Chapter 6 — Purchased Credit-Deteriorated Assets
Chapter 6 — Purchased Credit-Deteriorated Assets
6.1 Introduction
Since the beginning of its credit losses project, the FASB has sought to
develop a model in which an entity would recognize in net income, in each reporting
period (including upon initial recognition), a credit loss expense that arises from an
allowance for expected credit losses that reflects management’s current estimate of such
losses for both originated and purchased assets. However, as discussed in paragraph BC85
of ASU 2016-13,
the Board questioned whether the same model should be applied to all originated and
purchased assets:
[R]ecognizing interest revenue on the basis of contractual cash
flows for all purchased assets could result in situations in which an entity
accretes to an amount that it does not expect to collect, which would result in
artificially inflated yields. For this reason, the Board concluded that when
recognizing interest income on certain assets, it is inappropriate to accrete
from the purchase price to the contractual cash flows. Specifically, when a
purchased asset has deteriorated more than insignificantly since origination, it
is more decision useful to exclude the credit discount from the amount accreted
to interest income. As a result, the discount embedded in the purchase price
that is attributable to credit losses at the date of acquisition of a purchased
financial asset with credit deterioration should not be recognized as interest
income.
On the basis of that logic, the Board developed an alternative credit loss and interest
income recognition model for acquired assets for which a certain level of credit
deterioration has occurred since origination. The alternative model applies to PCD
assets (see discussion below of what constitutes a PCD asset). An entity’s method for
measuring expected credit losses on PCD assets should be consistent with its method for
measuring such losses on originated and purchased non-credit-deteriorated 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, any changes in the estimate of
cash flows that the entity expects to collect (favorable or unfavorable) would be
recognized immediately as credit loss expense in the income statement. Interest income
recognition would be based on the purchase price plus the initial allowance accreting to
the contractual cash flows.
Changing Lanes
FASB Proposed ASU on Purchased Financial Assets
On June 27, 2023, the FASB issued a proposed ASU that would expand the model
for PCD assets to include all financial assets acquired in (1) a business
combination, (2) an asset acquisition, or (3) the consolidation of a VIE that is
not a business. The term PCD would be replaced with the term PFA.1
See Section
10.2.4 for more information.
Footnotes
1
AFS debt securities would be excluded from the PFA
model. In addition, for financial assets acquired as a result of an
asset acquisition or through consolidation of a VIE that is not a
business, the asset acquirer would apply the gross-up approach to
seasoned assets, which are acquired assets unless the asset is deemed
akin to an in-substance origination. A seasoned asset is an asset (1)
that is acquired more than 90 days after origination and (2) for which
the asset acquirer was not involved with the origination.
6.2 Scope of the PCD Model
ASU 2016-13 adds the following definition of PCD assets to the ASC
master glossary:
Acquired individual 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, as determined by an acquirer’s assessment.
ASC 326 does not specify either the cause of “more-than-insignificant
deterioration” or the factors an entity should consider when assessing whether the
deterioration in the credit quality of an asset (or a group of assets) has been more
than insignificant since origination. Paragraph BC90 of ASU 2016-13 notes that the FASB
did not want to identify which assets would meet the definition of a PCD asset:
Some stakeholders requested clarification on which purchased financial assets
should be recognized through a gross-up approach. The Board discussed the
definition of purchased assets with credit deterioration and did not intend for
the gross-up approach to be limited to nonaccrual loans or other assets that may
have been considered to be an “impaired” asset before the issuance of the
amendments in this Update. The Board was concerned that stakeholders would
misinterpret the guidance and apply the guidance to the same scope of assets as
Subtopic 310-30. As a result, the Board clarified that a gross-up approach
should be applied to purchased financial assets with a more-than-insignificant
amount of credit deterioration since origination. This change in wording was
recommended by user stakeholders. In addition, the Board concluded that this
will expand the population of purchased financial assets that are eligible to be
considered purchased financial assets with credit deterioration.
Although ASC 326 does not discuss what constitutes a
more-than-insignificant deterioration in credit quality, it does provide an example
illustrating one way in which an entity may evaluate the credit quality of PFAs.
ASC 326-20
Example 11: Identifying
Purchased Financial Assets With Credit
Deterioration
55-57 This Example illustrates factors
that may be considered when assessing whether the purchased
financial assets have more than an insignificant deterioration
in credit quality since origination.
55-58 Entity N purchases a portfolio of
financial assets subsequently measured at amortized cost basis
with varying levels of credit quality. When determining which
assets should be considered to be in the scope of the guidance
for purchased financial assets with credit deterioration, Entity
N considers the factors in paragraph 326-20-55-4 that are
relevant for determining collectibility.
55-59 Entity N assesses what is
more-than-insignificant credit deterioration since origination
and considers the purchased assets with the following
characteristics to be consistent with the factors that affect
collectibility in paragraph 326-20-55-4. Entity N records the
allowance for credit losses in accordance with paragraph
326-20-30-13 for the following assets:
- Financial assets that are delinquent as of the acquisition date
- Financial assets that have been downgraded since origination
- Financial assets that have been placed on nonaccrual status
- Financial assets for which, after origination, credit spreads have widened beyond the threshold specified in its policy.
55-60 Judgment is required when
determining whether purchased financial assets should be
recorded as purchased financial assets with credit
deterioration. Entity N’s considerations represent only a few of
the possible considerations. There may be other acceptable
considerations and policies applied by an entity to identify
purchased financial assets with credit deterioration.
Example 11 in ASC 326-20 illustrates that an entity could use the
factors in ASC 326-20-55-4 to evaluate whether the deterioration of an asset’s credit
quality has been more than insignificant. ASC 326-20-55-4 states, in part:
Examples of factors an entity may consider include any of the
following, depending on the nature of the asset (not all of these may be relevant to
every situation, and other factors not on the list may be relevant):
- The borrower’s financial condition, credit rating, credit score, asset quality, or business prospects
- The borrower’s ability to make scheduled interest or principal payments
- The remaining payment terms of the financial asset(s)
- The remaining time to maturity and the timing and extent of prepayments on the financial asset(s)
- The nature and volume of the entity’s financial asset(s)
- The volume and severity of past due financial asset(s) and the volume and severity of adversely classified or rated financial asset(s)
- The value of underlying collateral on financial assets in which the collateral-dependent practical expedient has not been utilized
- The entity’s lending policies and procedures, including changes in lending strategies, underwriting standards, collection, writeoff, and recovery practices, as well as knowledge of the borrower’s operations or the borrower’s standing in the community
- The quality of the entity’s credit review system
- The experience, ability, and depth of the entity’s management, lending staff, and other relevant staff
- The environmental factors of a borrower and the areas in
which the entity’s credit is concentrated, such as:
- Regulatory, legal, or technological environment to which the entity has exposure
- Changes and expected changes in the general market condition of either the geographical area or the industry to which the entity has exposure
- Changes and expected changes in international, national, regional, and local economic and business conditions and developments in which the entity operates, including the condition and expected condition of various market segments.
These factors are provided in the context of how an entity might adjust historical loss
information on the basis of certain conditions and characteristics that affect the
asset’s collectibility. While the existence of these factors may signify that
collectibility concerns are associated with a particular asset (or group of assets), it
may not indicate that the asset (or group of assets) should be considered PCD because an
entity can only conclude that an asset is PCD if the deterioration of its credit quality
has been more than insignificant since origination.
Connecting the Dots
Considerations Related to AFS Debt
Securities Under the PCD Model
The PCD model applies to an AFS debt security that meets the definition of a PCD
asset. To determine whether this definition is met, an entity must consider the
factors in ASC 326-30-55-1, which are the same factors that an investor uses to
identify whether there is a credit loss on an AFS debt security. In addition,
the subsequent-accounting guidance in ASC 326-30 on AFS debt securities that are
considered PCD assets slightly differs from the PCD model for assets measured at
amortized cost (e.g., loans and HTM debt securities). See Section
7.2.5 for further discussion of the accounting for AFS debt
securities that are considered PCD assets.
Changing Lanes
Scope of the PCD Model Differs From That
of the PCI Model
As noted previously, ASU 2016-13 defines a PCD asset as an acquired asset that
has “experienced a more-than-insignificant deterioration in credit quality since
origination.” Under current U.S. GAAP, a purchased credit-impaired (PCI) asset
accounted for under ASC 310-30 is considered credit-impaired if it is probable
that the investor would be unable to collect all contractual cash flows because
of deterioration in the asset’s credit quality since origination. Consequently,
in determining whether the credit deterioration of an acquired asset has been
more than insignificant, entities will most likely need to use more judgment
when applying the guidance in ASU 2016-13 than they do under current
guidance.
6.2.1 Application of PCD Model to BIs
The PCD model sometimes applies to BIs in securitized financial
assets. The PCD model applies to assets that meet the definition of PCD assets
as well as to certain BIs in debt securities that do not necessarily meet that
definition (see Connecting the Dots below). ASC 325-40-30-1A (added by ASU
2016-13) states:
An entity shall apply the initial
measurement guidance for purchased financial assets with credit
deterioration in Subtopic 326-20 to a beneficial interest classified as
held-to-maturity and in Subtopic 326-30 to a beneficial interest classified
as available for sale, if it meets either of the following conditions:
- There is a significant difference between contractual cash flows and expected cash flows at the date of recognition.
- The beneficial interests meet the definition of purchased financial assets with credit deterioration.
For more information about BIs accounted for under ASC 325-40,
see Section
6.4.
Connecting the Dots
PCD Model May Apply to a BI That
Does Not Meet the Definition of a PCD Asset
Under ASC 325-40-30-1A (see the section above), an
entity may need to account for a BI under the respective PCD model in
ASC 326-20 or ASC 326-30, even if the BI does not meet the definition of
a PCD asset. For example, the entity may be required to apply the PCD
model to certain BIs in new securitizations (i.e., securitizations for
which there is no deterioration in credit quality because they are new)
since there may be a significant difference between contractual cash
flows and expected cash flows on the date of recognition.
6.2.2 Application of PCD Model to Assets Acquired in a Business Combination
Assets acquired in a business combination are within the scope
of the PCD model. The PCD model applies to any acquired asset whose
deterioration in credit quality has been more than insignificant since
origination. Paragraph BC88 of ASU 2016-13 states that “the Board concluded that
there is no inherent difference between assets acquired in a business
combination and those that are purchased outside a business combination.”
An entity will still have to evaluate whether the individual
financial assets (or groups of financial assets with similar risk
characteristics) acquired in a business combination meet the definition of a PCD
asset before applying the PCD model. This may differ from the current practice
in which an entity can elect to apply ASC 310-30 to a pool of acquired assets
even if it cannot assert that each individual asset acquired is within the scope
of ASC 310-30.2
Note that while it may generally be relatively simple to
determine whether the PCD model applies to acquired assets in a business
combination, an entity may be required to perform an additional step if those
acquired assets were previously written off by the seller. We believe that, in
those instances, the acquirer would first need to evaluate whether it still has
a contractual right to the cash flows of the asset at the time of acquisition
and therefore has an asset to recognize. We believe that if the acquirer
determines that it has a contractual right to the cash flows of a financial
asset that was previously written off, it would then apply the PCD model to the
acquired assets as of the acquisition date.
6.2.3 Partially Funded Lines of Credit That Are PCD
Upon initially acquiring a partially drawn line of credit, an
acquirer should account for the funded portion (that is considered to be PCD and
noncancelable by the acquirer) in a manner similar to how it would account for
any other PCD asset, as described in ASC 326-20-30-13. The accounting for the
unfunded portion of the line of credit would be the same as that prescribed in
ASC 326-20-30-11 for all unfunded loan commitments. That is, a liability for the
expected credit losses should be recognized for the unfunded portion of the line
of credit for which subsequent adjustments as of each reporting date are
reported in net income as credit loss expense. In addition, adjustments to the
allowance for expected credit losses on the funded portion of the line of credit
are also reported in net income as credit loss expense.
As the entity continues to draw down on the line of credit, the
acquirer would revise its estimate for credit losses recognized on the unfunded
portion of the line of credit (i.e., potentially reducing its liability for
off-balance-sheet credit exposure) while adjusting the allowance for expected
credit losses on the funded loan amount (to reflect the newly funded amount).
6.2.4 Whether Pushdown Accounting Results in Applying PCD Accounting at the Subsidiary Level
Under ASC 805-50-30-10, if an acquiree elects to apply pushdown
accounting, the carrying amounts of its assets and liabilities in its separate
financial statements are adjusted to reflect the amounts recognized in the
acquirer’s consolidated financial statements as of the date on which control was
obtained. As a result, if the acquirer applies (or would have applied) PCD
accounting at the consolidated level to assets acquired and the acquiree elects to
apply pushdown accounting, the acquiree would need to adjust its assets to reflect
the application of PCD accounting in its separate, stand-alone financial statements.
Note that an acquiree that elects pushdown accounting must apply it in its entirety;
the acquiree cannot pick and choose which assets or liabilities to recognize in its
separate financial statements.
6.2.5 Accounting for a Net Investment in a Lease by Using the PCD Model
A lessor should consider a decline in the fair value of the
residual asset in an acquired net investment in a sales-type or direct financing
lease when evaluating whether the net investment in the lease meets the
definition of a PCD asset. The unit of account used when the impairment model is
applied from the lessor’s perspective is meant to encompass amounts related to
the entire net investment in the lease, which would include the residual asset.
Therefore, we believe that when evaluating whether the deterioration in the
credit quality of an acquired net investment in a sales-type or direct financing
lease has been more than insignificant since origination, the lessor should
consider declines in the (1) lessee’s credit quality that are related to lease
payments and (2) fair value of the underlying residual asset.
6.2.6 Unit of Account for PCD Assets
The unit of account used in the PCD model depends on the type of
financial asset to which the entity is applying the PCD model. An entity is allowed
to evaluate the applicability of the PCD model to loans, HTM debt securities, and
other assets measured at amortized cost on a collective basis if they share similar
risk characteristics (see Section
3.2). However, the entity is not permitted to determine whether PCD
accounting applies to AFS debt securities on a collective or pool basis; instead, it
must make that determination on the basis of each individual AFS debt security. For
more information about the PCD assessment for AFS debt securities, see
Section 7.2.5.
Connecting the Dots
Maintaining Integrity of Pool No
Longer Required
ASC 310-30-40-1 states that, among other things, “once a
pool of [PCI] loans is assembled, the integrity of the pool shall be
maintained” and that a loan could only be removed if it met certain
conditions. ASU 2016-13 removes that language. As a result, the general
principles in ASC 326-20 that address the unit of account apply similarly to
all assets measured at amortized cost. That is, an entity must evaluate
financial assets within the scope of the model on a collective (i.e., pool)
basis if they share similar risk characteristics. If a financial asset’s
risk characteristics are not similar to those of any of the entity’s other
financial assets, the entity would evaluate that financial asset
individually. For more information about when to remove a financial asset
from a pool of financial assets, including PCD assets, see Section 3.2.1.
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. As discussed in
Section 9.2.1, entities have a choice of
maintaining their existing pools accounted for under ASC 310-30 either at
adoption only or on an ongoing basis after adoption. Furthermore, an
entity’s approach to maintaining its existing pools should be determined on
a pool-by-pool basis. As a result, while ASC 326-20 does not require an
entity to maintain the integrity of a pool of PCD assets, an entity would be
required to do so if it elected to maintain its pools of PCI assets upon
adopting ASU 2016-13.
Footnotes
2
In a December 18, 2009, letter to the SEC staff, the AICPA
documented the SEC staff’s position that after a purchase of loans in a
business acquisition or an asset purchase, an entity is permitted to
make an accounting policy election to accrete the discount on the basis
of either contractual cash flows (by using an ASC 310-20 approach) or
expected cash flows (by using an ASC 310-30 approach) for portfolios of
acquired assets for which the entity does not individually evaluate each
asset to determine whether it meets the scope requirements of ASC
310-30. Accordingly, some loans in the portfolio may individually meet
the scope criteria while others may not.
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
Currently, an entity that is accounting for PCI assets recognizes
unfavorable changes in expected cash flows as an immediate credit
impairment but treats favorable changes in expected cash flows as
prospective yield adjustments. The CECL model’s approach to PCD assets
eliminates 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 current 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 2022-01, 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 now required to determine whether a
modification of an individual PCD asset is a TDR in accordance with ASC
310-40-15-5.3
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
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.)
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
3
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.
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.