6.4 Considerations Related to BIs
Under ASC 325-40, as amended by ASU 2016-13, an entity should measure an allowance for
expected credit losses for a purchased or retained BI in a manner consistent with how it
measures an allowance for expected credit losses for PCD assets if the BI is (1) within
the scope of ASC 325-40, (2) classified as AFS or HTM, and (3) meets the definition of a
PCD asset or there is a significant difference between the contractual cash flows and
expected cash flows of the BI.
Therefore, if a BI is within the scope of the PCD asset model, at initial recognition,
the BI holder would present an allowance for expected credit losses equal to the
estimate of expected credit losses and add that allowance to the purchase price to
determine the initial amortized cost basis of the BI. Any subsequent changes to the
entity’s estimate of expected credit losses — whether unfavorable or favorable — would
be recorded as a credit loss expense (or the reduction of an expense) during the period
of change. In addition, the entity must accrete changes in expected cash flows
attributable to factors other than credit into interest income over the asset’s life.
Changes in cash flows due to prepayments are considered credit-related and are therefore
reflected as a change to the entity’s estimate of expected credit losses.
Under the CECL model, an entity must determine the contractual cash flows of BIs in
securitized transactions. However, the BIs in certain structures may not have easily
determinable contractual cash flows (e.g., when a BI holder receives only residual cash
flows of a securitization structure). Further, ASU 2016-13 does not define the term
“contractual cash flows.” In these situations, the entity may need to use a proxy for
the contractual cash flows of the BI (e.g., the gross contractual cash flows of the
underlying debt instrument).
6.4.1 Prepayment Expectations in BIs
An entity should not assume that there will be no prepayments
when determining the contractual cash flows of BIs in securitized transactions.
As discussed at the June 2017 TRG meeting, while ASC 325-40-30-1A uses the term
“contractual cash flows,” it would be reasonable for entities to determine such
cash flows on the basis of the expected prepayments of the assets underlying the
securitization on the acquisition date. However, in determining contractual cash
flows, entities should assume that there will be no defaults. The rationale for
allowing an expected level of prepayments but no expected level of defaults was
to prevent expected prepayments alone from causing a BI to be accounted for
under the PCD model.
6.4.2 Accounting for BIs Classified as HTM Debt Securities — Comparison Between PCD and Non-PCD Guidance
The paragraphs below discuss how the guidance in ASC 325-40 on
non-PCD BIs classified as HTM debt securities differs from the PCD model for BIs
classified as HTM debt securities in ASC 326-20-30-13 through 30-15.
6.4.2.1 Initial Accounting Under ASC 325-40
Under ASC 325-40 (as amended by ASU 2016-13), entities must
initially estimate the timing and amount of all future cash inflows from a
BI within the scope of ASC 325-40 by employing assumptions used in the
determination of fair value at recognition. The excess of those expected
future cash flows over the initial investment is the accretable yield.
Entities recognize this excess as interest income over the life of the
investment by using the effective interest method.
6.4.2.2 Subsequent Accounting Under ASC 325-40
A subsequent adjustment to expected cash flows is recognized
as a yield adjustment affecting interest income or, if related to credit,
may be recognized through earnings by means of an allowance for credit
losses. In other words, a cumulative adverse change in expected cash flows
would be recognized as an allowance, and a cumulative favorable change in
expected cash flows would be recognized as a prospective yield
adjustment.
6.4.2.3 Initial Accounting Under the PCD Model in ASC 326-20
Under the PCD accounting model in ASC 326-20, entities are
required to gross up the cost basis of a PCD asset by the estimated credit
losses as of the date of acquisition and establish a corresponding allowance
for credit losses. The initial allowance is based on the difference between
expected cash flows and contractual cash flows (adjusted for prepayments as
discussed in Section
6.4.1).
6.4.2.4 Subsequent Accounting Under the PCD Model in ASC 326-20
For PCD assets within the scope of ASC 325-40 that are
classified as HTM debt securities, cumulative adverse changes in expected
cash flows would be recognized currently as an increase to the allowance for
credit losses (in a manner similar to recognition under the normal ASC
325-40 model, as amended by ASU 2016-13).
However, favorable changes in expected cash flows would
first be recognized as a decrease to the allowance for credit losses
(recognized currently in earnings). Favorable changes in expected cash flows
would be recognized as a prospective yield adjustment only when the
allowance for credit losses is reduced to zero.
6.4.3 Requirement for Using a DCF Approach to Measure Credit Losses on BIs
An entity is permitted to use various measurement methods to
estimate expected credit losses on assets within the scope of ASC 326 (see
Section 4.4).
However, the entity would not have the same flexibility when measuring expected
credit losses on BIs in securitization transactions.
ASC 325-40-35-7 requires an entity to use a DCF approach to measure expected
credit losses on a BI in a securitization transaction within the scope of ASC
325-40. While this requirement is similar to that in existing U.S. GAAP, the
requirement to use a DCF approach may result in differences between how an
entity measures expected credit losses on HTM debt securities that are BIs
within the scope of ASC 325-40 and how it measures such losses on other HTM debt
securities. In other words, the entity may choose to use a loss-rate approach
when measuring expected credit losses on an HTM debt security that is not a BI
within the scope of ASC 325-40 but may be required to use a DCF approach when
measuring expected credit losses on an HTM debt security that is a BI in a
securitization transaction within the scope of ASC 325-40.