Chapter 6 — Purchased Credit-Deteriorated Assets

6.3 Recognition and Measurement Under the PCD Model

6.3.1 Overview

ASC 326-20

30-13 An entity shall record the allowance for credit losses for purchased financial assets with credit deterioration in accordance with paragraphs 326-20-30-2 through 30-10, 326-20-30-12, and 326-20-30-13A. An entity shall add the allowance for credit losses at the date of acquisition to the purchase price to determine the initial amortized cost basis for purchased financial assets with credit deterioration. Any noncredit discount or premium resulting from acquiring a pool of purchased financial assets with credit deterioration shall be allocated to each individual asset. At the acquisition date, the initial allowance for credit losses determined on a collective basis shall be allocated to individual assets to appropriately allocate any noncredit discount or premium.

30-13A The allowance for credit losses for purchased financial assets with credit deterioration shall include expected recoveries of amounts previously written off and expected to be written off by the entity and shall not exceed the aggregate of amounts previously written off and expected to be written off by the entity.

If the entity estimates expected credit losses using a method other than a discounted cash flow method in accordance with paragraph 326-20-30-4, expected recoveries shall not include any amounts that result in an acceleration of the noncredit discount.
The entity may include increases in expected cash flows after acquisition.

(See Examples 18 and 19 in paragraphs 326-20-55-86 through 55-90.)

30-14 If an entity estimates expected credit losses using a discounted cash flow method, the entity shall discount expected credit losses at the rate that equates the present value of the purchaser’s estimate of the asset’s future cash flows with the purchase price of the asset. If an entity estimates expected credit losses using a method other than a discounted cash flow method, the entity shall estimate expected credit losses on the basis of the unpaid principal balance (face value) of the financial asset(s). See paragraphs 326-20-55-66 through 55-78 for implementation guidance and examples.

30-15 An entity shall account for purchased financial assets that do not have a more-than-insignificant deterioration in credit quality since origination in a manner consistent with originated financial assets in accordance with paragraphs 326-20-30-1 through 30-10 and 326-20-30-12. An entity shall not apply the guidance in paragraphs 326-20-30-13 through 30-14 for purchased financial assets that do not have a more-than-insignificant deterioration in credit quality since origination.

As previously stated, an entity’s initial recognition of expected credit losses for PCD assets differs from that for non-PCD assets. Upon acquiring a PCD asset, the entity would recognize its allowance for expected credit losses as an adjustment that increases the asset’s cost basis (the “gross-up” approach). After initial recognition of the PCD asset and its related allowance, the entity would continue to apply the CECL model to the asset — that is, it would immediately recognize in the income statement any changes in its estimate of the cash flows it expects to collect (favorable or unfavorable). Consequently, any subsequent changes to the entity’s estimate of expected credit losses — whether unfavorable or favorable — would be recorded as credit loss expense (or a reduction of expense) during the period of change. Interest income recognition would be based on the purchase price plus the initial allowance accreting to the contractual cash flows.

Changing Lanes

Eliminating Asymmetrical Accounting From U.S. GAAP

Before adopting ASU 2016-13, an entity that was accounting for PCI assets recognized unfavorable changes in expected cash flows as an immediate credit impairment but treated favorable changes in expected cash flows as prospective yield adjustments. The CECL model’s approach to PCD assets eliminated this asymmetrical treatment of cash flow changes by requiring an entity to record all subsequent changes to its estimate of expected credit losses — whether unfavorable or favorable — as impairment expense (or a reduction of expense) during the period of change. However, in a manner consistent with prior practice, the model precludes an entity from recognizing as interest income the discount embedded in the purchase price that is attributable to the expected credit losses as of the acquisition date.

6.3.2 Initial Recognition

A key difference between the PCD model and the credit losses model lies in how an entity recognizes expected credit losses on a PCD asset when it is acquired. As described in ASC 326-20-30-1, for financial assets not considered to be PCD, “[a]n entity shall report in net income (as a credit loss expense) the amount necessary to adjust the allowance for credit losses for management’s current estimate of expected credit losses on financial asset(s)” (emphasis added). However, as previously stated, the FASB believes that there is a certain subset of assets for which the entity should not apply the guidance in ASC 326-20-30-1, specifically the requirement to recognize in net income the credit losses the entity expects upon acquisition.

As a result, for an asset that meets the definition of a PCD asset, the FASB believes that an entity should apply the gross-up approach when initially recognizing expected credit losses upon acquisition. That is, upon acquiring the PCD asset, the entity would recognize such losses as an adjustment to the asset’s cost basis. Because the entity applies the gross-up approach to recognize expected credit losses on PCD assets, it does not recognize in net income the initial expected credit losses on those assets.

Example 12 in ASC 326-20 illustrates how an entity would apply the PCD model, specifically the gross-up approach to recognizing expected credit losses as an adjustment to the amortized cost basis of the acquired assets.

ASC 326-20

Example 12: Recognizing Purchased Financial Assets With Credit Deterioration

55-61 This Example illustrates application of the guidance to an individual purchased financial asset with credit deterioration.

55-62 Under paragraphs 326-20-30-13 and 310-10-35-53B, for purchased financial assets with credit deterioration, the discount embedded in the purchase price that is attributable to expected credit losses should not be recognized as interest income and also should not be reported as a credit loss expense upon acquisition.

55-63 Bank O records purchased financial assets with credit deterioration in its existing systems by recognizing the amortized cost basis of the asset, at acquisition, as equal to the sum of the purchase price and the associated allowance for credit loss at the date of acquisition. The difference between amortized cost basis and the par amount of the debt is recognized as a noncredit discount or premium. By doing so, the credit-related discount is not accreted to interest income after the acquisition date.

55-64 Assume that Bank O pays $750,000 for a financial asset with a par amount of $1 million. The instrument is measured at amortized cost basis. At the time of purchase, the allowance for credit losses on the unpaid principal balance is estimated to be $175,000. At the purchase date, the statement of financial position would reflect an amortized cost basis for the financial asset of $925,000 (that is, the amount paid plus the allowance for credit loss) and an associated allowance for credit losses of $175,000. The difference between par of $1 million and the amortized cost of $925,000 is a non-credit-related discount. The acquisition-date journal entry is as follows:

55-65 Subsequently, the $75,000 noncredit discount would be accreted into interest income over the life of the financial asset consistent with other Topics. The $175,000 allowance for credit losses should be updated in subsequent periods consistent with the guidance in Section 326-20-35, with changes in the allowance for credit losses on the unpaid principal balance reported immediately in the statement of financial performance as a credit loss expense.

6.3.3 Initial and Subsequent Measurement

ASC 326-20-30-14 permits an entity to use various methods to estimate expected credit losses for PCD assets. This guidance is similar to that for non-PCD assets in ASC 326-20-30-3 (see Section 4.4 for more information). ASC 326-20-30-14 states, in part:

If an entity estimates expected credit losses using a discounted cash flow method, the entity shall discount expected credit losses at the rate that equates the present value of the purchaser’s estimate of the asset’s future cash flows with the purchase price of the asset. If an entity estimates expected credit losses using a method other than a discounted cash flow method, the entity shall estimate expected credit losses on the basis of the unpaid principal balance (face value) of the financial asset(s).

Although there are similarities between the methods an entity uses to estimate expected credit losses for PCD assets and those for non-PCD assets, there are also two distinct differences:

Application of the DCF method:
- Non-PCD assets — ASC 326-20-30-4 requires an entity to discount expected credit losses by using the asset’s EIR (i.e., the rate of return implicit in the financial asset).
- PCD assets — ASC 326-20-30-14 requires an entity to discount expected credit losses by using a “rate that equates the present value of the purchaser’s estimate of the asset’s future cash flows with the purchase price of the asset.” For an illustration of how an entity would apply the DCF method to estimate expected credit losses on PCD assets, see Example 14 in ASC 326-20-55-72 through 55-78.
Application of a method other than the DCF method (e.g., a loss-rate method):
- Non-PCD assets — ASC 326-20-30-5 requires an entity to estimate expected credit losses on the basis of an asset’s amortized cost.
- PCD assets — ASC 326-20-30-14 requires an entity to estimate expected credit losses “on the basis of [the asset’s] unpaid principal balance.” For an illustration of how an entity would apply a loss-rate method to estimate expected credit losses on PCD assets, see Example 13 in ASC 326-20-55-66 through 55-71.

Paragraphs BC92 and BC93 of ASU 2016-13 provide the FASB’s rationale for the differences between the measurement guidance for PCD assets and that for non-PCD assets:

BC92. For purchased financial assets with credit deterioration, the Board decided to include additional guidance on how to determine the amortized cost basis and effective interest rate due to circularity concerns. Stakeholders noted that there could be a circularity issue because the amortized cost basis of the purchased asset with credit deterioration should include the allowance for credit losses, which may not be measured until one knows the amortized cost basis. Similarity, a circularity concern was expressed on determining the effective interest rate when measuring expected credit losses using a discounted cash flow approach. Again, the effective interest rate could not be determined for the amortized cost basis of the asset if one did not know the effective interest rate to discount the expected credit loss.

BC93. After receiving feedback from stakeholders on how best to operationalize the accounting for purchased financial assets with credit deterioration, the Board decided that when using a method to estimate expected credit losses that does not project future interest and principal cash flows (for example, a loss rate approach), the allowance for credit losses should be based on the unpaid principal balance (or par) amount of the asset. When using a discounted cash flow approach to estimate expected credit losses, the expected credit losses should be discounted at the rate that equates the present value of estimated future cash flows with the purchase price of the financial asset. The Board concluded that this guidance, which stakeholders did not object to, eliminates circularity concerns and maintains the flexibility to use various approaches to measure credit risk.

After initial recognition of the PCD asset and its related allowance, an entity would continue to apply the CECL model to the asset — that is, any changes to the estimate of cash flows that the entity expects to collect (favorable or unfavorable) would be recognized immediately in the income statement (such recognition differs from how the original estimate of expected credit losses was recognized under the gross-up approach).

6.3.3.1 Modification of a PCD Asset

Before the adoption of ASU 2022-02, an entity should evaluate whether a modification of a PCD asset meets the definition of a TDR. ASU 2016-13 deleted the guidance in ASC 310-40-15-11(d) that allowed an entity not to evaluate whether a modification of an individual PCI asset within a pool accounted for under ASC 310-30 was considered a TDR. As a result of that amendment, an entity is required to determine whether a modification of an individual PCD asset is a TDR in accordance with ASC 310-40-15-5.4

However, note that the transition guidance in ASU 2016-13 allows an entity to continue to apply ASC 310-30 to pools of PCI assets if it elects to maintain those pools when adopting ASU 2016-13. Accordingly, we believe that an entity that makes this election would not be required to evaluate whether a modification of an individual PCI asset within a pool accounted for under ASC 310-30 is a TDR. See Section 9.2.1 for more information about this transition guidance.

6.3.3.2 Expected Recoveries

ASC 326-20

If the entity estimates expected credit losses using a method other than a discounted cash flow method in accordance with paragraph 326-20-30-4, expected recoveries shall not include any amounts that result in an acceleration of the noncredit discount.
The entity may include increases in expected cash flows after acquisition.

(See Examples 18 and 19 in paragraphs 326-20-55-86 through 55-90.)

ASU 2019-04 amended ASU 2016-13 to clarify that an entity should consider recoveries in its allowance for expected credit losses. However, stakeholders questioned whether an entity was required to apply this guidance to PCD assets. As a result, in ASU 2019-11, the FASB clarified that when measuring expected credit losses on a PCD asset by using an approach other than a DCF method, an entity may include increases in expected cash flows after acquisition and amounts written off or expected to be written off. However, the ASU also states that an entity is prohibited from accelerating the recognition of the asset’s noncredit discount. Accordingly:

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.
Unlike the guidance on recoveries that applies to non-PCD financial assets (see Section 4.5.2), ASU 2019-11’s guidance on expected recoveries is not limited to that on the aggregate of amounts previously written off and amounts that are expected to be written off by the entity.

When a non-DCF approach is applied to a PCD asset, an entity could determine its negative allowance for a previously written-off PCD asset by performing the following two steps:

Subtracting the noncredit discount that existed just before write-off from the total recoveries expected to be received.
Applying subsequent cash recoveries to the negative allowance until the negative allowance is reduced to zero. Any additional collections would be recognized as income.

We believe that the application of these two steps achieves the FASB’s objective of not allowing entities to accelerate the recognition of the noncredit discount when writing off a PCD asset because the noncredit discount is immediately deducted from any expected recoveries. Once the noncredit discount is deducted, any increases in expected recoveries would have the effect of increasing the negative allowance and reducing the credit loss provision.

We acknowledge that there could be other acceptable methods of applying the guidance in ASC 326-20-30-13A(a) that prohibits an entity from prematurely recognizing the noncredit discount.

Footnotes

Because ASU 2022-02 eliminates the accounting guidance on TDRs for creditors in ASC 310-40, an entity that has adopted ASU 2022-02 will no longer be required to determine whether a modification of an individual PCD asset is a TDR.

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