5.1 Off-Balance-Sheet Arrangements
ASC 326-20
30-11 In estimating expected credit
losses for off-balance-sheet credit exposures, an entity shall
estimate expected credit losses on the basis of the guidance in
this Subtopic over the contractual period in which the entity is
exposed to credit risk via a present contractual obligation to
extend credit, unless that obligation is unconditionally
cancellable by the issuer. At the reporting date, an entity
shall record a liability for credit losses on off-balance-sheet
credit exposures within the scope of this Subtopic. An entity
shall report in net income (as a credit loss expense) the amount
necessary to adjust the liability for credit losses for
management’s current estimate of expected credit losses on
off-balance-sheet credit exposures. For that period of exposure,
the estimate of expected credit losses should consider both the
likelihood that funding will occur (which may be affected by,
for example, a material adverse change clause) and an estimate
of expected credit losses on commitments expected to be funded
over its estimated life. If an entity uses a discounted cash
flow method to estimate expected credit losses on
off-balance-sheet credit exposures, the discount rate used
should be consistent with the guidance in Section 310-20-35.
Off-balance-sheet arrangements, such as commitments to extend credit, guarantees, and
standby letters of credit, are subject to credit risk; therefore, arrangements that are
not considered derivatives under ASC 815 are within the scope of the CECL model.
Accordingly, under ASC 326, an entity’s method for determining the estimate of expected
credit losses on the funded portion of a loan commitment must be similar to its method
for determining the estimate for other loans. For an unfunded portion of a loan
commitment, an entity must estimate expected credit losses over the full contractual
period over which it is exposed to credit risk under an unconditional present legal
obligation to extend credit. Such an estimate takes into account both the likelihood
that funding will occur and the expected credit losses on commitments to be funded.
5.1.1 Allowances for Credit Card Loans
An allowance for expected credit losses on credit card loans
would only be required for the funded portion, not for the unfunded portion for
which the issuer has an unconditional right to cancel the commitment.
ASC 326-20-30-11 states that an entity must “estimate expected
credit losses . . . over the contractual period in which the entity is exposed
to credit risk via a present contractual obligation to extend credit, unless
that obligation is unconditionally cancellable by the issuer.” Therefore, if an
entity has the unconditional ability to cancel the unfunded portion of a loan
commitment, it would not be required to estimate expected credit losses on that
portion, even if it historically has never exercised its cancellation right. In
other words, if the issuer has the unconditional right to cancel the commitment
at any time, it should not record an allowance for unfunded commitments
because it does not have a present contractual obligation to extend credit on
the unfunded commitments.
The example in ASC 326-20-55-55 and 55-56 illustrates
application of this guidance:
55-55 Bank M has a significant credit card
portfolio, including funded balances on existing cards and unfunded
commitments (available credit) on credit cards. Bank M’s card holder
agreements stipulate that the available credit may be unconditionally
cancelled at any time.
55-56 When determining the allowance for credit
losses, Bank M estimates the expected credit losses over the remaining
lives of the funded credit card loans. Bank M does not record an
allowance for unfunded commitments on the unfunded credit cards because
it has the ability to unconditionally cancel the available lines of
credit. Even though Bank M has had a past practice of extending credit
on credit cards before it has detected a borrower’s default event, it does not have a present contractual obligation to
extend credit. Therefore, an allowance for unfunded commitments
should not be established because credit risk on commitments that
are unconditionally cancellable by the issuer are not considered to
be a liability. [Emphasis added]
In addition, an entity should not recognize a contingent
liability under ASC 450 for the operational risk associated with extending loans
in the future under unconditionally cancelable credit commitments related to
accounts that are performing or are in default.
5.1.2 Effect of a Required Cancellation Notice Period on a Commitment to Extend Credit
When the issuer has the unconditional right to cancel a
commitment but only after a specific notice period is given, allowances for
credit losses should be provided on the unfunded portion of lines of credit or
expected losses related to estimated fundings during the notice period. In
estimating expected credit losses, an entity should report its credit loss
exposure for the period of exposure, which would include a specific notice
period if applicable. ASC 326-20-30-11 states, in part:
[A]n
entity shall estimate expected credit losses . . . over the contractual
period in which the entity is exposed to credit risk via a present
contractual obligation to extend credit, unless that obligation is
unconditionally cancellable by the issuer. . . . For that period of
exposure, the estimate of expected credit losses should consider both the
likelihood that funding will occur . . . and an estimate of expected credit
losses on commitments expected to be funded over its estimated
life.
Since a contractual period of exposure includes the notice
period, the estimate of expected credit losses should include expected credit
losses related to expected future borrowings during the notice period. The
entity is not required to estimate losses for any expected borrowings that would
occur beyond the period when the issuer has an unconditional right to cancel the
commitment (i.e., after the notice period).
5.1.3 Recognition of the Allowance for Credit Losses Related to Unfunded Loan Commitments Assumed in a Business Combination
Unfunded loan commitments assumed by an acquirer in a business
combination must be measured and recognized at fair value as of the acquisition
date in accordance with ASC 805.
We believe that an acquirer should recognize
a separate liability under ASC 326-20 for expected credit losses related
to an unfunded portion of a loan commitment acquired if that commitment is
noncancelable by the acquirer. In a manner consistent with how other unfunded
loan commitments are accounted for under ASC 326-20, the acquirer must estimate
expected credit losses over the full contractual period in which it is exposed
to credit risk under an unconditional present legal obligation to extend the
credit. Such an estimate takes into account both the likelihood that funding
will occur and the expected credit losses on commitments to be funded.
5.1.4 Accounting for the Off-Balance-Sheet Credit Exposure Related to a Forward Commitment to Purchase Loans
As stated in Section
2.1.2, a forward commitment to purchase loans from a third party is
within the scope of ASC 326-20 because it exposes the purchaser to the credit
risk associated with the underlying loans to be purchased if it is neither (1)
unconditionally cancelable by the issuer nor (2) accounted for as a derivative
under ASC 815.
The accounting for off-balance-sheet credit exposure related to
a forward commitment to purchase loans depends on whether the loans are
determined to be PCD as of the date on which the forward commitment is entered
into. If the loans are not determined to be PCD, the entity would recognize a
liability at inception of the commitment and would reflect the credit losses
expected over the loans’ contractual term.
If the loans are determined to be PCD as of the date on which
the forward commitment is entered into, the entity would not recognize a
liability for the credit exposure related to a forward commitment to purchase
the loans. Instead, it would recognize an allowance for expected credit losses
by applying the gross-up approach upon acquiring the assets, as discussed in
Chapter 6. That
is, when the entity acquires the PCD assets, it would recognize the allowance
for expected credit losses as an adjustment that increases the assets’ cost
bases. If the entity applies the gross-up approach when the loans are acquired
(and does not recognize a liability at inception of the commitment), the entity
would recognize credit exposure on PCD loans and credit exposure on forward
commitments to acquired PCD loans in a similar manner.
We generally believe that an entity should measure and recognize
a liability for off-balance-sheet credit exposure related to a forward
commitment to purchase loans from a third party as of the commitment inception
date even if the specific loans to be purchased are not specifically identified.
In such an arrangement, the entity has entered into a noncancelable commitment
to purchase loans for which it is exposed to credit losses and therefore should
recognize a liability for expected credit losses upon inception of the
commitment. We believe that the entity should analyze all facts and
circumstances related to the forward commitment to assess the type and quality
of loans expected to be purchased. In addition, the entity should use judgment
to (1) identify those loans that are expected to be accounted for as PCD and (2)
measure and recognize the liability for expected credit losses.
5.1.5 Guarantees
5.1.5.1 Overview
ASC 460-10
15-4 Except as provided in
paragraph 460-10-15-7, the provisions of this Topic
apply to the following types of guarantee
contracts:
-
Contracts that contingently require a guarantor to make payments (as described in the following paragraph) to a guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party. For related implementation guidance, see paragraph 460-10-55-2.
-
Contracts that contingently require a guarantor to make payments (as described in the following paragraph) to a guaranteed party based on another entity’s failure to perform under an obligating agreement (performance guarantees). For related implementation guidance, see paragraph 460-10-55-12.
-
Indemnification agreements (contracts) that contingently require an indemnifying party (guarantor) to make payments to an indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party.
-
Indirect guarantees of the indebtedness of others, even though the payment to the guaranteed party may not be based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party.
Guarantee arrangements can take various forms and expose guarantors to
varying levels of obligations and risks. ASC 326-20 applies to certain
financial guarantee arrangements within the scope of ASC 460 that create
off-balance-sheet credit exposure for the guarantor. Examples of financial
guarantees that create off-balance-sheet credit exposure include financial
standby letters of credit and other types of guarantees related to the
nonpayment of a financial obligation. ASC 326-20 does not apply to financial
guarantees that create off-balance-sheet exposure and that are (1) accounted
for as insurance or (2) within the scope of ASC 815-15. See Chapter 2 for more information about the
scope of ASC 326-20.
5.1.5.2 Initial Recognition and Measurement
ASC 460-10
25-2 The issuance of a
guarantee obligates the guarantor (the issuer) in
two respects:
-
The guarantor undertakes an obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur (the noncontingent aspect).
-
The guarantor undertakes a contingent obligation to make future payments if those triggering events or conditions occur (the contingent aspect).
For guarantees that are not within
the scope of Subtopic 326-20 on financial
instruments measured at amortized cost, no
bifurcation and no separate accounting for the
contingent and noncontingent aspects of the
guarantee are required by this Topic. For guarantees
that are within the scope of Subtopic 326-20, the
expected credit losses (the contingent aspect) shall
be measured and accounted for in addition to and
separately from the fair value of the guarantee (the
noncontingent aspect) in accordance with paragraph
460-10-30-5.
25-3 Because the
issuance of a guarantee imposes a noncontingent
obligation to stand ready to perform in the event
that the specified triggering events or conditions
occur, the provisions of Section 450-20-25 regarding
a guarantor’s contingent obligation under a
guarantee should not be interpreted as prohibiting a
guarantor from initially recognizing a liability for
a guarantee even though it is not probable that
payments will be required under that guarantee.
Similarly, for guarantees within the scope of
Subtopic 326-20, the requirement to measure a
guarantor’s expected credit loss on the guarantee
should not be interpreted as prohibiting a guarantor
from initially recognizing a liability for the
noncontingent aspect of a guarantee.
25-4 At the inception of a
guarantee, a guarantor shall recognize in its
statement of financial position a liability for that
guarantee. This Subsection does not prescribe a
specific account for the guarantor’s offsetting
entry when it recognizes a liability at the
inception of a guarantee. That offsetting entry
depends on the circumstances in which the guarantee
was issued. See paragraph 460-10-55-23 for
implementation guidance.
30-2 Except as indicated
in paragraphs 460-10-30-3 through 30-5, the
objective of the initial measurement of a guarantee
liability is the fair value of the guarantee at its
inception. For example:
-
If a guarantee is issued in a standalone arm’s-length transaction with an unrelated party, the liability recognized at the inception of the guarantee shall be the premium received or receivable by the guarantor as a practical expedient.
-
If a guarantee is issued as part of a transaction with multiple elements with an unrelated party (such as in conjunction with selling an asset), the liability recognized at the inception of the guarantee should be an estimate of the guarantee’s fair value. In that circumstance, a guarantor shall consider what premium would be required by the guarantor to issue the same guarantee in a standalone arm’s-length transaction with an unrelated party as a practical expedient.
-
If a guarantee is issued as a contribution to an unrelated party, the liability recognized at the inception of the guarantee shall be measured at its fair value, consistent with the requirement to measure the contribution made at fair value, as prescribed in Section 720-25-30. For related implementation guidance, see paragraph 460-10-55-14.
30-5 At the inception of a
guarantee within the scope of Subtopic 326-20 on
financial instruments measured at amortized cost,
the guarantor is required to recognize both of the
following as liabilities:
-
The amount that satisfies the fair value objective in accordance with paragraph 460-10-30-2
-
The contingent liability related to the expected credit loss for the guarantee measured under Subtopic 326-20.
ASC 460-10-25-2 states that a guarantee comprises a
noncontingent obligation and a contingent obligation. The noncontingent
obligation is the “obligation to stand ready to perform over the
term of the guarantee” if certain events or conditions occur, while the
contingent obligation is the “obligation to make future payments”
if certain events or conditions occur.
For financial guarantees not within the scope of ASC 326-20,
ASC 460 requires the guarantor to initially recognize at fair value a
guarantee liability comprising both the noncontingent obligation and the
contingent obligation (i.e., the guarantor is not required to separately
recognize at fair value a liability for the noncontingent and contingent
aspects of the guarantee). However, for financial guarantees within the
scope of ASC 326-20, the guarantor must also recognize a liability related
to the expected credit losses on the guarantee, estimated in accordance with
ASC 326-20.
A guarantor’s estimation of expected credit losses related to the contingent
element of the financial guarantee should take into account both (1) the
likelihood that the guarantor will have to fulfill its obligation and (2) an
estimate of expected credit losses related to the guarantee obligation.
Example 5-1
Accounting for a Financial Guarantee Within the
Scope of ASC 326-20
Entity X is a guarantor of debt incurred by Entity Y.
The guarantee arrangement stipulates that X must
guarantee payment of 100 percent of Y’s debt
obligations owed to a third-party debtor for a
specified time frame. Entity X is not an insurance
entity, and the guarantee is not within the scope of
ASC 815.
On July 1, 20X1, Y borrows $5
million from a third-party debtor for which X is
obligated to guarantee repayment under the guarantee
arrangement. Entity X receives an up-front cash
premium payment of $250,000 for the guarantee and
the cash premium is considered to be at arm’s
length. Entity X measures the fair value of its
stand-ready obligation (i.e., the noncontingent
obligation) to guarantee Y’s repayment under the
debt arrangement to be $250,000 on the basis of the
arm’s-length premium it received. Entity X applies
ASC 326-20 and measures its estimate of expected
credit losses related to the guarantee to be
$100,000 (i.e., the contingent obligation). Entity X
would record the following journal entry for the
guarantee arrangement:
Journal
Entry: July 1, 20X1
Connecting the Dots
Changes to Guarantee
Liability Recognition Under the CECL Model
Before the adoption of ASU 2016-13, a guarantor was not required to
bifurcate and separately account for the contingent and
noncontingent aspects of a financial guarantee under ASC 460.
Rather, the guarantor was required to initially recognize the
guarantee liability at the greater of the following:
-
The noncontingent liability stand-ready obligation of the guarantee measured at fair value in accordance with ASC 460-10-30-2.
-
The contingent liability measured in accordance with ASC 450-20-30.
However, ASU 2016-13 amended ASC 460-10-30-5 to
remove the entity’s ability to initially and subsequently recognize
the “greater of” the unamortized noncontingent obligation (ASC 460)
or the contingent obligation (ASC 450) for financial guarantees
within the scope of ASC 326-20. In other words, a guarantor must
measure and recognize a liability for the contingent element of the
guarantee obligation in accordance with ASC 326-20 in addition
to the liability for the noncontingent element under ASC
460. See Chapter
9 for transition guidance related to guarantees
within the scope of ASC 326-20. In certain circumstances,
application of the guidance in ASC 460-10-30-5 may result in a
scenario in which the sum of the noncontingent and contingent
liabilities exceeds the total amount that the guarantor is obligated
to pay. Consider the example below.
Example 5-2
Accounting for a Financial Guarantee Within
the Scope of ASC 326-20
Entity X is a guarantor for debt incurred by
Entity Y. The guarantee arrangement stipulates
that X must guarantee payment of 30 percent of Y’s
debt obligations owed to a third-party debtor for
a specified time frame. The other 70 percent of
Y’s debt obligations is guaranteed by an
independent third-party entity. Entity X is not an
insurance entity and the guarantee is not within
the scope of ASC 815.
On July 1, 20X1, Y borrows $10
million from a third-party debtor with a term of
three years for which X is obligated to guarantee
repayment of $3 million ($10 million multiplied by
X’s 30 percent guarantee obligation). Entity X
receives an up-front cash premium payment of
$300,000 for the guarantee, and the cash premium
is considered to be at arm’s length. Entity X
measures the fair value of its stand-ready
obligation (i.e., the noncontingent obligation) to
guarantee Y’s repayment under the debt arrangement
to be $300,000 on the basis of the arm’s-length
premium it received. At inception, X applies ASC
326-20 and measures its estimate of expected
credit losses related to the guarantee to be
$100,000 (i.e., the contingent element). On July
1, 20X1, X would record the following journal
entry for the guarantee arrangement:
Journal
Entry: July 1, 20X1
In the latter half of 20X1,
there is a significant macroeconomic decline in
key input factors affecting Y’s business that is
expected to persist over the contractual term of
the debt. As a result, Y experiences significant
credit deterioration and there is general concern
that Y will not be able to service the entire debt
obligation. Entity X applies ASC 326-20 and
remeasures its estimate of expected credit losses
related to the guarantee as of December 31, 20X1,
to be $2.8 million. Entity X’s
subsequent-measurement accounting policy for the
noncontingent guarantee liability is to amortize
the obligation on a straight-line basis over the
life of the guarantee, which is equal to the term
of the debt (i.e., three years). As of December
31, 20X1, the unamortized noncontingent guarantee
obligation is $250,000. Entity X would record the
following journal entry on December 31, 20X1, to
reflect the change in the liability for
off-balance-sheet credit losses:
Journal
Entry: December 31, 20X1
In this example, X’s total liability under the
guarantee as of December 31, 20X1, is $3.05
million,1 which exceeds the total amount of debt of $3
million that X is obligated to pay. While this
example is meant to portray extreme facts and
circumstances, it illustrates a potential outcome
of applying the conceptual framework of measuring
and recognizing the noncontingent and contingent
obligations of guarantees within the scope of ASC
326-20.
5.1.5.2.1 Credit Guarantee Between Entities Under Common Control
As discussed in Chapter 2, we generally believe
that guarantee arrangements between common-control entities that are
related to third-party credit exposure are within the scope of ASC
326-20. Consider the example below.
Example 5-3
Entity X and Entity Y are wholly
owned subsidiaries of Parent. As a result, X and Y
are entities under common control. Entity X
originates loans to third-party entities. Entity Y
enters into a credit guarantee with X under which
Y must reimburse X in the event that the
third-party loans were to default. Entity Y cannot
unconditionally cancel the guarantee arrangement,
and the guarantee is not within the scope of ASC
815. Entity Y prepares separate, stand-alone
financial statements.
In its separate, stand-alone
financial statements, Y should separately measure
and recognize the expected credit losses related
to the contingent element of its guarantee
obligation with X. Entity Y is exposed to the
credit risk of the third-party entities through
its guarantee arrangement with X. Therefore, Y
must measure and recognize the contingent element
(i.e., the expected credit losses) separately from
the noncontingent element (i.e., the stand-ready
obligation) of the guarantee.
5.1.5.3 Subsequent Measurement
ASC 460-10
35-1 This Subsection does
not describe in detail how the guarantor’s liability
for its obligations under the guarantee would be
measured after its initial recognition. The
liability that the guarantor initially recognized
under paragraph 460-10-25-4 would typically be
reduced (by a credit to earnings) as the guarantor
is released from risk under the guarantee.
35-2 Depending on the
nature of the guarantee, the guarantor’s release
from risk has typically been recognized over the
term of the guarantee using one of the following
three methods:
-
Only upon either expiration or settlement of the guarantee.
-
By a systematic and rational amortization method.
-
As the fair value of the guarantee changes.
Although those three methods are
currently being used in practice for subsequent
accounting, this Subsection does not provide
comprehensive guidance regarding the circumstances
in which each of those methods would be appropriate.
A guarantor is not free to choose any of the three
methods in deciding how the liability for its
obligations under the guarantee is measured
subsequent to the initial recognition of that
liability. A guarantor shall not use fair value in
subsequently accounting for the liability for its
obligations under a previously issued guarantee
unless the use of that method can be justified under
generally accepted accounting principles (GAAP). For
example, fair value is used to subsequently measure
guarantees accounted for as derivative instruments
under Topic 815.
35-4 The discussion in
paragraph 460-10-35-2 about how a guarantor
typically reduces the liability that it initially
recognized does not encompass the recognition and
subsequent adjustment of the contingent liability
related to the contingent loss for the guarantee.
The contingent aspect of the guarantee shall be
accounted for in accordance with Subtopic 450-20
unless the guarantee is accounted for as a
derivative instrument under Topic 815 or the
guarantee is within the scope of Subtopic 326-20 on
financial instruments measured at amortized cost.
For guarantees within the scope of Subtopic 326-20,
the expected credit losses (the contingent aspect)
of the guarantee shall be accounted for in
accordance with that Subtopic in addition to and
separately from the fair value of the guarantee
liability (the noncontingent aspect) accounted for
in accordance with paragraph 460-10-30-5.
A guarantor subsequently measures the noncontingent and contingent elements
of financial guarantees within the scope of ASC 326-20 differently because
the noncontingent obligation is measured under ASC 460 and the contingent
obligation is measured under ASC 326-20.
The guidance in ASC 460 does not specifically prescribe how a guarantor
subsequently measures the noncontingent element of the guarantee obligation.
Instead, ASC 460 indicates that the liability is typically reduced through
the income statement as the guarantor is released from risk under the
guarantee and cites three methods for making such a reduction:
-
Upon either expiration or settlement of the guarantee.
-
Using a systematic and rational amortization method.
-
Through changes in the fair value of the guarantee liability.
Entities cannot freely choose to elect one of the above subsequent-accounting
alternatives. Often, a systematic and rational amortization method is
appropriate. At the 2003 AICPA Conference on Current SEC Developments, the
SEC staff stated that “[i]t would seem a systematic and rational
amortization method would most likely be the appropriate [subsequent]
accounting” for the obligation to stand ready. For some guarantees, an
entity is required or permitted by U.S. GAAP to use a fair value model for
subsequent measurement as follows:
-
A fair value model is required for a guarantee that meets the definition of a derivative and is within the scope of the derivative accounting guidance in ASC 815-10.
-
For a guarantee that meets the definition of a financial instrument or is otherwise within the scope of the guidance in ASC 825-10 on the fair value option (e.g., a warranty that permits the warrantor to settle by paying a third party to provide goods or services), an entity is permitted to elect a fair value model unless the guarantee is specifically exempted from the scope of that guidance under ASC 825-10-15-5.
A fair value model cannot be justified solely on the basis
of the statement in ASC 460-10-35-2 that for some guarantees, the
guarantor’s release from risk is recognized as the fair value of the
guarantee changes. ASC 460-10-35-2 states, in part, that a “guarantor shall
not use fair value in subsequently accounting for the liability for its
obligations under a previously issued guarantee unless the use of that
method can be justified under generally accepted accounting principles
(GAAP).”
The contingent element (i.e., the expected credit losses) of the guarantee
within the scope of ASC 326-20 is subsequently measured in accordance with
ASC 326-20.
Footnotes
1
The sum of the unamortized noncontingent
guarantee obligation of $250,000 and the liability
for off-balance-sheet credit losses of $2.8
million.