DCFs.
4.4 Measurement Methods and Techniques
ASC 326-20
30-3 The allowance
for credit losses may be determined using various methods. For
example, an entity may use discounted cash flow methods,
loss-rate methods, roll-rate methods, probability-of-default
methods, or methods that utilize an aging schedule. An entity is
not required to utilize a discounted cash flow method to
estimate expected credit losses. Similarly, an entity is not
required to reconcile the estimation technique it uses with a
discounted cash flow method.
30-4 If an entity estimates
expected credit losses using methods that project future
principal and interest cash flows (that is, a discounted cash
flow method), the entity shall discount expected cash flows at
the financial asset's effective interest rate. When a discounted
cash flow method is applied, the allowance for credit losses
shall reflect the difference between the amortized cost basis
and the present value of the expected cash flows. If a financial
asset is modified and is considered to be a continuation of the
original asset, an entity shall use the post-modification
contractual interest rate to derive the effective interest rate
when using a discounted cash flow method. See paragraph
815-25-35-10 for guidance on the treatment of a basis adjustment
related to an existing portfolio layer method hedge. If the
financial asset's contractual interest rate varies based on
subsequent changes in an independent factor, such as an index or
rate, for example, the prime rate, the London Interbank Offered
Rate (LIBOR), or the U.S. Treasury bill weekly average, that
financial asset's effective interest rate (used to discount
expected cash flows as described in this paragraph) shall be
calculated based on the factor as it changes over the life of
the financial asset. An entity is not required to project
changes in the factor for purposes of estimating expected future
cash flows. If the entity projects changes in the factor for the
purposes of estimating expected future cash flows, it shall use
the same projections in determining the effective interest rate
used to discount those cash flows. In addition, if the entity
projects changes in the factor for the purposes of estimating
expected future cash flows, it shall adjust the effective
interest rate used to discount expected cash flows to consider
the timing (and changes in the timing) of expected cash flows
resulting from expected prepayments in accordance with paragraph
326-20-30-4A. Subtopic 310-20 on receivables—nonrefundable fees
and other costs provides guidance on the calculation of interest
income for variable rate instruments.
Pending Content (Transition
Guidance: ASC 815-20-65-6)
30-4
If an entity estimates expected credit losses
using methods that project future principal and
interest cash flows (that is, a discounted cash
flow method), the entity shall discount expected
cash flows at the financial asset’s effective
interest rate. When a discounted cash flow method
is applied, the allowance for credit losses shall
reflect the difference between the amortized cost
basis and the present value of the expected cash
flows. See paragraph 815-25-35-10 for guidance on
the treatment of a basis adjustment related to an
existing portfolio layer method hedge. If the
financial asset’s contractual interest rate varies
based on subsequent changes in an independent
factor, such as an index or rate, for example, the
prime rate, the London Interbank Offered Rate
(LIBOR), or the U.S. Treasury bill weekly average,
that financial asset’s effective interest rate
(used to discount expected cash flows as described
in this paragraph) shall be calculated based on
the factor as it changes over the life of the
financial asset. An entity is not required to
project changes in the factor for purposes of
estimating expected future cash flows. If the
entity projects changes in the factor for the
purposes of estimating expected future cash flows,
it shall use the same projections in determining
the effective interest rate used to discount those
cash flows. In addition, if the entity projects
changes in the factor for the purposes of
estimating expected future cash flows, it shall
adjust the effective interest rate used to
discount expected cash flows to consider the
timing (and changes in the timing) of expected
cash flows resulting from expected prepayments in
accordance with paragraph 326-20-30-4A. Subtopic
310-20 on receivables — nonrefundable fees and
other costs provides guidance on the calculation
of interest income for variable rate
instruments.
30-4A As an accounting policy
election for each class of financing receivable or major
security type, an entity may adjust the effective interest rate
used to discount expected cash flows to consider the timing (and
changes in timing) of expected cash flows resulting from
expected prepayments.
30-5A An entity may
make an accounting policy election, at the class of financing
receivable or the major security-type level, not to measure an
allowance for credit losses for accrued interest receivables if
the entity writes off the uncollectible accrued interest
receivable balance in a timely manner. This accounting policy
election should be considered separately from the accounting
policy election in paragraph 326-20-35-8A. An entity may not
analogize this guidance to components of amortized cost basis
other than accrued interest.
There is no loss recognition probability threshold under ASC 326. In
accordance with ASC 326-20-30-3 (see above), various methods can be used to estimate
credit losses. In paragraph BC50 of ASU 2016-13, the FASB indicates that its reasoning
behind allowing entities to use various methods in estimating credit losses is that
“entities manage credit risk differently and should have flexibility to best report
their expectations.” The Board also acknowledges that “different methods may result in a
range of acceptable outcomes” and do not inherently cause a particular estimate to be
unreasonable.
Accordingly, an entity can select from a number of measurement
approaches to determine the allowance for expected credit losses. Some approaches
project future principal and interest cash flows (i.e., a DCF method), while others
project only future principal losses. If an entity chooses to estimate credit losses by
using a method other than a DCF method, it has the option of estimating such losses on
the asset’s amortized cost basis in the aggregate or by separately measuring the
components of the amortized cost basis (e.g., premiums and discounts), as described in
ASC 326-20-30-5.
While ASC 326 does not prescribe the use of specific methods, an entity
should ensure that the methods used for each type of financial asset appropriately meet
the objectives of ASC 326. For example, the entity may determine that certain methods
are not suitable for measuring expected credit losses on prepayable financial assets
(see Section 4.4.5 for
discussion of how estimated prepayments may affect the estimate of expected credit
losses if a method other than a DCF approach is used). In addition, as required by ASC
326-20-30-10 and discussed in paragraph BC63 of ASU 2016-13, regardless of the method
used, an entity’s estimate of expected credit losses should take into account “the
expected risk of loss, even if that risk is remote.”
To faithfully estimate the collectibility of financial assets within the scope of ASC
326-20, an entity should use judgment in developing estimation techniques and apply
those techniques consistently over time. ASC 326-20-55-7 emphasizes that an entity
should use methods that are “practical and relevant” given the specific facts and
circumstances and that “[t]he method(s) used to estimate expected credit losses may vary
on the basis of the type of financial asset, the entity’s ability to predict the timing
of cash flows, and the information available to the entity.”
The method(s) used must be disclosed by portfolio segment and major
security type in accordance with ASC 326-20-50-11. If the estimation technique or
assumptions used to calculate expected credit losses are changed, an entity should
consider whether the change reflects a change in accounting
principle3 or a change in accounting estimate4 in accordance with ASC 250. ASC 250 also discusses a change in
accounting estimate effected by a change in accounting principle.5 The table below discusses (1) when it is appropriate to effect a change in
accounting principle or a change in accounting estimate and (2) how such changes should
be accounted for in an entity’s financial statements.
Type of Change
|
When a Change Is Appropriate
|
Accounting for the Change
|
---|---|---|
Change in accounting principle
|
May be made upon the initial adoption of a newly
issued Codification update. If it occurs under any other
circumstances, it must be justified on the basis that the
alternative accounting principle is preferable (see ASC
250-10-45-2).
SEC registrants are required to file a
preferability letter to effect a change in accounting principle.
|
Reported “through retrospective application of
the new accounting principle to all prior periods, unless it is
impracticable to do so” (see ASC 250-10-45-5).
|
Change in accounting estimate
|
Generally results from “the continuing process
of obtaining additional information and revising estimates”
related to the present status and expected future benefits and
obligations associated with assets and liabilities (see ASC
250-10-45-18 and the definition of a change in accounting
estimate). The objective of measuring an asset or liability in
other Codification topics will affect the assessment of when a
change in accounting estimate is justified given the particular
facts and circumstances.
|
Should not be accounted for by restating or
retrospectively adjusting amounts reported in prior-period
financial statements. Rather, such a change should “be accounted
for in the period of change if the change affects that period
only or in the period of change and future periods if the change
affects both” (see ASC 250-10-45-17).
|
Change in accounting estimate effected by a
change in accounting principle
|
May only be made “if the new accounting
principle is justifiable on the basis that it is preferable”
(see ASC 250-10-45-19).
An SEC registrant is not required to file a
preferability letter to make a change in accounting estimate
effected by a change in accounting principle (see paragraph
4230.2(c)(4) of the SEC Financial Reporting
Manual).
|
Treated as a change in accounting estimate (see
ASC 250-10-45-18).
|
The determination of the allowance for credit losses on financial assets
reflects an accounting estimate. Making such an estimate involves the determination of
both the estimation technique (e.g., DCFs, loss-rate method) and the assumptions
inherent in that technique. ASC 326-20-55-6 notes that “[e]stimating expected credit
losses is highly judgmental” and includes the following nonexhaustive list of judgments
that may be involved in such estimation:
- The definition of default for default-based statistics
- The approach to measuring the historical loss amount for loss-rate statistics, including whether the amount is simply based on the amortized cost amount written off and whether there should be adjustments to historical credit losses (if any) to reflect the entity’s policies for recognizing accrued interest
- The approach to determine the appropriate historical period for estimating expected credit loss statistics
- The approach to adjusting historical credit loss information to reflect current conditions and reasonable and supportable forecasts that are different from conditions existing in the historical period
- The methods of utilizing historical experience
- The method of adjusting loss statistics for recoveries
- How expected prepayments affect the estimate of expected credit losses
- How the entity plans to revert to historical credit loss information for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses
- The assessment of whether a financial asset exhibits risk characteristics similar to other financial assets.
As part of its processes for estimating expected credit losses, an
entity will need to continually obtain and evaluate new information to determine how it
affects the presentation of the net amounts expected to be collected on financial
assets. Such processes could include changing the estimation technique for specific
types of financial assets, changing the assumptions inherent in the application of a
particular estimation technique, or both.
4.4.1 Changes in Estimation Techniques
ASC 326-20-35-1 and ASC 326-20-55-7 address considerations related to determining the
estimation technique used to calculate expected credit losses and state:
35-1 At each reporting date, an entity shall record an allowance for
credit losses on financial assets (including purchased financial assets with
credit deterioration) within the scope of this Subtopic. An entity shall
compare its current estimate of expected credit losses with the estimate of
expected credit losses previously recorded. An entity shall report in net
income (as a credit loss expense or a reversal of 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). The
method applied to initially measure expected credit losses for the
assets included in paragraph 326-20-30-14 generally would be applied
consistently over time and shall faithfully estimate expected credit
losses for financial asset(s). [Emphasis added]
55-7 Because of the subjective nature of the estimate, this Subtopic
does not require specific approaches when developing the estimate of
expected credit losses. Rather, an entity should use judgment to develop
estimation techniques that are applied consistently over time and should
faithfully estimate the collectibility of the financial assets by
applying the principles in this Subtopic. An entity should utilize
estimation techniques that are practical and relevant to the
circumstance. The method(s) used to estimate expected credit losses may
vary on the basis of the type of financial asset, the entity’s ability
to predict the timing of cash flows, and the information available to
the entity. [Emphasis added]
An entity may consider changing its estimation technique for a particular type of
financial asset for various reasons. For example, in practice, it may be common for
a financial asset’s risk characteristics to no longer be similar to those of the
original pool of financial assets. In such situations, an entity may need to measure
expected credit losses on the asset by using a method different from that used for
the original pool. Accordingly, it may be appropriate for the entity to change the
estimation technique for the financial asset and, depending on the facts and
circumstances, the new estimation technique may be applied to the financial asset
individually or to a different pool of financial assets whose risk characteristics
are now similar to those of that asset. For instance, an entity may determine that
the allowance for credit losses on a credit-deteriorated financial asset (including,
but not limited to, a modified financial asset) should be estimated by using a DCF
approach or by applying the practical expedient related to collateral-dependent
financial assets, but the entity may also determine that the allowance for credit
losses on the original pool of financial assets should continue to be estimated by
using a loss-rate approach.
If there is no change in risk characteristics, an entity would
generally be expected to apply its estimation technique consistently over time.
However, when a change in an estimation technique is justified given the particular
facts and circumstances, an entity should treat the change as a change in accounting
estimate rather than as a change in accounting estimate effected by a change in
accounting principle. Although the definition of a change in accounting principle in
ASC 250 indicates that “[a] change in the method of applying
an accounting principle also is considered a change in accounting principle”
(emphasis added), the definition of a change in accounting estimate cites
uncollectible receivables as an item for which estimates are necessary. In prior
registrant comment letters and informal conversations, the SEC staff has expressed
its view that changes in the method of estimating the allowance for credit losses
represent changes in accounting estimates.
4.4.2 Applying Different Measurement Methods to Similar Pools of Assets
An entity can select from a number of measurement approaches to
estimate expected credit losses. Some approaches project future principal and
interest cash flows (i.e., a DCF method), while others project only future
principal losses. An entity is not necessarily required to apply the same
measurement approach when measuring expected credit losses related to similar
pools of assets. While it is clear that an entity could use different approaches
to measure expected credit losses related to individual financial assets that do
not share similar risk characteristics, it is less clear whether that same
conclusion applies to similar pools of financial assets. As discussed in
Chapter 3, an
entity must evaluate financial assets on a collective (i.e., pool) basis if they
share similar risk characteristics. Once the entity determines a pool of
financial assets, it can apply any of the measurement methods discussed in ASC
326-20 to that pool. As a result, an entity could potentially apply a different
measurement approach to different pools of similar financial assets.
Example 4-1
A commercial real estate lender has
historically provided financing in the northeastern and
southeastern United States and has determined its pools
of assets for measuring expected credit losses on the
basis of internal risk rating (1–5). The internal risk
rating takes into account borrower-specific factors such
as size, geographical location, historical payment
defaults, and loan term (note that the lender does not
believe that the borrower-specific factors cause the
loans not to share similar risk characteristics). Given
the amount of historical information gathered on these
commercial pools, the lender uses a DCF method to
estimate expected credit losses related to the pools.
In the current year, the lender begins
to finance commercial loans in the southwestern United
States. As the lender has historically done, it assigns
an internal risk rating to the loans issued in the
southwestern United States and determines that those
loans should be pooled together. However, the lender
does not have sufficient information to apply a DCF
method to these loans (as noted above, the lender did
have such information for the loans issued in the
northeastern and southeastern United States). Therefore,
on the basis of the guidance in ASC 326-20-55-7, which
emphasizes that an entity should use methods that are
“practical and relevant” given the specific facts and
circumstances and that “[t]he method(s) used to estimate
expected credit losses may vary on the basis of . . .
the entity’s ability to predict the timing of cash
flows, and the information available to the entity,” the
lender chooses to apply a loss-rate method to the pool
of commercial real estate loans issued in the
southwestern United States and continues to apply a DCF
method to the pools of commercial real estate loans
issued in the northeastern and southeastern United
States.
4.4.3 Changes in Assumptions
Changes to the assumptions an entity uses in applying a particular estimation
technique are appropriate when the entity is making those changes because it has
obtained and evaluated new information that affects its process for faithfully
estimating the collectibility of financial assets in accordance with ASC 326. Any
such changes, which should be justifiable given the particular facts and
circumstances, should be reflected as a change in accounting estimate. Such changes
would include the nonexhaustive list of judgments listed in ASC 326-20-55-6.
While changes in the estimation techniques and assumptions used to measure expected
credit losses are considered changes in accounting estimates, changes in certain
items, which are described in ASC 326 as “significant accounting policies,” could
indirectly affect the estimation of credit losses and would need to be reflected as
changes in accounting principles. ASC 326-20-50-17 states that an entity’s
significant accounting policies would include the following:
- Nonaccrual policies, including the policies for discontinuing accrual of interest, recording payments received on nonaccrual assets (including the cost recovery method, cash basis method, or some combination of those methods), and resuming accrual of interest, if applicable
- The policy for determining past-due or delinquency status
- The policy for recognizing writeoffs within the allowance for credit losses.
In addition, an entity’s change in its interest income recognition practices may
reflect a change in accounting principle or a change in accounting estimate effected
by a change in accounting principle. Interest income recognition guidance is largely
addressed in other Codification topics. However, ASC 326 does address an entity’s
treatment of the change in the allowance for credit losses that results from the
passage of time when a DCF approach is used to estimate expected credit losses. ASC
326-20-45-3 allows an entity to either (1) report the entire change in present value
as credit loss expense or (2) report the change in present value attributable to the
passage of time as interest income. The alternative chosen would reflect an
accounting policy; thus, any change in the alternative used would be considered a
change in accounting principle.
See ASC 250-10-50 for information about the disclosures that must accompany a change
in accounting principle or a change in accounting estimate.
4.4.4 Considerations Related to Estimating Credit Losses by Using a DCF Method
4.4.4.1 Effect of Prepayments on an Entity Using a DCF Method
An entity that uses a DCF method to estimate expected credit
losses must “discount expected cash flows at the financial asset’s effective interest rate” (emphasis added) in accordance
with ASC 326-20-30-4. This paragraph further states that “[w]hen a discounted
cash flow method is applied, the allowance for credit losses shall reflect the
difference between the amortized cost basis and the present value of the
expected cash flows.” ASC 326-20-20 defines the EIR, in part, as “[t]he rate of
return implicit in the financial asset, that is, the contractual interest rate
adjusted for any net deferred fees or costs, premium, or discount existing at
the origination or acquisition of the financial asset.”6
Consequently, ASC 326 is unclear on whether an entity that applies a DCF method
to discount the expected cash flows should use the same EIR it applied to
recognize interest income in accordance with ASC 310-20. With few exceptions, it
is assumed under ASC 310-20 that for interest income recognition purposes, the
loan will remain outstanding until its contractual maturity (and that,
therefore, expected prepayments are not considered). However, the CECL model
requires an entity to consider prepayments when applying the DCF method. As a
result, the loan term used for recognizing interest income is inconsistent with
that used for estimating expected credit losses.
Further, this inconsistency could result in certain anomalies. For example, when
an entity uses a DCF method to estimate expected credit losses for a loan that
includes a premium to par, any expected prepayments would accelerate the
recognition of premiums that are related solely to the use of a discount rate
under which, for CECL model purposes, prepayments are assumed to a set of cash
flows for which prepayments are not assumed for interest income recognition
purposes. The acceleration of the premium recognition results in an increase to
the credit allowance because the amortized cost basis on day 1 would be greater
than the present value of the expected cash flows. The opposite is true for a
loan that includes a discount to par under which the use of a DCF method that
includes expected prepayments would accelerate the recognition of the discount.
This acceleration would, in turn, artificially lower the allowance because the
amortized cost basis on day 1 would be less than the present value of the
expected cash flows.
This issue, among others discussed at the June 2017 TRG meeting, led the FASB to
issue ASU 2019-04, under which an entity can make an accounting policy election
(at the “class of financing receivable” level) to use a prepayment-adjusted EIR
when applying a DCF method under the CECL model, even though the EIR used for
interest income recognition is not adjusted for prepayments. The ASU also states
that an entity that has elected an accounting policy of adjusting the EIR for
prepayments should update the adjusted EIR periodically to match any changes in
expected prepayments. Moreover, the ASU clarifies that an entity should not
adjust the EIR used to discount expected cash flows for subsequent changes in
expected prepayments if the financial asset is restructured in a TDR.7
4.4.4.2 Variable-Rate Instruments
If a financial asset’s contractual interest rate varies on the
basis of an independent factor, such as an index or rate, an entity is permitted
to consider projections of changes in the factor as long as such projections are
the same as those used to estimate expected future cash flows. For example, the
reasonable and supportable forecast period over which an entity chooses to
project the contractual variable interest rate should be consistent for both
estimating future cash flows and determining the EIR.
Specifically, ASC 326-20-30-4 states, in part:
If the financial asset’s
contractual interest rate varies based on subsequent changes in an
independent factor, such as an index or rate, for example, the prime rate,
the London Interbank Offered Rate (LIBOR), or the U.S. Treasury bill weekly
average, that financial asset’s effective interest rate (used to discount
expected cash flows as described in this paragraph) shall be calculated
based on the factor as it changes over the life of the financial asset. An
entity is not required to project changes in the factor for purposes of
estimating expected future cash flows. If the entity projects changes in the
factor for the purposes of estimating expected future cash flows, it shall
use the same projections in determining the effective interest rate used to
discount those cash flows. In addition, if the entity projects changes in
the factor for the purposes of estimating expected future cash flows, it
shall adjust the effective interest rate used to discount expected cash
flows to consider the timing (and changes in the timing) of expected cash
flows resulting from expected prepayments in accordance with paragraph
326-20-30-4A. Subtopic 310-20 on receivables — nonrefundable fees and other
costs provides guidance on the calculation of interest income for variable
rate instruments.
Connecting the Dots
Measuring Expected Credit Losses
When an EIR on a Fixed-Rate Loan Is Lower Than a Current Market
Rate
An entity is permitted to consider projections of
changes in factors that lead to changes in a variable-rate
instrument’s contractual interest rate when determining the asset’s EIR.
However, when an entity is determining the EIR on a fixed-rate
loan, even in situations in which interest rates have increased since
the origination of the loan, the entity would not consider the current
market rate when discounting the expected future cash flows of the loan.
Keep in mind that discounting the future cash flows at a rate lower than
the current market rate will result in a lower amount of expected credit
losses. An entity should change its estimate of expected credit losses
solely on the basis of changes in credit quality (i.e., a change in
future cash flows that is attributable to credit). The FASB did not
intend the measurement of expected credit losses to reflect changes in
interest rates in general or changes specific to a borrower.
However, if the creditor uses a practical expedient in measuring expected
credit losses (e.g., fair value of collateral on a collateral-dependent
loan), the measurement may reflect changes in interest rates because
fair value incorporates current market conditions as of the measurement
date.
4.4.5 Estimating Credit Losses by Using Methods Other Than a DCF Method
If an entity chooses to estimate credit losses by using a method other than a DCF
method, it has the option of estimating credit losses on the asset’s amortized cost
basis in the aggregate or by separately measuring the components of the amortized
cost basis (e.g., premiums and discounts), as described in ASC 326-20-30-5.
Depending on which of these alternatives the entity chooses, it may be required to
adjust its historical loss information. For example, if an entity’s historical loss
rate reflects losses of only principal amounts, it may need to adjust that
information if it chooses to estimate credit losses on the entire amortized cost
basis of an asset to which premiums, discounts, or other basis adjustments
apply.
4.4.5.1 Accrued Interest
ASC 326 defines “amortized cost basis” as “the amount at which a
financing receivable or investment is originated or acquired, adjusted for applicable accrued interest, accretion or amortization
of premium, discount, and net deferred fees or costs, collection of cash,
writeoffs, foreign exchange, and fair value hedge accounting adjustments”
(emphasis added). Although accrued interest is included in the definition of
amortized cost basis, ASC 326 provides certain alternatives for the measurement,
presentation, and disclosure that, if applied, alleviate certain potential
operational burdens. Specifically, an entity can:
- Measure the allowance for credit losses on accrued interest receivable balances separately from other components of the amortized cost basis of associated financial assets (see ASC 325-20-30-5).
- Elect an accounting policy of not measuring an allowance for credit losses on accrued interest receivable amounts if the uncollectible accrued interest receivable balance is written off in a timely manner and certain disclosures are provided (see ASC 326-20-30-5A and ASC 326-20-50-3C).
- Elect an accounting policy of writing off accrued interest amounts by reversing interest income, recognizing credit loss expense, or a combination of both (see ASC 326-20-35-8A). The entity also is required to provide certain disclosures (see ASC 326-20-50-3D).
- Elect an accounting policy of presenting accrued interest receivable balances and the related allowance for credit losses for those accrued interest receivable balances separately from the associated financial assets on the balance sheet (see ASC 326-20-45-5). If the accrued interest receivable balances and the related allowance for credit losses are not presented as a separate line item on the balance sheet, an entity should disclose the amount of accrued interest receivable balances and the related allowance for credit losses and where the balance is presented (see ASC 326-20-50-3A).
- Elect a practical expedient to disclose separately the total amount of accrued interest included in the amortized cost basis as a single balance to meet certain disclosure requirements (see ASC 326-20-50-3B).
4.4.5.2 Nonaccrual Loans
ASC 310-20-35-17 states that the amortization of net
deferred fees and costs should be discontinued when an entity is not
accruing interest on a loan “because of concerns about the realization of
loan principal or interest.” The guidance in ASC 310-20-35-17 applies even
if an entity has net deferred costs or a premium associated with the loan.
While ASC 310-20 does not explicitly refer to premiums and
discounts, if a loan is on nonaccrual status, presumably no interest should
be recorded, including the amortization of premiums and discounts. Note,
however, that when an entity estimates expected credit losses on a
nonaccrual loan, it must consider the entire amortized cost basis of the
loan, including unamortized net deferred costs and unamortized premiums
(irrespective of whether the entity chooses to measure expected credit
losses on the asset’s amortized cost basis in the aggregate or by separately
measuring the components of the amortized cost basis, as permitted by ASC
326-20-30-5).
4.4.5.3 Discounting Inputs When a Method Other Than a DCF Method Is Used
An entity that uses a method other than a DCF method (e.g.,
a probability-of-default or a loss-given-default credit loss method) in
estimating credit losses is not allowed to discount only certain inputs;
partial discounting is prohibited. If an entity wants to discount the inputs
used to measure the allowance for credit losses, it should discount all the
inputs used in the measurement. Note that this question was addressed at the
November 2018 TRG meeting, and it was
determined that ASC 326’s guidance on discounting is clear.
In addition, it would not be acceptable for an entity to
discount future losses when using a loss-rate method (i.e., amortized cost ×
expected loss rate). Discounting is allowed only under a DCF approach in
which an entity uses the appropriate EIR.
4.4.5.4 Consideration of Capitalized Interest When a Method Other Than a DCF Method Is Used
When an entity uses a method other than a DCF method to
estimate credit losses, its allowance for credit losses should not take into
account future capitalized interest, since such interest is not included in
the asset’s amortized cost basis on which the entity is estimating expected
credit losses. For a financial asset issued at a discount, the amount due
upon default — provided that there are no terms or conditions that only
require the repayment of “accreted value” at any point in the asset’s term —
would be the par amount and accrued interest to date (which is greater than
the asset’s amortized cost basis). For a financial asset issued at par with
expected future capitalized interest, the amount due upon default is also
the par amount and accrued interest to date, which would equal the amortized
cost basis at the time of default (as long as there are no other adjustments
to the amortized cost basis). Therefore, an entity would not consider any
unearned interest, regardless of the expectation that it will be capitalized
in future periods before a default occurs, in the calculation of an
allowance for credit losses because the legal amount owed upon default would
not include that future expected accrued interest.
To illustrate this point, at its June 2018 meeting, the TRG discussed an example in
which an entity issues a student loan for $60,000. The student is not
required to make any payments on the loan until after four years (i.e., the
loan will be in deferment for four years). However, interest accrues during
the deferment period in such a way that at the end of year 4, the student
will owe the lender $100,000, comprising a principal amount of $60,000 and
interest of $40,000. In this scenario, although the student will owe the
lender $100,000 after the deferment period ends, the lender will calculate
its expected credit losses during the deferment period by using an amortized
cost amount that does not include future capitalized interest (i.e., the
principal amount of $60,000).
4.4.6 Effect of Timing on Expected Credit Losses
The timing of defaults and prepayments (e.g., repayment of the
financial asset, either partially or entirely, before its stated maturity
according to its contractual terms) affects an entity’s calculation of expected
credit losses differently depending on the method used:
- DCF method — When a DCF method is applied to a pool of financial assets, the time value of money is explicitly incorporated (i.e., both the amount and timing of cash flows matter). For example, the timing of prepayments affects the timing of the recognition of discounts and premiums and the number of interest coupons to be received. These factors could increase or offset credit losses when a DCF method is applied to a pool of assets by using an overall EIR.
- Measuring expected credit losses on the separate components of amortized cost (e.g., premiums, discounts) or on the asset’s combined amortized cost basis — Regardless of whether an entity estimates expected credit losses on the separate components of amortized cost or the combined amortized cost basis of the asset, an entity is permitted but not required to consider the timing of when credit losses will occur.8 However, if an entity chooses to consider timing when estimating expected credit losses, the timing will affect the amount of amortized premiums, discounts, deferred fees and costs, etc. In addition, the entity would also need to estimate the acceleration of the amortization of the amounts resulting from prepayments.
4.4.7 Inclusion of Taxes, Insurance, and Other Costs
A lender’s expectations of future losses on payments of tax,
insurance premiums, and other “costs” (i.e., payments made by the lender that
may not be recovered from borrowers) should not be included in the lender’s day
1 estimate of expected credit losses. Those amounts should only be included in
its estimate of expected credit losses when the funds are advanced. Some would
argue that because the lender is not obligated to make those payments on the
borrower’s behalf, not establishing an allowance for these amounts before such
advances is consistent with the treatment of unfunded loan commitments discussed
in Section 2.1.
Others would argue that even if the lender was effectively compelled to make the
advances to protect its collateral, not including estimates of future advances
in the expected credit losses is consistent with the treatment of future
capitalized interest discussed in Section 4.4.5.4 since those amounts do not
represent the amount owed by the borrower on the balance sheet date.
4.4.8 Weighted-Average Remaining Maturity Method
In January 2019, the FASB staff issued a Q&A document that addresses whether
and, if so, how the WARM method could be used to estimate expected credit
losses. The document states that the “WARM method uses an average annual
charge-off rate [that] contains loss content over several vintages and is used
as a foundation for estimating the credit loss content for the remaining
balances of financial assets in a pool at the balance sheet date. The average
annual charge-off rate is applied to the contractual term, further adjusted for
estimated prepayments to determine the unadjusted historical charge-off rate for
the remaining balance of the financial assets.” The staff indicated that it is
acceptable to use the WARM method to estimate an allowance for credit losses,
particularly for less complex financial asset pools, and that an entity needs to
consider whether qualitative adjustments should be made.
To illustrate how an entity might apply the WARM method, the FASB staff included
a number of examples in the Q&A, one of which is reproduced below.
FASB Staff Q&A
Topic 326, No. 1: Whether the Weighted-Average
Remaining Maturity Method Is an Acceptable Method to
Estimate Expected Credit Losses
Question 3 . .
.
Fact Pattern
- Estimate the allowance for credit losses as of 12/31/2020
- Pool of financial assets of similar risk characteristics
- Amortized cost basis of ~$13.98 million
- 5-year financial assets (contractual term adjusted by prepayments)
- Management expects the following in 2021 and 2022:
- Rise in unemployment rates
- Management cannot reasonably forecast beyond 2022
- Assume 0.25% qualitative adjustment to represent both current conditions and reasonable and supportable forecasts
The example illustrates estimating an allowance for
credit losses on a pool of financial assets as of
December 31, 2020. The pool has an outstanding balance
of approximately $13.98 million as of December 31, 2020
and has financial assets with a contractual life of 5
years. The $13.98 million amortized cost is for a pool
of financial assets with similar credit risk
characteristics.
Management expects a rise in unemployment rates for 2021
and 2022 and cannot reasonably forecast beyond 2022. The
example assumes a 0.25% qualitative adjustment for
current conditions and reasonable and supportable
forecasts discussed further below. It is important to
note that this input will be a significant assumption
when estimating expected credit losses under Update
2016-13 because it represents amounts for the current
conditions and reasonable and supportable forecast.
Moreover, because the example is for illustrative
purposes, the staff has not assumed a specific type of
financial asset pool given the breadth of products that
exist in the market place and the specific facts and
circumstances that may exist for a particular entity.
Rather, the calculations are meant to depict the
mechanics of the model in various ways. Therefore, as
noted in the example calculations, an entity will need
to determine if adjustments need to be made to
historical loss data in accordance with paragraph
326-20-30-8 in addition to the reasonable and
supportable forecasts.
Step 1: Calculate Annual Charge-Off Rate
In Table 1 above:
- Red bolded number of 0.36% is an average of 5 years of annual charge-off rates.
- The historical time period used to determine the average annual charge-off rate is a significant judgment that will need to be properly supported and documented in accordance with paragraph 326-20-30-8. For this example, assume the entity compared historical information for similar financial assets with the current and forecasted direction of the economic environment, and believes that its most recent 5-year period is a reasonable period on which to base its expected credit-loss-rate calculation after considering the underwriting standards and contractual terms for loans that existed over the historical period in comparison with the current pool. Additionally, assume the entity considered whether any adjustments to historical loss information in accordance with paragraph 326-20-30-8 were needed before considering adjustments for current conditions and reasonable and supportable forecasts but determined that none were necessary. It should be noted that this is a simplified example using a generic pool. An entity that estimates the allowance for credit losses using the WARM method (or any method) should determine if its historical loss information needs to be adjusted for changes in underwriting standards, portfolio mix, or asset term within the pool at the reporting date.
Step 2: Estimate the Allowance for Credit
Losses
In Table 2 above:
-
First column titled “Year End” displays subsequent years, until 2025, which represents the time anticipated for the pool to be paid off.
-
Second column titled “Est. Paydown” represents expected payments in the future periods until the pool is expected to fully pay off. Management will need to estimate the future paydowns, which includes the scheduled payments + prepayments.Note: Do not include the expected credit losses in this column. Paydowns should include scheduled payments and non-credit related prepayments.Note: Estimated prepayments are also a significant judgment that will need to be properly supported and documented.
-
Third column titled “Projected Amort Cost”:
- Begin with $13.98MM outstanding balance as of the balance sheet date of 12/31/2020.
- Subtract projected paydowns from the “Est. Paydown” column to estimate future projected amortized cost for each of the remaining years of the pool’s life (for example, $13,980M minus $3,700M equals $10,280M).
-
Fifth column titled “Allowance for Credit Losses”:
- Take each of the future years’ projected amortized cost and multiply by the average annual charge-off rate, thereby estimating each of the remaining years’ losses and aggregating to estimate the cumulative losses (for example, in the first year, $13.98MM of amortized cost is multiplied by the average annual charge-off rate of 0.36% for a first year’s credit loss estimate of $50K dollars).
- For the second year, which is 2022, the $10.28MM representing the ending balance as of 2021 and the beginning balance as of 2022 is multiplied by the average annual charge-off rate of 0.36% to estimate the second year’s credit losses of $37K dollars. This process is repeated for each remaining year.
- Sum the last column to
estimate the total expected credit losses of $126K
dollars.Note: This is not the full allowance for credit losses because the entity has not yet accounted for current conditions and reasonable and supportable forecasts.
- Convert $126K of expected losses into a loss rate of 0.90% by dividing $126K by the amortized cost of $13.98MM.
- Finally, add 0.25% of qualitative adjustments as
an assumption established as part of the fact
pattern of the example to estimate the allowance
for credit losses rate of 1.15%. The 1.15% is
multiplied by $13.98MM to estimate the total
allowance for credit losses of $161K dollars.
Note: 0.25% is a significant assumption made by management that will need to be adequately documented and supported. For this example, in accordance with paragraph 326-20-55-4, the entity considered significant factors that could affect the expected collectability of the amortized cost basis of the pool and determined that the primary factor is the unemployment rate. As part of this analysis, assume that the entity observed that the unemployment rate has increased as of the current reporting period date. Based on current conditions and reasonable and supportable forecasts, the entity expects that unemployment rates are expected to increase further over the next one to two years. To adjust the historical loss rate to reflect the effects of those differences in current conditions and forecasted changes, the entity estimates a 25-basis-point increase in credit losses incremental to the 0.9 percent historical lifetime loss rate related to the expected deterioration in unemployment rates. Management estimates that the incremental 25-basis-point increase based on its knowledge of historical loss information during past years in which there were similar trends in unemployment rates. Management is unable to support its estimate of expectations for unemployment rates beyond the reasonable and supportable forecast period. Under this loss-rate method, the incremental credit losses for the current conditions and reasonable and supportable forecast (the 25 basis points) is added to the 0.9 percent rate that serves as the basis for the expected credit loss rate. No further reversion adjustments are needed because the entity has applied a 1.15% loss rate where it has immediately reverted into historical losses that reflect the contractual term in accordance with paragraphs 326-20-30-8 through 30-9. This approach reflects an immediate reversion technique for the loss-rate method. It is important to note that the 25-basis-point increase reflects the entity’s estimate of the incremental losses in years 2021 and 2022 from unemployment and assumes no incremental losses for the remaining years. Further, the reversion technique selected by the entity is a significant assumption that will need to be supported by management and is not a policy election or practical expedient.
Connecting the Dots
Applicability of the WARM
Method
The FASB staff indicated that it is acceptable to use the WARM method to
estimate expected credit losses. Under that method, entities use
qualitative adjustments to alleviate the operational challenges they may
face when applying other loss methods. For example, in its response to
Question 2 of the Q&A document, the staff suggests that such
qualitative adjustments may be used to overcome “situations involving
minimal loss history, losses that are sporadic with no predictive
patterns, low numbers of loans in each pool, data that is only available
for a short historical period, a composition that varies significantly
from historical pools of financial assets, or changes in the economic
environment.”
However, the FASB staff also cautions preparers that although the WARM
method can be used effectively in some situations, certain “challenges
will be more significant, and an entity may find that the WARM method is
inappropriate for its situation.” Because the WARM method relies heavily
on qualitative adjustments for which significant judgment is required,
we believe that entities may discover that the costs of applying it
outweigh its benefits. As a result, we do not expect many entities to
apply the WARM method in practice.
4.4.9 Practical Expedients Related to Measuring Expected Credit Losses
ASC 326 permits entities to use practical expedients to measure expected credit
losses for the following two types of financial assets:
- Collateral-dependent financial assets — In a manner consistent with its practice under existing U.S. GAAP, an entity is permitted to measure its estimate of expected credit losses for collateral-dependent financial assets as the difference between the financial asset’s amortized cost and the collateral’s fair value (adjusted for selling costs, when applicable).
- Financial assets for which the borrower must continually adjust the amount of securing collateral (e.g., certain repurchase agreements and securities-lending arrangements) — An entity is permitted to measure its estimate of expected credit losses on these financial assets as the difference between the amortized cost basis of the asset and the collateral’s fair value.
4.4.9.1 Collateral-Dependent Financial Assets
A financial asset is considered collateral-dependent if
“repayment is expected to be provided substantially through the operation or
sale of the collateral.” Furthermore, under ASC 326-20-35-4, an entity is
required to measure the allowance for credit losses on the basis of the fair
value of the collateral when it determines that foreclosure is probable.
In addition, under ASC 326-20-35-5, if foreclosure is not
probable, an entity can elect a practical expedient to measure the allowance for
credit losses on a collateral-dependent financial asset that is impaired on the
basis of the collateral’s fair value “when the borrower is experiencing
financial difficulty based on the entity’s assessment as of the reporting date.”
The phrase “when the borrower is experiencing financial difficulty” is
consistent with the guidance that an entity considers to determine whether a
modification of a financial asset is subject to the disclosure requirements in
ASC 310-10-50-42 through 50-44. The guidance in ASC 310-10-50-45 is relevant in
the determination of an entity’s ability to use the practical expedient for a
collateral-dependent financial asset. ASC 310-10-50-45 states that the following
indicators should be considered in the determination of when a debtor may be
experiencing financial difficulties (this list is not all-inclusive):
- The debtor is currently in payment default on any of its debt. In addition, a creditor shall evaluate whether it is probable that the debtor would be in payment default on any of its debt in the foreseeable future without the modification. That is, a creditor may conclude that a debtor is experiencing financial difficulties, even though the debtor is not currently in payment default.
- The debtor has declared or is in the process of declaring bankruptcy.
- There is substantial doubt as to whether the debtor will continue to be a going concern.
- The debtor has securities that have been delisted, are in the process of being delisted, or are under threat of being delisted from an exchange.
- On the basis of estimates and projections that only encompass the debtor’s current capabilities, the creditor forecasts that the debtor’s entity-specific cash flows will be insufficient to service any of its debt (both interest and principal) in accordance with the contractual terms of the existing agreement for the foreseeable future.
- Without the current modification, the debtor cannot obtain funds from sources other than the existing creditors at an effective interest rate equal to the current market interest rate for similar debt for a nontroubled debtor.
In determining when the practical expedient for
collateral-dependent financial assets can be applied, an entity should also
consider the FASB’s rationale for limiting the application of this expedient.
Since the CECL model is built on the foundation that expected credit losses are
estimated over the contractual life of a financial asset, the FASB was concerned
that allowing an unrestricted practical expedient for collateral-dependent
financial assets could enable entities to defer the recognition of credit losses
that are expected to occur over the asset’s contractual life as a result of
declines in the collateral’s fair value. Consequently, under the guidance, the
practical expedient can only be elected if the borrower is experiencing
financial difficulties, since only at this point does the collateral’s fair
value signify a reasonable expectation of the recoverability of the financial
asset. This guidance is consistent with paragraph BC64 of ASU 2016-13, which
refers to the acceptability of measuring expected credit losses on the basis of
the fair value of the collateral “because fair value reflects the amount
expected to be collected.” Before the point at which a debtor is experiencing
financial difficulties, the collateral’s fair value would not necessarily
reflect the net amount of the financial asset expected to be collected because
of an entity’s prolonged exposure to declines in that fair value.
Entities may wish to implement accounting practices under which
they perform an objective determination of when a borrower is experiencing
financial difficulties (e.g., when a loan is a certain number of days past due
or becomes subject to the entity’s nonaccrual policy). The reasonableness of
such practices would depend on the specific facts and circumstances, including
the financial asset type, and any such objective evidence would need to be
supplemented by qualitative considerations since an entity must use judgment and
consider its particular facts and circumstances in determining when a borrower
is experiencing financial difficulties.
Since ASC 326 does not require entities to use the practical
expedient for collateral-dependent financial assets before foreclosure is
probable, the principal risk in the application of objective evidence lies in
prematurely measuring expected credit losses on the basis of the collateral’s
fair value. Rather, to apply this practical expedient when foreclosure is not
probable, an entity must appropriately assess all relevant facts and
circumstances to determine whether the borrower is experiencing financial
difficulties. The entity may consider both quantitative and qualitative
indicators in performing this assessment. While the mere fact that a borrower is
past due on its payments would generally indicate that it is experiencing
financial difficulties, this may not always be the case. For example, a borrower
may be past due on a loan because a payment delay was temporarily caused by a
natural disaster or other similar event that did not have a significant bearing
on the borrower’s wherewithal to make the contractually required payments on the
loan receivable.
Keep in mind that the entity is only allowed to use the practical expedient (when
foreclosure is not probable) if the borrower is experiencing financial
difficulty. As a result, the entity would be permitted to continue to use the
practical expedient only if it concludes that the borrower continues to
experience financial difficulty. In other words, the conditions related to using
the practical expedient when foreclosure is not probable must be met in every
reporting period. To the extent that the entity determines that the borrower is
no longer experiencing financial difficulty (or that repayment will no longer be
substantially provided through the collateral’s sale or operation), the entity
would need to measure expected credit losses by using another appropriate
measurement method discussed in ASC 326-20-30-3.
An entity must use judgment in determining whether repayment of
a loan is expected to be provided solely by the underlying collateral. On
October 24, 2013, the federal financial institution regulatory agencies jointly
issued “Interagency Supervisory Guidance Addressing Certain Issues
Related to Troubled Debt Restructurings” (the “Interagency
Guidance”9), which provides the following additional interpretation of the definition
of a collateral-dependent loan:
An impaired loan is collateral dependent if “repayment
is expected to be provided solely by the underlying collateral,” which
includes repayment from the proceeds from the sale of the collateral,
cash flow from the continued operation of the collateral, or both.
Whether the underlying collateral is expected to be the sole source of
repayment for an impaired loan is a matter requiring judgment as to the
availability, reliability, and capacity of sources other than the
collateral to repay the debt. Generally, repayment of an impaired loan
would be expected to be provided solely by the sale or continued
operation of the underlying collateral if cash flows to repay the loan
from all other available sources (including guarantors) are expected to
be no more than nominal. For example, the existence of a guarantor is
one factor to consider when determining whether an impaired loan,
including a TDR loan, is collateral dependent. To assess the extent to
which a guarantor provides repayment support, the ability and
willingness of the guarantor to make more-than-nominal payments on the
loan should be evaluated.
The repayment of some impaired loans collateralized by
real estate may depend on cash flow generated by the operation of a
business or from sources outside the scope of the lender’s security
interest in the collateral, such as cash flows from borrower resources
other than the collateral. These loans are generally not considered
collateral dependent due to the more-than-nominal payments expected to
come from these other repayment sources. For such loans, even if a
portion of the cash flow for repayment is expected to come from the sale
or operation of the collateral (but not solely from the sale or
operation of the collateral), the loan would not be considered
collateral dependent.
For example, an impaired loan collateralized by an
apartment building, shopping mall, or other income-producing property
where the anticipated cash flows for loan repayment are expected to be
derived solely from the property’s rental income, and there are no other
available and reliable repayment sources, would be considered collateral
dependent because repayment is expected to be provided only from the
continued operation of the collateral. However, an impaired loan secured
by the owner-occupied real estate of a business (such as a manufacturer
or retail store) where the anticipated cash flows to repay the loan are
expected to be derived from the borrower’s ongoing business operations
and activities would not be considered collateral dependent because the
loan is not expected to be repaid solely from cash flows from the sale
or operation of the collateral. Nevertheless, if the borrower’s
condition worsens so that any payments from the operation of the
business are expected to be nominal and repayment instead is expected to
depend solely on the sale or operation of the underlying collateral, the
loan would then be considered collateral dependent. [Footnotes
omitted]
Under this guidance, a loan would be collateral-dependent if it
is a nonrecourse loan and the creditor expects to foreclose on it, because in
such circumstances, the creditor may only look to the collateral for
satisfaction of the loan. Conversely, if the creditor is unsure whether it will
foreclose on the collateral, the loan would not be considered
collateral-dependent unless it is expected to be repaid solely through the
continued operation of the collateral.10
However, if the loan is collateralized by real estate and the
creditor has recourse to the general credit of the borrower or to a guarantor,
the assessment is less clear. The creditor would need to (1) consider whether
the borrower’s financial ability to satisfy the obligation would include
repayment sources other than the collateral and (2) formulate an expectation
regarding the borrower’s future actions. If a debtor has no means of repaying
the loan other than through operation of the collateral, the creditor should
conclude that the loan is collateral-dependent. However, if more-than-nominal
payments are expected to come from other repayment sources, the loan would
generally not be considered collateral-dependent. A similar assessment should be
performed when a source of repayment may come from a guarantor. The ability and
willingness of a guarantor to make more-than-nominal payments on a loan would
result in a conclusion that the loan is not collateral-dependent.
4.4.9.1.1 Considering Collateral Values in the Measurement of Expected Credit Losses
For collateral-dependent financial assets, ASC
326-20-35-4 requires an entity to measure expected credit losses on the
basis of the collateral’s fair value if the entity determines that
foreclosure is probable. Further, even if a financial asset does not
qualify for the practical expedient for collateral-dependent financial
assets, the collateral value is still relevant to the estimate of
expected credit losses on the financial asset. ASC 326-20-30-10 states,
in part:
Except for the circumstances described in
paragraphs 326-20-35-4 through 35-6, an entity shall not expect
nonpayment of the amortized cost basis to be zero solely on the
basis of the current value of collateral securing the financial
asset(s) but, instead, also shall consider the nature of the
collateral, potential future changes in collateral values, and
historical loss information for financial assets secured with
similar collateral.
Accordingly, if the practical expedient for
collateral-dependent financial assets in ASC 326-20-35-5 is not applied,
an entity should consider, among other factors that may affect expected
credit losses on the financial asset (or group of similar financial
assets), how the collateral’s fair value may affect the estimation of
such losses over the contractual life of the financial asset (or group
of financial assets).11 If the practical expedient is not applied, an entity cannot
measure the allowance for credit losses solely on the basis of the
reporting-date fair value of the collateral or avoid recognizing an
allowance for credit losses solely because the reporting-date fair value
of the collateral equals or exceeds the amortized cost basis of the
financial asset (or group of financial assets).
Nevertheless, the collateral security on a financial
asset would be expected to affect an entity’s estimation of expected
credit losses. In this regard, as discussed in ASC 326-20-30-10, an
entity should consider the nature of the collateral (including the
nature of the security and the seniority thereon), potential future
changes in the collateral’s fair value, and historical losses (adjusted
for current conditions and reasonable and supportable forecasts) for
financial assets secured with similar collateral. ASC 326-20-55-15
further indicates that debt-to-value ratios and collateral affect the
credit quality indicators that are pertinent to financial assets.
Accordingly, the collateral securing a financial asset is likely to have
an impact on both the probability of default and the loss-given default
on the financial asset.
If the practical expedient for collateral-dependent
financial assets is not applied, there could potentially be no allowance
for credit losses on financial assets, although such situations are not
typical. Paragraph BC63 of ASU 2016-13 states:
The
Board decided that an entity should consider the expected risk of
loss, even if that risk is remote, and that an entity need not
measure an expected credit loss when historical information adjusted
for current conditions and reasonable and supportable forecasts
results in an expectation that the risk of nonpayment of the
amortized cost basis is zero. The Board decided not to explicitly
state which financial assets are appropriate to have a zero
allowance for expected credit losses. The Board understands that an
expectation of zero loss is entirely based on the nature and
characteristics of a financial asset, which may change over time. As
a result, the Board concluded that a “bright-line” approach would be
inappropriate for all facts and circumstances and decided not to
provide explicit guidance on what specific assets are appropriate
for zero expected credit losses. The Board decided that an entity
should determine at the reporting date an estimate of credit loss
that best reflects its expectations (or its best estimate of
expected credit loss).
For example, it may be appropriate not to recognize an
allowance for credit losses on certain secured financial assets in which
the loan-to-value ratio is so low that it reduces the expected credit
losses to zero. To make such a determination, an entity would need to
appropriately consider the relevant facts and circumstances, including,
but not limited to, the following:
- The remaining contractual term of the financial asset (and, if relevant, the entity’s ability to call the financial asset upon a decline in the collateral’s fair value).
- The nature of the collateral.
- The nature and terms of the security (including any subordination provided by other interests in the collateral).
- Past experience with similar collateralized financial assets.
- Current conditions and reasonable and supportable forecasts that may affect the prior historical loss information (e.g., potential reasonable and supportable declines in the fair value of the collateral that have not occurred in the past). An entity is not required to consider extremely remote scenarios but should consider those that are reasonably possible.
However, if an entity is aware of a historical default
on a particular asset or an asset with similar risk characteristics,
regardless of whether the asset was held by the entity or another
entity, it would be difficult for the entity to conclude that it is not
required to recognize an allowance for credit losses for that asset or
asset class. In addition, an entity should consider that paragraph BC71
of ASU 2016-13 states, in part, that “it would be inappropriate to
measure credit losses for financial assets on an individual basis to
arrive at a zero expected credit loss when a pool of financial assets
with similar risk characteristics exists that would indicate otherwise.”
4.4.9.1.2 Consideration of Costs to Sell When Foreclosure Is Probable
In accordance with ASC 326-20-35-4, in estimating credit
losses, an entity that believes foreclosure is probable should consider
the costs to sell the collateral securing the financial asset if it
intends to sell rather than operate the collateral.
4.4.9.2 Collateral Maintenance Provisions
ASC 326-20
35-6 For certain financial
assets, the borrower may be contractually required to
continually adjust the amount of the collateral securing
the financial asset(s) as a result of fair value changes
in the collateral. In those situations, if an entity
reasonably expects the borrower to continue to replenish
the collateral to meet the requirements of the contract,
an entity may use, as a practical expedient, a method
that compares the amortized cost basis with the fair
value of collateral at the reporting date to measure the
estimate of expected credit losses. An entity may
determine that the expectation of nonpayment of the
amortized cost basis is zero if the fair value of the
collateral is equal to or exceeds the amortized cost
basis of the financial asset and the entity reasonably
expects the borrower to continue to replenish the
collateral as necessary to meet the requirements of the
contract. If the fair value of the collateral at the
reporting date is less than the amortized cost basis of
the financial asset and the entity reasonably expects
the borrower to continue to replenish the collateral as
necessary to meet the requirements of the contract, the
entity shall estimate expected credit losses for the
unsecured amount of the amortized cost basis. The
allowance for credit losses on the financial asset is
limited to the difference between the fair value of the
collateral at the reporting date and the amortized cost
basis of the financial asset.
In arrangements in which the borrower must continually adjust
the collateral securing the asset to reflect changes in the collateral’s fair
value (e.g., reverse repurchase arrangements), the entity is permitted to
measure its estimate of expected credit losses on these financial assets only on
the basis of the unsecured portion of the amortized cost as of the balance sheet
date (i.e., the difference between the amortized cost basis of the asset and the
collateral’s fair value). In such arrangements, the entity must reasonably
expect that the borrower will continue to replenish the collateral as necessary.
Under the practical expedient for the collateral maintenance provision, the
entity may assume that there will be zero losses on the portion of the asset’s
amortized basis that is equal to the fair value of the collateral as of the
balance sheet date. If the fair value of the collateral is equal to or greater
than the amortized cost of the asset, the expected losses would be zero. If the
fair value of the collateral is less than the amortized cost of the asset, the
expected losses are limited to the difference between the fair value of the
collateral and the amortized cost basis of the asset. Example 7 in ASC 326-20
illustrates application of this practical expedient.
ASC 326-20
Example 7:
Estimating Expected Credit Losses — Practical
Expedient for Financial Assets With Collateral
Maintenance Provisions
55-45 This Example
illustrates one way an entity may implement the guidance
in paragraph 326-20-35-6 for estimating expected credit
losses on financial assets with collateral maintenance
provisions.
55-46 Bank H enters into a
reverse repurchase agreement with Entity I that is in
need of short-term financing. Under the terms of the
agreement, Entity I sells securities to Bank H with the
expectation that it will repurchase those securities for
a certain price on an agreed-upon date. In addition, the
agreement contains a provision that requires Entity I to
provide security collateral that is valued daily, and
the amount of the collateral is adjusted up or down to
reflect changes in the fair value of the underlying
securities transferred. This collateral maintenance
provision is designed to ensure that at any point during
the arrangement, the fair value of the collateral
continually equals or is greater than the amortized cost
basis of the reverse repurchase agreement.
55-47 At the end of the first
reporting period after entering into the agreement with
Entity I, Bank H evaluates the reverse repurchase
agreement’s collateral maintenance provision to
determine whether it can use the practical expedient in
accordance with paragraph 326-20-35-6 for estimating
expected credit losses. Bank H determines that although
there is a risk that Entity I may default, Bank H’s
expectation of nonpayment of the amortized cost basis on
the reverse repurchase agreement is zero because Entity
I continually adjusts the amount of collateral such that
the fair value of the collateral is always equal to or
greater than the amortized cost basis of the reverse
repurchase agreement. In addition, Bank H continually
monitors that Entity I adheres to the collateral
maintenance provision. As a result, Bank H uses the
practical expedient in paragraph 326-20-35-6 and does
not record expected credit losses at the end of the
first reporting period because the fair value of the
security collateral is greater than the amortized cost
basis of the reverse repurchase agreement. Bank H
performs a reassessment of the fair value of collateral
in relation to the amortized cost basis each reporting
period.
4.4.9.2.1 Frequency of Collateral Replenishment
ASC 326-20-35-6 states, in part, that “[a]n entity may
determine that the expectation of nonpayment of the amortized cost basis
is zero if the fair value of the collateral is equal to or exceeds the
amortized cost basis of the financial asset and the entity reasonably
expects the borrower to continue to replenish the collateral.”
The guidance is not clear on how frequently an entity
must post additional collateral to meet the condition that it
“continually” replenish the collateral. While “continually” may mean
that the replenishment must occur on a daily basis, certain arrangements
require that collateral be replenished only if a specific minimum
threshold is reached (i.e., if the change in the fair value of the
collateral is greater than a specified amount). In such arrangements,
the requirements to use the practical expedient would never be met,
which we believe was not the FASB’s intent. Therefore, we think that an
entity should use judgment when evaluating the terms of the arrangement
with respect to posting additional collateral. In performing this
evaluation, the entity should consider whether there are certain
situations in which the posting of additional collateral is either
required or prohibited when a specified threshold is reached.
In addition, we believe that the entity should also
consider the collateral’s nature as well as how frequently it evaluates
the collateral’s adequacy. The adequacy of the collateral’s value should
be evaluated continually, even daily. If the evaluation is performed
less frequently than daily, we believe that it would be more difficult
for the entity to support its use of the practical expedient.
Furthermore, the entity should consider the nature of the collateral
because the more liquid and observable the collateral’s value is, the
easier it is to support the collateral’s adequacy in the arrangement.
The less liquid and observable the value of the collateral is (e.g.,
Level 3 for fair value disclosure purposes), the harder it will be for
the entity to demonstrate that it has evaluated the adequacy of the
collateral in attempting to qualify to use the practical expedient.
4.4.10 U.S. Treasury Securities and Other Highly Rated Debt Instruments
ASC 326-20
Example 8: Estimating Expected Credit Losses When
Potential Default Is Greater Than Zero, but
Expected Nonpayment Is Zero
55-48 This
Example illustrates one way, but not the only way, an
entity may estimate expected credit losses when the
expectation of nonpayment is zero. This example is not
intended to be only applicable to U.S. Treasury
securities.
55-49 Entity
J invests in U.S. Treasury securities with the intent to
hold them to collect contractual cash flows to maturity.
As a result, Entity J classifies its U.S. Treasury
securities as held to maturity and measures the
securities on an amortized cost basis.
55-50
Although U.S. Treasury securities often receive the
highest credit rating by rating agencies at the end of
the reporting period, Entity J’s management still
believes that there is a possibility of default, even if
that risk is remote. However, Entity J considers the
guidance in paragraph 326-20-30-10 and concludes that
the long history with no credit losses for U.S. Treasury
securities (adjusted for current conditions and
reasonable and supportable forecasts) indicates an
expectation that nonpayment of the amortized cost basis
is zero, even if the U.S. government were to technically
default. Judgment is required to determine the nature,
depth, and extent of the analysis required to evaluate
the effect of current conditions and reasonable and
supportable forecasts on the historical credit loss
information, including qualitative factors. In this
circumstance, Entity J notes that U.S. Treasury
securities are explicitly fully guaranteed by a
sovereign entity that can print its own currency and
that the sovereign entity’s currency is routinely held
by central banks and other major financial institutions,
is used in international commerce, and commonly is
viewed as a reserve currency, all of which qualitatively
indicate that historical credit loss information should
be minimally affected by current conditions and
reasonable and supportable forecasts. Therefore, Entity
J does not record expected credit losses for its U.S.
Treasury securities at the end of the reporting period.
The qualitative factors considered by Entity J in this
Example are not an all-inclusive list of conditions that
must be met in order to apply the guidance in paragraph
326-20-30-10.
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.” On the basis of
Example 8 in ASC 326-20-55-48 through 55-50, we believe that the FASB may have
contemplated U.S. Treasury securities and other similar financial assets when it
decided to allow an entity to recognize zero credit losses on an asset.
Keep in mind, however, that the FASB did not specifically exclude certain
financial assets from the scope of the CECL model on the basis of the level of
an asset’s credit risk. Rather, Example 8 illustrates that although it may be
easy to conclude that the risk of nonpayment is zero on a U.S. Treasury
security, the entity should still apply the CECL model to financial assets, even
if the risk of loss associated with those assets is low. Consequently, the
entity should apply the CECL model consistently to all of its financial assets
regardless of the credit risk associated with each asset. That is, the entity
should measure expected credit losses by considering all available relevant
information, including details about past events, current conditions, and
reasonable and supportable forecasts and their implications related to such
losses.
Connecting the Dots
Zero Expected Losses
While the FASB did not explicitly exclude specific assets from the CECL
model (other than by illustrating that an entity may conclude that the
allowance on a U.S. Treasury security could be zero), the AICPA has
published guidance indicating that an entity can expect zero
losses on U.S. Treasury securities, Government National Mortgage
Association (Ginnie Mae) mortgage-backed securities, and agency
mortgage-backed securities (Fannie Mae and Freddie Mac). In reaching its
conclusion, the AICPA compared indicators that would cause the entity to
incur zero losses with indicators that would cause the entity to incur
losses greater than zero. While none of the indicators are individually
determinative, the comparison illustrated that, in the current economic
environment, there was sufficient evidence that the entity could expect
zero losses on the financial assets considered.
Footnotes
3
ASC 250-10-20 defines a change in accounting principle as
follows:
A change from one generally accepted accounting
principle to another generally accepted accounting principle when there are
two or more generally accepted accounting principles that apply or when the
accounting principle formerly used is no longer generally accepted. A change
in the method of applying an accounting principle also is considered a
change in accounting principle.
4
ASC 250-10-20 defines a change in accounting estimate as
follows:
A change that has the effect of adjusting the
carrying amount of an existing asset or liability or altering the subsequent
accounting for existing or future assets or liabilities. A change in
accounting estimate is a necessary consequence of the assessment, in
conjunction with the periodic presentation of financial statements, of the
present status and expected future benefits and obligations associated with
assets and liabilities. Changes in accounting estimates result from new
information. Examples of items for which estimates are necessary are
uncollectible receivables, inventory obsolescence, service lives and salvage
values of depreciable assets, and warranty obligations.
5
ASC 250-10-20 defines a change in accounting estimate effected
by a change in accounting principle as follows:
A change in
accounting estimate that is inseparable from the effect of a related change
in accounting principle. An example of a change in estimate effected by a
change in principle is a change in the method of depreciation, amortization,
or depletion for long-lived, nonfinancial assets.
ASC 250-10-45-18
highlights that an entity must often use judgment to differentiate between a
change in accounting principle and a change in accounting estimate and discusses
certain changes that reflect a change in accounting estimate effected by a
change in accounting principle.6
The EIR is different for PCD assets. ASC 326 states that
when determining the EIR “[f]or purchased financial assets with credit
deterioration, however, to decouple interest income from credit loss
recognition, the premium or discount at acquisition excludes the
discount embedded in the purchase price that is attributable to the
acquirer’s assessment of credit losses at the date of acquisition.”
7
After adoption of ASU 2022-02, this requirement would no
longer be relevant because the ASU eliminated the concept of a TDR from
a creditor’s accounting.
8
Discussed at the August 29, 2018, FASB
meeting.
9
The Interagency Guidance was jointly issued by the Board
of Governors of the Federal Reserve System, the FDIC, the National
Credit Union Administration, and the OCC.
10
As indicated in the examples in the Interagency
Guidance, an entity must use judgment and consider the specific facts
and circumstances, including the nature and functionality of the
underlying collateral, in determining whether a loan is expected to be
repaid solely through continued operation of the collateral. In OCC
Supervisory Memorandum No. 2009-7, the OCC indicated that “[r]esidential
real estate loan modifications without evidence of a sustained repayment
capacity or cash flows from the borrower rely on the underlying
collateral as the sole source of repayment and, as such, would likely be
deemed collateral-dependent upon modification.”
11
Other factors that can affect an entity’s
estimation of expected credit losses may include estimated
prepayments on the financial asset (or group of financial
assets) and expected repayments that may be received from
sources other than the collateral (e.g., general recourse to the
borrower or an embedded credit enhancement provided by a
third-party guarantor).
4.5 Write-Offs and Recoveries
ASC 326-20
35-8 Writeoffs of
financial assets, which may be full or partial writeoffs, shall
be deducted from the allowance. The writeoffs shall be recorded
in the period in which the financial asset(s) are deemed
uncollectible.
35-8A An entity may
make an accounting policy election, at the class of financing
receivable or the major security-type level, to write off
accrued interest receivables by reversing interest income or
recognizing credit loss expense or a combination of both. This
accounting policy election should be considered separately from
the accounting policy election in paragraph 326-20-30-5A. An
entity may not analogize this guidance to components of
amortized cost basis other than accrued interest.
4.5.1 Write-Offs
The write-off guidance in ASC 326-20-35-8 and 35-8A stipulates that
an entity is required to write off a financial asset when it is “deemed
uncollectible.” That requirement is not limited to loan and other receivables and
applies to HTM and AFS debt securities (see Section 7.2.4 for a discussion specific to AFS
debt securities). An entity’s process for determining that a financial asset is
uncollectible should be similar from one asset type to the next (e.g., loan
receivables and HTM securities).
4.5.2 Recoveries
An entity should consider recoveries in its allowance for expected
credit losses. Specifically, ASC 326-20-30-1, notes that “[e]xpected 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.” As a result:
- Entities should include expected recoveries within the allowance for expected credit losses and should not directly write up the related assets.
- Because an entity recognizes expected recoveries as an adjustment to the allowance for expected credit losses, the allowance may have a negative balance in situations in which a full or partial write-off has occurred.
- Expected recoveries should not exceed the aggregate of amounts previously written off and amounts that are expected to be written off by the entity.
Example 9 in ASC 326-20 illustrates an entity’s accounting for a recovery of an
amount previously written off.
ASC 326-20
Example 9: Recognizing Writeoffs and
Recoveries
55-51 This
Example illustrates how an entity may implement the guidance
in paragraphs 326-20-35-8 through 35-9 relating to writeoffs
and recoveries of expected credit losses on financial
assets.
55-52 Bank K
currently evaluates its loan to Entity L on an individual
basis because Entity L is 90 days past due on its loan
payments and the loan no longer exhibits similar risk
characteristics with other loans in the portfolio. At the
end of December 31, 20X3, the amortized cost basis for
Entity L’s loan is $500,000 with an allowance for credit
losses of $375,000. During the first quarter of 20X4, Entity
L issues a press release stating that it is filing for
bankruptcy. Bank K determines that the $500,000 loan made to
Entity L is uncollectible. Bank K considers all available
information that is relevant and reasonably available,
without undue cost or effort, and determines that the
information does not support an expectation of a future
recovery in accordance with paragraph 326-20-30-7. Bank K
measures a full credit loss on the loan to Entity L and
writes off its entire loan balance in accordance with
paragraph 326-20-35-8, as follows:
During March 20X6, Bank K receives a partial payment of
$50,000 from Entity L for the loan previously written off.
Upon receipt of the payment, Bank K recognizes the recovery
in accordance with paragraph 326-20-35-8, as follows:
55-53 For its
March 31, 20X6 financial statements, Bank K estimates
expected credit losses on its financial assets and
determines that the current estimate is consistent with the
estimate at the end of the previous reporting period. During
the period, Bank K does not record any change to its
allowance for credit losses account other than the recovery
of the loan to Entity L. To adjust its allowance for credit
losses to reflect the current estimate, Bank K reports the
following on March 31, 20X6:
Alternatively, Bank K could record the recovery of $50,000
directly as a reduction to credit loss expense, rather than
initially recording the cash received against the
allowance.
4.5.2.1 Expected Recoveries and Contractual Interest
When estimating expected credit losses in accordance with
ASC 326-20-30-1 by using a method other than a DCF method, an entity is not
allowed to consider expected recoveries of contractual interest before that
interest has been accrued. Contractual interest that the entity has not
accrued would not meet the condition described in ASC 326-20-30-1, which
indicates that an entity’s estimated recoveries are limited to “amounts
previously written off and expected to be written off.”
4.5.2.2 Considering Recoveries When Foreclosure Is Probable
If foreclosure on a collateral-dependent financial asset is
probable, an entity is not allowed to adjust its estimate of expected credit
losses (determined on the basis of the fair value of the collateral) for any
expected recoveries if the entity has a history of collecting payment after
foreclosure or repossession. ASC 326-20-35-4 indicates that when foreclosure
on a collateral-dependent financial asset is probable, an entity measures
the estimate of expected credit losses as the difference between the
financial asset’s amortized cost and the collateral’s fair value (adjusted
for selling costs, when applicable). Once the entity is using fair value to
measure the estimate of expected credit losses in accordance with ASC
326-20-35-4, it must not adjust the fair value by any amounts (other than
selling costs), including expected recoveries.
4.6 Credit Enhancements
ASC 326-20
30-12 The estimate
of expected credit losses shall reflect how credit enhancements
(other than those that are freestanding contracts) mitigate
expected credit losses on financial assets, including
consideration of the financial condition of the guarantor, the
willingness of the guarantor to pay, and/or whether any
subordinated interests are expected to be capable of absorbing
credit losses on any underlying financial assets. However, when
estimating expected credit losses, an entity shall not combine a
financial asset with a separate freestanding contract that
serves to mitigate credit loss. As a result, the estimate of
expected credit losses on a financial asset (or group of
financial assets) shall not be offset by a freestanding contract
(for example, a purchased credit-default swap) that may mitigate
expected credit losses on the financial asset (or group of
financial assets).
Among other factors that may affect expected credit losses on a financial asset (or group
of similar financial assets), an entity should consider whether the asset includes an
embedded credit enhancement provided by a third-party guarantor (e.g., private mortgage
insurance). In determining whether an enhancement feature is embedded or freestanding,
an entity must consider the following definition of a freestanding contract in the ASC
master glossary:
A freestanding contract is entered into either:
- Separate and apart from any of the entity’s other financial instruments or equity transactions
- In conjunction with some other transaction and is legally detachable and separately exercisable.
If the financial asset includes an embedded credit enhancement feature,
the entity should consider how the cash flows associated with such a feature should be
incorporated into the expectation of cash flows that are recoverable on the financial
asset. By contrast, the entity must not consider cash flows associated with a
freestanding credit enhancement contract (e.g., credit insurance purchased by the
entity, including credit default swaps) even though the objective of obtaining such a
contract is the same as if it were embedded in the financial asset (i.e., to mitigate
credit exposure). To avoid double counting, an entity is prohibited from considering the
effects of a freestanding credit enhancement feature when estimating expected credit
losses. For example, the cash flows from a credit default swap that is a credit
enhancement of a loan asset should not be included in the measurement of expected credit
losses because such a swap would be recognized separately (e.g., as a derivative
financial instrument if it is within the scope of ASC 815). Even if the freestanding
credit insurance is not accounted for as a derivative, cash flows from freestanding
credit insurance should not be considered in the estimation of expected losses on the
related “covered” assets.
4.6.1 Freestanding Credit Insurance and Other Credit Risk Mitigation Contracts
Although ASC 326-20 is clear that an entity must not consider cash flows
associated with a freestanding credit enhancement contract when estimating its
expected credit losses, questions have arisen regarding how an entity must
account for these freestanding contracts. ASC 326-20 does not address
freestanding contracts that mitigate credit risk on financial assets.
To address these questions, the FASB staff stated, in response
to a technical inquiry, that it would be appropriate for an entity that is
applying ASC 326 to recognize an insurance recovery asset on a freestanding
credit insurance contract at the time expected credit losses are recorded. The
staff also noted that there may be other acceptable approaches to recognizing
freestanding contracts, including recognition of the insurance recovery asset on
an incurred basis. However, the staff clarified that its views on freestanding
contracts pertain only to contracts that (1) qualify for the scope exception in
ASC 815-10-15-13(c) or (d) related to applying derivative accounting and (2)
pass the risk transfer test in ASC 340-30 and ASC 944-20.
Connecting the Dots
Recording the Recovery
Asset
We believe that, in accounting for recoveries from freestanding insurance
contracts, it is appropriate for entities to analogize to the guidance
on indemnification assets in ASC 805. That guidance requires entities to
measure an indemnification asset on the same basis as the indemnified
item.
An approach in which a recovery asset is recorded at the same time an
expected credit loss is recorded in earnings under ASC 326 is generally
referred to as the “mirror image approach.” Under the mirror image
approach, the expected recovery asset would be measured in a manner
consistent with the expected credit loss; accordingly, the accounting
for the insured instruments would be “matched” and the economics of the
arrangement would be reflected. Further, the credit insurance recovery
asset would be estimated by using the same assumptions as the loss
estimate on the underlying assets and would result in the recording of
equal amounts for the allowance for loan losses and the credit insurance
recovery asset (provided that the insurance covered the full amount of
the expected credit loss). Therefore, an entity would most likely
recognize in earnings a “day one recovery of expected credit losses” on
purchased credit insurance.
Keep in mind, however, that ASC 326-20 applies to the insurance recovery
asset recognized on a freestanding insurance contract. That is, just as
expected credit losses must be measured on a reinsurance receivable, an
entity must measure expected credit losses on an insurance recovery
asset.
Although the credit insurance recovery asset is measured by using assumptions
that are consistent with those used to estimate expected credit losses, the
credit insurance recovery asset should not be presented net or offset against
the allowance for credit losses related to the insured instruments. Moreover,
the amounts recorded in the income statement in connection with the credit
insurance recovery asset should not be presented net against the related credit
loss expense.
4.7 Considerations Related to Postacquisition Accounting for Acquired Loans
An entity may acquire loans in a business combination or in an asset
acquisition. Loans acquired in a business combination are initially recognized at
fair value in accordance with ASC 805-20-25-1. Loans acquired in an asset
acquisition are initially recognized at the amount paid to the seller plus any fees
paid or less any fees received in accordance with ASC 310-20-30-5. Alternatively, an
entity may acquire loans when it becomes the primary beneficiary of a VIE that does
not meet the definition of a business. In such instances, there is a scope exception
to the initial recognition guidance for asset acquisitions under ASC 805-50-25-4,
which states that the primary beneficiary of a VIE that does not meet the definition
of a business should initially recognize the acquired loans at fair value in
accordance with ASC 805-20-25-1. That is, the primary beneficiary of a VIE that does
not meet the definition of a business initially recognizes the acquired loans in the
same way as they would be recognized in a business combination. See Section C.1.2.1 of Deloitte’s Roadmap Business Combinations for more information.
Other sections of the Codification may address the initial recognition of loans
acquired in exchange for noncash consideration or loans acquired in an asset
acquisition that includes other assets acquired or liabilities assumed. ASC 310
requires an investor to initially classify acquired loans as “held for investment”
or “held for sale” unless the loans are accounted for at fair value in accordance
with ASC 825. For more information about the reclassification of the loans, see
Section 4.9.
4.7.1 Postacquisition Accounting for Acquired Loans Receivable Classified as Held for Investment
If the fair value option in ASC 825 is elected as of the
acquisition date, the acquired loans are subsequently measured at fair value
through earnings. Section
12.4.1 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including
the Fair Value Option) addresses the separate
presentation of interest income when the fair value option has been elected.
If the fair value option in ASC 825 is not elected as of the
acquisition date, the investor should recognize the acquired loans at amortized
cost and would need to evaluate whether to apply the PCD model to the acquired
loans. The PCD model applies to acquired financial assets (or acquired groups of
financial assets with similar risk characteristics) that, as of the date of
acquisition, have experienced a more-than-insignificant deterioration in credit
quality since origination. See Chapter 6 for more information about the PCD model, including
guidance on the recognition of income and expected credit losses on PCD assets.
If the investor determines that the PCD model does not apply to the acquired
loans, the investor should subsequently account for them by applying the
following guidance in ASC 310-20 and ASC 326-20 on income recognition and
expected credit losses, respectively:
-
ASC 310-20 addresses specific matters related to the application of the interest method to loans within its scope. Under ASC 310-20, the interest method is used to recognize, as a level-yield adjustment, the difference between the initial recorded investment in the loan and the principal amount of the loan.
-
ASC 326-20 addresses the measurement of expected credit losses for financial assets measured at amortized cost. Upon acquiring the loan(s), the investor would be required to record an allowance for expected credit losses on acquired assets within the scope of ASC 326 (even if the acquired loans were initially recognized at fair value in a business combination or at the amount paid to the seller if acquired in an asset acquisition).
4.7.2 Postacquisition Accounting for Acquired Loans Receivable Classified as Held for Sale
If the fair value option in ASC 825 is elected as of the
acquisition date, the acquired loans are subsequently measured at fair value
through earnings. Section
12.4.1 of Deloitte’s Roadmap Fair Value Measurements and Disclosures
(Including the Fair Value Option) addresses the separate
presentation of interest income when the fair value option has been elected.
If the fair value option in ASC 825 is not elected as of the
acquisition date, the investor should subsequently measure loans classified as
held for sale at the lower of cost or fair value, as required by ASC
310-10-35-48 for nonmortgage loans held for sale and ASC 948-310-35-1 for
mortgage loans held for sale. Purchase discounts or premiums on nonmortgage and
mortgage loans are not amortized as interest income when the loans are
classified as held for sale. Rather, recognition of interest income on HFS loans
is generally based on the stated coupon rate on the loan receivable.
4.8 Subsequent Events
ASC 855-10
55-1 The following are examples of
recognized subsequent events addressed in paragraph
855-10-25-1:
- If the events that gave rise to litigation had taken place before the balance sheet date and that litigation is settled after the balance sheet date but before the financial statements are issued or are available to be issued, for an amount different from the liability recorded in the accounts, then the settlement amount should be considered in estimating the amount of liability recognized in the financial statements at the balance sheet date.
- Subsequent events affecting the realization of assets, such as inventories, or the settlement of estimated liabilities, should be recognized in the financial statements when those events represent the culmination of conditions that existed over a relatively long period of time.
55-2 The following are examples of
nonrecognized subsequent events addressed in paragraph
855-10-25-3:
- Sale of a bond or capital stock issued after the balance sheet date but before financial statements are issued or are available to be issued
- A business combination that occurs after the balance sheet date but before financial statements are issued or are available to be issued (Topic 805 requires specific disclosures in such cases.)
- Settlement of litigation when the event giving rise to the claim took place after the balance sheet date but before financial statements are issued or are available to be issued
- Loss of plant or inventories as a result of fire or natural disaster that occurred after the balance sheet date but before financial statements are issued or are available to be issued
- Changes in estimated credit losses on receivables arising after the balance sheet date but before financial statements are issued or are available to be issued
- Changes in the fair value of assets or liabilities (financial or nonfinancial) or foreign exchange rates after the balance sheet date but before financial statements are issued or are available to be issued
- Entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees after the balance sheet date but before financial statements are issued or are available to be issued.
ASC 326’s expected loss model incorporates forward-looking information.
As a result, questions have arisen about whether an entity is required to consider
certain events that occur or information that arises after the reporting date when
estimating its expected credit losses as of the reporting date. While we believe that an
entity must exercise significant judgment when evaluating whether information that
arises after the balance sheet date should be included in the entity’s estimate of
expected credit losses, a speech by the SEC staff is informative in this regard and
provides a framework for an entity’s evaluation of subsequent events.
Specifically, at the 2018 AICPA Conference on Current SEC and PCAOB
Developments, Kevin Vaughn, senior associate chief accountant in the SEC's OCA,
addressed the SEC staff’s observations about a
recent consultation related to a registrant’s evaluation of subsequent events under ASC
326. The consultation addressed the following three scenarios in which information (1)
is received after the balance sheet date but before the financial statements are issued
or available to be issued and (2) significantly differs from that expected by
management:
- Scenario 1 — An entity receives a loan servicer report that includes loan activity (e.g., delinquencies and prepayments) that occurred on or before the balance sheet date.
- Scenario 2 — An entity receives an appraisal report detailing the fair value of loan collateral as of the balance sheet date.
- Scenario 3 — The government announces unemployment rates for a period that includes the balance sheet date.
The SEC staff indicated that in the first two scenarios, it would object to the
registrant’s exclusion of the information from its process for estimating expected
credit losses. The staff noted that in both scenarios, an important consideration “was
that this information was loan-specific information about factual conditions that
existed at the balance sheet date.” By contrast, because the information in Scenario 3
is used to make projections for periods that extend beyond the balance sheet date and is
not loan-specific, the SEC staff would not object if such information is included in, or
omitted from, the registrant’s estimation process.
In addition, Mr. Vaughn acknowledged that if other facts and circumstances become known
after the balance sheet date, a registrant will need to evaluate whether such
information should be incorporated into the estimate of expected credit losses. He
shared the following views on how an entity should perform subsequent-event evaluations
in estimating expected credit losses:
- Category 1 — A registrant receives loan-specific information related to facts that exist on the balance sheet date. The registrant should include such information in its estimation process.
- Category 2 — A registrant receives information related to forecasting before it completes its estimation process. The registrant is permitted but not required to include such information in its estimation process (unless the information indicates a material weakness or a deficiency in the registrant’s CECL process, in which case the registrant must include such information).
- Category 3 — A registrant receives information related to forecasting after it completes its estimation process. The registrant would not include such information in its process (unless the information indicates a material weakness or a deficiency in the registrant’s CECL process, in which case the registrant must include such information).
4.9 Transfers Between Classification Categories
Financial assets reported at amortized cost are within the scope of ASC 326-20. By
contrast, HFS loans and AFS debt securities are not within the scope of the guidance on
expected credit losses in ASC 326-20 since (1) HFS loans are reported at the lower of
amortized cost basis or fair value as of the balance sheet date and (2) AFS debt
securities are reported at fair value as of the balance sheet date. However, upon either
(1) the transfer of an HFS loan to an HFI loan or (2) the transfer of an AFS debt
security to an HTM debt security, the transferred loan (i.e., HFI loan or HTM debt
security) then becomes subject to ASC 326-20.
The table below summarizes the guidance that applies when an HFS loan is
transferred into an HFI classification (or vice versa) or when a debt security is
transferred from AFS to HTM (or vice versa).
HFS Loan to HFI Loan
|
HFI Loan to HFS Loan
|
---|---|
|
|
HTM Debt Security to AFS Debt Security
|
AFS Debt Security to HTM Debt Security
|
---|---|
|
|
ASC 320-10-35-10 through 35-16 provide guidance on transfers between the
classifications of investments in debt and equity securities (i.e., trading, AFS, and
HTM). Transfers involving the trading classification are expected to be rare. Transfers
out of the HTM classification may call into question the entity’s ability to use that
classification for a period of time. Transfers from AFS to HTM are not restricted,
provided that the entity has the positive intent and ability to hold the transferred
security to its maturity.
Example 4-2
Transfer From HTM to
AFS
Company X has an investment in a bond that is
classified as HTM. The bond was acquired for $1,000 with a par
value of $1,000. Upon initial recognition of the bond, X
recognized an allowance of $70 for credit losses. During the
following year, X transfers the bond from HTM to AFS. As of the
transfer date, the bond’s amortized cost and fair value are
$1,000 and $900, respectively. In addition, as of the transfer
date, because the bond is now classified as AFS, X determines,
in accordance with ASC 326-30, that $90 of the unrealized loss
is related to credit and $10 is related to interest rate
changes.
As of the transfer date, X would record the following journal
entries:
Example 4-3
Transfer From AFS to
HTM
Company Z purchases a security and classifies it
as AFS. The security is acquired at its par value of $4,000.
Immediately before the transfer date, the security’s fair value
is $3,500 and its allowance for credit losses is $300
(accordingly, Z recognizes in OCI an unrealized loss of $200
that is due to non-credit-related factors). Once Z transfers the
security from AFS to HTM, it estimates the allowance for credit
losses on the security to be $350 in accordance with ASC 326-20.
As of the transfer date, Z would record the
following journal entries:
Keep in mind that the unrealized loss of $200 as of the transfer
date will continue to be recorded in AOCI; however, it should be
amortized prospectively over the remaining life of the security
from AOCI. The amortization should be performed in a manner
consistent with the recognition of a premium or discount (e.g.,
the effective interest method). In addition, the transfer will
create a discount of $200 on the carrying amount of the security
that should be amortized prospectively over the remaining life
of the security. Typically, this amortization will have no net
impact on the reported yield of the security because the
amortization of the amount in AOCI and the amortization of the
discount will offset each other. Effectively, the amortization
of the unrealized loss in AOCI will reduce the debt discount,
thereby increasing the carrying amount of the investment.