Chapter 7 — Available-for-Sale Debt Securities

7.1 Introduction

The CECL model does not apply to AFS debt securities. Instead, the FASB decided to make targeted improvements to the existing OTTI model in ASC 320 for AFS debt securities to eliminate the concept of “other than temporary” from that model. Although the Board originally sought to develop an expected credit losses model that would apply similarly to loans and debt securities, feedback received from stakeholders throughout the model’s development indicated that an entity manages AFS debt securities differently from how it manages other assets measured at amortized cost (e.g., loans and HTM debt securities). Accordingly, in paragraph BC81 of ASU 2016-13, the Board indicates that “the same credit loss model cannot apply because there are different measurement attributes. The measurement attribute for available-for-sale debt securities necessitates a separate credit loss model because an entity may realize the total value of the securities either through collection of contractual cash flows or through sales of the securities.”

The targeted changes to the existing OTTI model can be summarized as follows (see Section 7.2.3.1 for more information):

The entity must use an allowance approach (as opposed to permanently writing down the security’s cost basis).
The entity must limit the allowance to the amount at which the security’s fair value is less than its amortized cost basis.
The entity may not consider the length of time fair value has been less than amortized cost.
The entity may not consider recoveries in fair value after the balance sheet date when assessing whether a credit loss exists.

These targeted changes do not apply to an AFS debt security if (1) the entity intends to sell the security or (2) it is more likely than not that the entity will be required to sell the security before the recovery of the security’s amortized cost basis. In such cases, the entity would write down the debt security’s amortized cost to its fair value, as required under existing U.S. GAAP. The flowchart below illustrates how an entity identifies and assesses impairment on AFS debt securities.

7.1.1 Generally Consistent With Existing U.S. GAAP

7.2 Identifying an Impairment

7.2.1 Whether Fair Value Is Less Than Amortized Cost

ASC 326-30

35-1 An investment is impaired if the fair value of the investment is less than its amortized cost basis.

35-4 Impairment shall be assessed at the individual security level (referred to as an investment). Individual security level means the level and method of aggregation used by the reporting entity to measure realized and unrealized gains and losses on its debt securities. (For example, debt securities bearing the same Committee on Uniform Security Identification Procedures [CUSIP] number that were purchased in separate trade lots may be aggregated by a reporting entity on an average cost basis if that corresponds to the basis used to measure realized and unrealized gains and losses for the debt securities.) Providing a general allowance for an unidentified impairment in a portfolio of debt securities is not appropriate.

Other than moving guidance from ASC 320-10 to ASC 326-30, ASU 2016-13 did not affect how an entity identifies whether there is an impairment on an AFS debt security. That is, an entity is still required to assess whether the security’s fair value is less than its amortized cost and this evaluation must be performed on an individual security level.

7.2.1.1 Expected Loss Presumption

If the fair value of an AFS debt security is less than its amortized cost, there is not necessarily a presumption that a credit loss must be recognized. For AFS debt securities that an entity does not intend and is not more likely than not required to sell, ASC 326-30 requires the entity to recognize in net income the impairment amount related only to credit and to recognize in OCI the noncredit impairment amount. However, ASU 2016-13 requires an entity to use an allowance approach for AFS debt securities when recognizing credit losses (as opposed to a permanent write-down of the AFS security’s cost basis). ASC 326-30-35-2 states:

For [AFS debt securities], an entity shall determine whether a decline in fair value below the amortized cost basis has resulted from a credit loss or other factors. An entity shall record impairment relating to credit losses through an allowance for credit losses. However, the allowance shall be limited by the amount that the fair value is less than the amortized cost basis. Impairment that has not been recorded through an allowance for credit losses shall be recorded through other comprehensive income, net of applicable taxes. An entity shall consider the guidance in paragraphs 326-30-35-6 and 326-30-55-1 through 55-4 when determining whether a credit loss exists. [Emphasis added]

Entities should consider the following factors (not all-inclusive) when determining whether a credit loss exists (for more information about determining whether a credit loss exists, see Section 7.2.3):

Adverse conditions related to the security, an industry, or a geographic area.
The payment structure of the debt security and the likelihood that the issuer will be able to make payments that increase in the future.
Failure of the issuer to make scheduled payments and all available information relevant to the security’s collectibility.
Changes in the ratings assigned by a rating agency.
Other credit enhancements that affect the security’s expected performance.

The fair value of an AFS security may fall below amortized cost solely because of changes in interest rates or market liquidity, which are considered noncredit events. In that case, the entire unrealized loss will be recognized in OCI unless either (1) the entity intends to sell the security or (2) it is more likely than not that the entity will be required to sell the security. If the entity intends to sell the security or will more likely than not be required to sell it before recovery of its amortized cost basis, the entity must write down the amortized cost basis of the AFS security to its fair value as of the reporting date.

7.2.1.2 Management’s Responsibilities

ASC 326-30-35-4 states that management must perform an evaluation for impairment in each reporting period “at the individual security level.” When performing this assessment, management should employ a systematic and rational method for determining whether (1) an investment is impaired and (2) a credit loss exists or the investment’s amortized cost basis needs to be written down to its current fair value. Management should document all factors it considered in reaching its conclusions about whether an investment is impaired; such documentation would typically include:

The nature of the investment.
The cause or causes of the impairment.
An evaluation of management’s intent to sell any debt securities as of the measurement date (see Section 7.2.2 for more information).
Management’s assessment of whether it is more likely than not that it will be required to sell a particular debt security before the recovery of its amortized cost basis (see Section 7.2.2 for more information).
All information relevant to the collectibility of a debt security that was considered in management’s conclusion about whether a credit loss exists (see Section 7.2.1.1 for more information about the assessment of the collectibility of debt securities).

7.2.1.3 Accrued Interest

ASC 326-30

30-1A If for the purposes of identifying and measuring an impairment the applicable accrued interest is excluded from both the fair value and the amortized cost basis of the available-for-sale debt security, an entity may develop its estimate of expected credit losses by measuring components of the amortized cost basis on a combined basis or by separately measuring the applicable accrued interest component from the other components of amortized cost basis.

30-1B If an entity excludes applicable accrued interest from both the fair value and the amortized cost basis of the available-for-sale debt security, the entity may make an accounting policy election, at the major security-type level, not to measure an allowance for credit losses for accrued interest receivables if it writes off the uncollectible accrued interest receivable balance in a timely manner. An entity that elects the accounting policy in this paragraph shall meet the disclosure requirements in paragraph 326-30-50-3C. This accounting policy election shall be considered separately from the accounting policy election in paragraph 326-30-35-13A. An entity may not analogize this guidance to components of amortized cost basis other than accrued interest.

In addition to its amendments on accrued interest for financial assets measured at amortized cost (see Section 4.4.5.1), ASU 2019-04 amended the guidance on how an entity considers accrued interest when measuring expected credit losses on AFS debt securities. The ASU states that for an AFS debt security, an entity is permitted to (1) evaluate for impairment and measure the allowance for credit losses on accrued interest receivable balances separately from other components of the security’s amortized cost basis and (2) make an accounting policy election not to measure an allowance for credit losses on accrued interest receivable amounts if the entity excludes the accrued interest from both the fair value and amortized cost basis of the security, writes off the uncollectible accrued interest receivable balance in a timely manner, and provides certain disclosures (see Section 8.2.7).

7.2.2 Intent or Requirement to Sell

ASC 326-30

35-10 If an entity intends to sell the debt security (that is, it has decided to sell the security), or more likely than not will be required to sell the security before recovery of its amortized cost basis, any allowance for credit losses shall be written off and the amortized cost basis shall be written down to the debt security’s fair value at the reporting date with any incremental impairment reported in earnings. If an entity does not intend to sell the debt security, the entity shall consider available evidence to assess whether it more likely than not will be required to sell the security before the recovery of its amortized cost basis (for example, whether its cash or working capital requirements or contractual or regulatory obligations indicate that the security will be required to be sold before the forecasted recovery occurs). In assessing whether the entity more likely than not will be required to sell the security before recovery of its amortized cost basis, the entity shall consider the factors in paragraphs 326-30-55-1 through 55-2.

7.2.2.1 Intent to Sell

An investor is required to assess, in each reporting period, whether it intends to sell an impaired AFS debt security. Under ASC 326-30-35-10, if the investor intends to sell the security, it must write down the security’s amortized cost basis to its fair value, write off any existing allowance for credit losses, and recognize in earnings any incremental impairment.

An investor is considered to have the intent to sell an impaired AFS debt security if it has decided to sell that security as of the reporting date. If the entity decided to sell the impaired security in a prior period (and thus recognized an impairment loss in that prior period) but has not sold the security by the end of a subsequent period, it would be required to assess whether it still has the intent to sell the security as of the end of that subsequent period. If the entity continues to have such intent, any further declines in fair value should be recognized as an additional impairment through earnings. If the entity revokes its decision to sell in a subsequent period, thereby asserting that it no longer has the intent to sell the security, it is not permitted to reverse any prior-period impairments recognized in earnings. (See Section 7.2.4 for a discussion of accounting for an AFS debt security after a write-down.)

In assessing whether it has decided to sell an AFS debt security, the entity should consider all available evidence, including the following:

The investor or its agent (e.g., a third party that manages the investor’s securities portfolio) has approved the sale of the security (see Section 7.2.2.1.1).
The investor has directed its agent to sell the security, and this sale is contingent on an event that is expected to occur (see Example 7-1).
The security is part of a group of securities that the investor or its agent has identified as being for sale.
The security or group of securities is being marketed to be sold at a price that does not significantly exceed fair value.
The security is sold shortly after the balance sheet date, and the facts and circumstances suggest that the decision to sell was made before that date. (See Section 7.2.2.2.1 for a more detailed discussion of impaired debt securities sold at a loss after the balance sheet date.)

Example 7-1

Company A holds an AFS debt security with a carrying (par) amount of $100, a fair value of $70, and a remaining maturity of five years. Further, A expects that, if it were to hold the security, it would recover the security’s full carrying amount and does not consider a credit loss to have occurred. On March 31, 20X1, A directs its third-party portfolio manager to sell the security if the value reaches $80.

Although A intends to sell the security, that intention is contingent on a future event (i.e., that the security’s value reaches $80). However, A expects to fully recover the security’s carrying amount by the maturity date. That is, A, expects the security’s value to reach $80 before maturity because of the mere passage of time. Therefore, A would be considered to have the present intent to sell the security and, accordingly, should write the security’s amortized cost basis down to $70 and record an impairment loss of $30 in earnings.

If A has not sold the security by the end of a subsequent period, A would still be considered to have the present intent to sell it. Further declines in value would necessitate further write-downs in the amortized cost basis and would be considered impairment losses unless A revokes its intention to sell or the security’s value is no longer expected to reach $80 as a result of credit losses (however, the security would still be evaluated for an allowance for credit losses on the basis of the current amortized cost basis). If A revokes its decision to sell the security in a subsequent period, thereby asserting that it no longer has the intent to sell, it is not permitted to reverse any prior-period impairments recognized in earnings.

7.2.2.1.1 Considerations Related to a Managed Investment Portfolio When the Manager Has Discretion to Sell

ASC 326-30-35-10 states, in part:

If an entity intends to sell the [AFS] debt security (that is, it has decided to sell the security), or more likely than not will be required to sell the security before recovery of its amortized cost basis, any allowance for credit losses shall be written off and the amortized cost basis shall be written down to the debt security’s fair value at the reporting date with any incremental impairment reported in earnings.

In certain circumstances, an AFS debt security is managed by an independent investment adviser that has discretion to purchase and sell debt securities without management approval. In such cases, management would evaluate whether an investor intends, or is more likely than not required, to sell the security before recovery of its amortized cost basis.

In performing such an evaluation, management should understand whether the investment manager has decided to sell impaired AFS debt securities as of the balance sheet date.1 Further, management should evaluate the facts and circumstances if the third-party manager subsequently sells an impaired AFS debt security after that date. See Section 7.2.2.2.1 for a discussion of impaired AFS debt securities sold after the balance sheet date.

In evaluating whether it is more likely than not that the entity will be required to sell an AFS debt security before recovery of the security’s amortized cost basis (see Section 7.2.2.2), management should consider the facts and circumstances that may affect this assessment. An entity may be required to sell a debt security for legal, regulatory, or operational reasons. For example, the entity may need to sell an AFS debt security because it matures later than the date on which it must be sold to meet a contractual obligation. In such cases, management would need to consider whether it is more likely than not that this required sale will occur before the expected recovery. A history of “voluntary” sales of AFS debt securities in an investment portfolio, including sales to meet tax and other investment objectives, is not relevant in the assessment of the likelihood of required sales from the portfolio in the future, regardless of whether the voluntary sales were based on the actions of management or an independent investment adviser. In addition, the possibility that AFS debt securities could be sold anytime at the discretion of the third-party investment manager is insufficient to support an assertion by management that it is more likely than not that the investor will be required to sell the security before recovery of its amortized cost basis (although this factor should be considered in the evaluation of whether there is an intent to sell AFS debt securities, as discussed above).

Note that the impairment model for AFS debt securities differs from that for HTM debt securities. The entity should separately evaluate AFS debt securities and HTM debt securities if they are managed by the same third-party investment manager.

7.2.2.1.2 Evaluating Impairment of Investments in AFS Auction Rate Securities — Intent to Sell

Auction rate securities (ARSs) are distinct from other, more traditional securities. ARSs generally have long-term stated maturities; issuers are not required to redeem them until 20 to 30 years after issuance. However, from an investor’s perspective, ARSs have certain economic characteristics of short-term investments because of their rate-setting mechanism. The return on these securities is designed to track short-term interest rates through a “Dutch” auction process, which resets the coupon (or dividend) rate.

The auction process gives an investor three options as of each remarketing date: (1) hold its ARS “at market” without participating in the auction process; (2) hold its ARS “at rate,” allowing the investor to participate in the auction process; or (3) tender its ARS, allowing the investor to sell its securities into the auction process provided that the auction does not fail. Existing investors that choose to hold their ARSs “at rate” and potential new investors enter into a “blind” competitive-bid process in which they specify the lowest interest/dividend rate and quantity they are willing to accept. The lowest rate at which all of the securities can be placed (including to investors that choose the “at market” option) becomes the interest/dividend rate for these securities until the next auction date.

A failed auction may occur if the demand for the ARS is insufficient to allow existing investors to liquidate their holdings in the auction process.2 For example, if there is a lack of demand for an ARS issuance and no rate is established in the auction process that would clear the entire issuance, a failed auction would occur and current investors would be forced to continue holding their positions (generally, investors in a failed auction receive a maximum predetermined interest rate from the issuer unless and until sufficient bids are received by the next auction date). In typical ARS issuances, investors cannot require the issuer to redeem the securities resulting from a failed auction.

An investor may sell its ARS into the secondary market. However, when an auction has failed, the secondary market may be inactive or nonexistent and the fair value of the ARS may be less than par. Depending on market conditions and the underlying collateral of the ARS, the discount from par may be significant.

Generally, investments in ARSs are debt securities that should be accounted for under ASC 320. If the ARS is designated as an AFS debt security and its fair value is less than its carrying amount, management should evaluate the security to determine whether the recognition of an impairment loss is required. If, for example, management intends to sell the ARS, an impairment loss would be recognized.

The existence of an auction process for an ARS generally does not affect the evaluation of whether the investor has an intent to sell it. If the investor elects to tender its ARS, the security is typically tendered at its par amount. If this amount is equal to or greater than the investor’s amortized cost basis, the investor would expect to recover its entire amortized cost basis. In such instances, an intent to sell before recovery does not exist because the tendering of the securities is contingent on the investor’s receiving at least its entire amortized cost basis in return. If the investor elects to hold its ARS “at market” or “at rate,” an intent to sell does not exist since the investor would continue to hold the ARS regardless of the outcome of the auction.

If management determines that it does not intend to sell, or that it is not more likely than not that it will be required to sell, the ARS before recovery, the entity must assess whether a “credit loss”3 has occurred (e.g., if an auction fails). See Section 7.2.3 for a discussion of the calculation of credit losses.

7.2.2.2 Assessment of Whether It Is More Likely Than Not That the Entity Will Be Required to Sell

As discussed above, if an entity does not intend to sell an impaired AFS debt security, it will still need to assess whether it is more likely than not that it will be required to sell the security before recovery of the security’s amortized cost basis. Such an evaluation should take into account (1) the factors that might affect whether the entity is required to sell the security and (2) the probability that those factors will occur during the expected recovery period.

Factors that influence whether the entity may be required to sell the impaired AFS debt security include, but are not limited to, the following:

The entity’s cash and working capital requirements:
- The entity’s liquidity position, whether the entity expects that it will have to sell the debt security to meet expected cash requirements (e.g., to repay its existing obligations).
- Whether there have been any adverse changes in the entity’s business or industry that could compel the entity to sell the debt security to meet working capital requirements.
Any contractual or regulatory obligations that may cause the debt security to be sold:
- Whether it is likely that a third party (e.g., a regulator) could force the entity to sell the debt security.
- Whether the entity has contracts that would require it to sell specific debt securities upon the occurrence of certain events.

Once the entity has identified the factors that are relevant to determining whether it will be required to sell an impaired AFS debt security, it must consider the probability that those factors will occur during the anticipated recovery period. In evaluating the existence of a credit loss and estimating the debt security’s recovery period, the entity should consider the guidance in ASC 326-30-55-1:

There are numerous factors to be considered in determining whether a credit loss exists. The length of time a security has been in an unrealized loss position should not be a factor, by itself or in combination with others, that an entity would use to conclude that a credit loss does not exist. The following list is not meant to be all inclusive. All of the following factors should be considered:

The extent to which the fair value is less than the amortized cost basis
Adverse conditions specifically related to the security, an industry, or geographic area; for example, changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, changes in the financial condition of the underlying loan obligors. Examples of those changes include any of the following:
1. Changes in technology
2. The discontinuance of a segment of the business that may affect the future earnings potential of the issuer or underlying loan obligors of the security
3. Changes in the quality of the credit enhancement.
The payment structure of the debt security (for example, nontraditional loan terms as described in paragraphs 825-10-55-1 through 55-2) and the likelihood of the issuer being able to make payments that increase in the future
Failure of the issuer of the security to make scheduled interest or principal payments
Any changes to the rating of the security by a rating agency.

A write-down of an AFS debt security’s amortized cost to fair value is required if — in light of all relevant factors and the probability that those factors will occur during the expected recovery period — an entity determines that it is more likely than not that it will be required to sell the impaired security before recovery of the security’s amortized cost basis. Consequently, the entity must recognize any incremental impairment loss (i.e., the difference between the security’s fair value and amortized cost basis, less any existing allowance for credit losses) in earnings.

An entity must use professional judgment in determining the factors to consider and the probability that such factors will occur during the recovery period. In addition, the entity should document its conclusions regarding whether it is more likely than not that it will be required to sell the impaired AFS debt security before recovery. The entity should also be mindful of the information disclosed in its financial statements and MD&A and of how to reconcile that information with its assertion that it is more likely than not that it will be required to sell the impaired AFS debt security before recovery of the security’s amortized cost basis.

7.2.2.2.1 Sale of an Impaired AFS Debt Security at a Loss After the Balance Sheet Date

A sale of an impaired AFS debt security at a loss after the balance sheet date does not necessarily indicate that the security’s amortized cost basis should have been written down to its fair value as of the balance sheet date and that any incremental impairment loss should have been recognized in earnings. Under ASC 326-30, an entity’s objective is to write down an AFS debt security’s amortized cost basis to its fair value, write off any allowance for credit losses, and record any incremental impairment loss in earnings in the period in which the investor (1) decides to sell the security or (2) determines that it is more likely than not that it will be required to sell the security before recovery of the security’s amortized cost basis (the “MLTN assertion”). Accordingly, if an impaired AFS debt security is sold after the balance sheet date, the entity must consider whether those sales are inconsistent with its assertions as of the balance sheet date. In doing so, it should consider (1) when the decision to sell was made or (2) whether the impaired debt security was sold as a result of a requirement to sell the security and when it became more likely than not that it would be required to sell.

To assess whether subsequent sales of impaired AFS debt securities are consistent with the entity’s “lack of intent to sell” assertion as of the balance sheet date, the entity should determine when it decided to sell the impaired security. In performing this assessment, the entity should consider factors that include, but are not limited to, the following:

How soon the entity sold the security after the balance sheet date.
When the process of selling the security started and how long it took to sell the security (e.g., the length of the marketing period). The entity should consider whether the security is actively traded and whether the period between the decision to sell and the actual selling was in line with the customary marketing period for the security.
Whether there were standing orders to sell the security as of the balance sheet date.

Assume that an entity originally asserts as of the balance sheet date that it did not intend to sell the impaired AFS debt security. If the entity then concludes that the decision to sell the security was made after the balance sheet date, the original assertion as of the balance sheet date would be supported. Decisions to sell after the balance sheet date could be made for various reasons, including changing market conditions that affect an entity’s risk appetite and investment strategies.

In determining whether the subsequent sale of the impaired AFS debt security is consistent with its MLTN assertion as of the balance sheet date, an entity must first determine whether the subsequent sale occurred as a result of a requirement to sell (e.g., because of regulatory or contractual obligations or cash flow or working capital requirements). If the subsequent sale is not a result of a requirement to sell, the MLTN assertion as of the balance sheet date would be supported. However, if this subsequent sale resulted from a requirement to sell, the entity should consider whether there has been a change in the factors that it considered as of the balance sheet date, a change in the probability of those factors occurring, or both.

Such an assessment is based, in part, on management’s intent. Accordingly, an entity must exercise professional judgment in performing this evaluation and should prepare documentation that supports its “lack of intent to sell” and the MLTN assertions as of the balance sheet date. The entity should also consider contemporaneously documenting (1) when a decision to sell has been made and (2) a requirement to sell the securities and when it becomes more likely than not that it will need to comply with such a requirement. That said, the threshold for not having the intent to sell is lower than that for having the intent and ability to hold the security until recovery.

7.2.3 Whether a Credit Loss Exists

ASC 326-30

35-2 For individual debt securities classified as available-for-sale securities, an entity shall determine whether a decline in fair value below the amortized cost basis has resulted from a credit loss or other factors. An entity shall record impairment relating to credit losses through an allowance for credit losses. However, the allowance shall be limited by the amount that the fair value is less than the amortized cost basis. Impairment that has not been recorded through an allowance for credit losses shall be recorded through other comprehensive income, net of applicable taxes. An entity shall consider the guidance in paragraphs 326-30-35-6 and 326-30-55-1 through 55-4 when determining whether a credit loss exists.

35-3 At each reporting date, an entity shall record an allowance for credit losses that reflects the amount of the impairment related to credit losses, limited by the amount that fair value is less than the amortized cost basis. Changes in the allowance shall be recorded in the period of the change as credit loss expense (or reversal of credit loss expense).

35-6 In assessing whether a credit loss exists, an entity shall compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis of the security, a credit loss exists and an allowance for credit losses shall be recorded for the credit loss, limited by the amount that the fair value is less than amortized cost basis. Credit losses on an impaired security shall continue to be measured using the present value of expected future cash flows.

35-7 In determining whether a credit loss exists, an entity shall consider the factors in paragraphs 326-30-55-1 through 55-4 and use its best estimate of the present value of cash flows expected to be collected from the debt security. One way of estimating that amount would be to consider the methodology described in paragraphs 326-30-35-8 through 35-10. Briefly, the entity would discount the expected cash flows at the effective interest rate implicit in the security at the date of acquisition.

35-7A As an accounting policy election for each major security type of debt securities classified as available-for-sale securities, an entity may adjust the effective interest rate used to discount expected cash flows to consider the timing (and changes in the timing) of expected cash flows resulting from expected prepayments.

35-8 The estimates of expected future cash flows shall be the entity’s best estimate based on past events, current conditions, and on reasonable and supportable forecasts. Available evidence shall be considered in developing the estimate of expected future cash flows. The weight given to the information used in the assessment shall be commensurate with the extent to which the evidence can be verified objectively. If an entity estimates a range for either the amount or timing of possible cash flows, the likelihood of the possible outcomes shall be considered in determining the best estimate of expected future cash flows.

When an entity has an impaired AFS debt security and (1) the entity does not intend to sell the security and (2) it is not more likely than not that it will be required to sell the security before the recovery of the security’s amortized cost basis, the entity will need to consider whether the decline in fair value is related to a credit loss in accordance with ASC 326-30-35-2. If the entity cannot qualitatively conclude that a credit loss does not exist, it must perform this assessment quantitatively. Specifically, ASC 326-30-35-6 states, in part, that “[i]f the present value of cash flows expected to be collected is less than the amortized cost basis of the security, a credit loss exists and an allowance for credit losses shall be recorded for the credit loss, limited by the amount that the fair value is less than amortized cost basis.”

Therefore, the amount of credit loss for an impaired AFS debt security is the excess of (1) the security’s amortized cost basis over (2) the present value of the investor’s best estimate of the cash flows expected to be collected from the security. In accordance with ASC 326-30-35-8, the investor calculates the present value on the basis of its best estimate of the expected future cash flows by using “past events, current conditions, and . . . reasonable and supportable forecasts.” As indicated in ASC 326-20-30-4, the investor discounts the expected future cash flows “at the financial asset’s effective interest rate.” The ASC master glossary, as amended by ASU 2016-13, defines the EIR as the rate implicit in the security as of the acquisition date (i.e., the contractual interest rate “adjusted for any net deferred fees or costs, premium, or discount existing” as of the acquisition date).

When calculating the present value of the expected future cash flows, an entity should consider the guidance in ASC 326-30-55-2 through 55-4:

55-2 An entity should consider available information relevant to the collectibility of the security, including information about past events, current conditions, and reasonable and supportable forecasts, when developing the estimate of cash flows expected to be collected. That information should include all of the following:

The remaining payment terms of the security
Prepayment speeds
The financial condition of the issuer(s)
Expected defaults
The value of any underlying collateral.

55-3 To achieve the objective in paragraph 326-30-55-2, the entity should consider, for example, all of the following to the extent they influence the estimate of expected cash flows on a security:

Industry analyst reports and forecasts
Credit ratings
Other market data that are relevant to the collectibility of the security.

55-4 An entity also should consider how other credit enhancements affect the expected performance of the security, including consideration of the current financial condition of the guarantor of a security (if the guarantee is not a separate contract as discussed in paragraph 326-30-35-5), the willingness of the guarantor to pay, and/or whether any subordinated interests are capable of absorbing estimated losses on the loans underlying the security. The remaining payment terms of the security could be significantly different from the payment terms in prior periods (such as for some securities backed by nontraditional loans; see paragraph 825-10-55-1). Thus, an entity should consider whether a security backed by currently performing loans will continue to perform when required payments increase in the future (including balloon payments). An entity also should consider how the value of any collateral would affect the expected performance of the security. If the fair value of the collateral has declined, an entity should assess the effect of that decline on its ability to collect the balloon payment.

When an investor holds an impaired AFS debt security that it does not intend and will not more likely than not be required to sell before the recovery of the security’s amortized cost basis, the investor must determine whether it expects to recover the entire amortized cost basis (i.e., whether a credit loss exists).

Note that for securities within the scope of ASC 325-40, an investor considers, as of each reporting date, current information and events to determine whether there has been a favorable or adverse change in estimated cash flows compared with previous projections. On the basis of such considerations, the investor may adjust the accretable yield for these securities. This section does not address the requirements of this guidance.

An investor must perform a quantitative analysis when determining the amount of a credit loss, but it does not always need to perform such an analysis to conclude that a credit loss does not exist. That is, in certain circumstances, it may be sufficient for an investor to conclude that a credit loss does not exist by performing a qualitative analysis of whether it expects to recover the entire amortized cost basis of the debt security (i.e., whether a credit loss exists).

ASC 326-30-55-1 lists the following factors (not all-inclusive)4 for entities to consider in determining whether a credit loss exists:

The extent to which the fair value is less than the amortized cost basis
Adverse conditions specifically related to the security, an industry, or geographic area; for example, changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, changes in the financial condition of the underlying loan obligors. Examples of those changes include any of the following:
1. Changes in technology
2. The discontinuance of a segment of the business that may affect the future earnings potential of the issuer or underlying loan obligors of the security
3. Changes in the quality of the credit enhancement.
The payment structure of the debt security (for example, nontraditional loan terms as described in paragraphs 825-10-55-1 through 55-2) and the likelihood of the issuer being able to make payments that increase in the future
Failure of the issuer of the security to make scheduled interest or principal payments
Any changes to the rating of the security by a rating agency.

In addition, entities should consider the following factors addressed in ASC 326-30-55-2 through 55-4:

Changes in prepayment speeds.
Expected defaults.
Credit enhancements, including guarantees (and the financial condition of the guarantor) and the “value of any underlying collateral.”
Reports and forecasts by industry analysts.
Sector credit ratings.
The presence of “any subordinated interests [that] are capable of absorbing estimated losses on the loans underlying the security.”
Other relevant market data (e.g., applicable credit default swap spreads of the issuer, relevant market indexes, or changes in market interest rates after the acquisition of the security).

If, after performing a qualitative assessment, an entity is unable to obtain sufficient evidence that a credit loss does not exist for a particular debt security (i.e., that the entity will recover the entire amortized cost basis of the debt security), it will need to perform a detailed quantitative cash flow analysis for that security.

7.2.3.1 Changes to the Existing Impairment Model

While the guidance in ASU 2016-13 will not affect the determination of whether a credit loss exists on an AFS debt security (i.e., the comparison of the present value of cash flows expected to be collected with the security’s amortized cost basis), the ASU made some targeted amendments to the existing impairment model for AFS debt securities, as described in the sections below.

7.2.3.1.1 Use of an Allowance Approach

One of the FASB’s objectives in developing an expected credit losses model for an AFS debt security was to allow entities to recognize such losses on a more timely basis. The Board believed that the existing requirement for entities to recognize an OTTI as a direct write-down to the AFS debt security’s amortized cost basis, among other things, made them reluctant to recognize OTTIs. In other words, in the FASB’s view, since the model did not allow entities to reflect improvements in such a security’s credit quality, it caused delays in the recognition of OTTIs. Consequently, the Board decided to require entities to use an allowance when recognizing expected credit losses on an AFS debt security. This requirement is consistent with the requirement to use an allowance approach for all other financial assets that are within the scope of ASC 326-20. As stated in ASC 326-30-35-3, any changes in the allowance for expected credit losses on an AFS debt security would be recognized as an adjustment to the entity’s credit loss expense.

7.2.3.1.2 Credit Losses Limited by a Fair Value Floor

ASC 326-30-35-3 requires an entity to recognize as an allowance an AFS debt security’s expected credit losses, limited by the difference between the security’s fair value and its amortized cost basis. Paragraph BC83 of ASU 2016-13 states, in part:

[A]n entity could look to limit its credit loss exposure by selling a security if the total fair value loss was less than the credit loss measured for the security. That outcome could occur if a portion of the fair value attributable to non-credit-related factors offset the portion of fair value attributable to credit factors. Given the importance of fair value in the measurement of available-for-sale securities, the Board decided to incorporate a fair value floor in the amended model.

Example 7-2

Entity ABC holds a corporate bond that it classifies as an AFS debt security. On the reporting date, the security’s amortized cost is $1,000 and its fair value is $930. In assessing whether there is a credit loss on the security, ABC compares the present value of cash flows it expects to collect from the security with its amortized cost and determines that a credit loss of $100 is expected. However, in accordance with ASC 326-30-35-3, ABC must recognize only $70 as an allowance for credit losses because the security’s fair value is $930 on the reporting date. In other words, since ABC could limit its exposure to credit losses by selling the security at its fair value on the reporting date ($930), it should only recognize $70 ($1,000 – $930) as its allowance for expected credit losses.

7.2.3.1.3 Information to Consider When Estimating Credit Losses

ASC 326-30-55-1 carries forward much of the guidance in ASC 320-10-35-33F on the factors an entity considers when determining whether a credit loss exists. However, because ASU 2016-13 removes the distinction between whether an impairment is temporary or other than temporary, it also amends that guidance by removing an entity’s ability to consider:

The length of time in which fair value has been less than amortized cost.
Recoveries in the securities’ fair value after the balance sheet date.

Example 7-3

Entity X owns a corporate debt security (that does not have nontraditional terms) with a fair value of $90 and an amortized cost basis of $100. Entity X classifies the security as AFS and does not intend to sell it. Further, X concludes that it is not more likely than not that it will be required to sell the debt security before the recovery of the security’s amortized cost basis. To determine whether it will recover the security’s entire amortized cost basis and whether it has incurred a credit loss on the security, X considers, among other factors, (1) the fact that the corporate issuer was making, and is expected to continue to make, timely payments of principal and interest; (2) the relevant factors in ASC 326-30-55-2 through 55-4; and (3) other relevant market indicators.

On the basis of this qualitative assessment, X obtains sufficient evidence that it expects to recover the entire amortized cost basis of the corporate debt security and therefore concludes that a credit loss does not exist. In this circumstance, X did not need to perform a quantitative analysis to make such an assertion.

Connecting the Dots

Whether Changes in Prepayment Assumptions Alone Cause a Credit Loss in Asset-Backed AFS Debt Securities Outside the Scope of ASC 325-40 and PCD Accounting

Changes in prepayment speeds for the assets underlying an asset-backed security (e.g., a mortgage-backed security) often affect the present value of the cash flows expected to be collected from the security. For example, assume that an entity purchases a pass-through security that gives it the right to a pro rata share of the cash flows from an underlying pool of fixed-rate prepayable mortgage loans. If the security was purchased at a premium to par, the present value of the cash flows expected to be collected from the security will decrease when prepayments on the underlying mortgage loans increase. However, if the security was purchased at a discount to par, the present value of the cash flows expected to be collected will decrease when prepayments on the underlying mortgage loans decrease.

ASC 326-30-55-2 requires an investor to consider prepayment speeds, among other factors, when estimating the cash flows expected to be collected.

For AFS debt securities that are within the scope of ASC 325-40 and those that are PCD assets, entities are explicitly required to perform a discounted expected cash flow analysis in every period because of the expectation that more than an insignificant amount of the contractual cash flows will not be collected. This Connecting the Dots addresses only the accounting for asset-backed AFS debt securities that are not within the scope of ASC 325-40 or PCD accounting and for which prepayments on the assets underlying the asset-backed debt security are made at par, plus accrued and unpaid interest.

On the basis of informal discussions with the FASB staff after the issuance of FSP FAS 115-2 and FAS 124-2 that addressed the superseded OTTI guidance in ASC 320-10, an entity was allowed to choose one of two views, discussed below, as an accounting policy for an asset-backed AFS debt security that is not within the scope of ASC 325-40 or PCD accounting. We do not believe that the targeted changes to the impairment model for AFS debt securities affect this policy choice. The policy choice an entity elects should be consistently applied.

View A — Changes in Prepayment Assumptions Alone Could Cause a Credit Loss

According to this view, prepayment speeds affect the economic return to the investor in an asset-backed AFS debt security that is acquired at a premium or discount; therefore, an entity should recognize a credit loss when changes in prepayment speeds alone cause the present value of the cash flows expected to be collected to be less than the amortized cost basis of an impaired asset-backed AFS debt security. View A is consistent with the guidance in ASC 326-30-35-6 and ASC 326-30-55-2; accordingly, an entity should consider whether changes in prepayment assumptions alone cause the present value of the cash flows expected to be collected to be less than the amortized cost basis of the impaired asset-backed AFS debt security.

View B — Changes in Prepayment Assumptions Alone Would Not Cause a Credit Loss

The guidance in ASC 310-20-35-26 continues to apply to accounting for the impact of prepayments on the amortization or accretion of a discount or premium on an asset-backed AFS debt security. In addition, ASC 326-30-55-2 states, in part, that “[a]n entity should consider available information relevant to the collectibility of the security” (emphasis added). Therefore, according to this view, changes in prepayment assumptions alone do not necessarily affect the “collectibility” of cash flows due on the assets underlying an asset-backed AFS debt security.

An entity that adopts View B should, in the absence of a credit loss that occurs for other reasons, continue to apply its accounting policy election under ASC 310-20-35-26 to account for prepayments on an asset-backed debt security. If the entity determines that there is a credit loss for reasons other than mere changes in prepayment assumptions, it would generally be expected to consider anticipated prepayments in determining the cash flows expected to be collected (to calculate the amount of the credit loss). This treatment is consistent with the guidance in ASC 326-20-30-4 and ASC 326-30-35-7 and 35-8, which requires an entity to consider the amount and timing of cash flows in calculating an impairment loss.

Note that for an entity that adopts View B, there will generally not be an impairment on an agency mortgage-backed security (e.g., one that is guaranteed by Freddie Mac or Fannie Mae) in the absence of an intent to sell the security or a conclusion that it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis. That is, given the guarantee from the agency and the implicit support of the agencies by the U.S. government, there generally will not be a credit loss.

7.2.3.2 Variable-Rate Instruments

As originally issued, ASU 2016-13 stated that if a financial asset’s contractual interest rate varies on the basis of an independent factor, such as an index or rate, “[p]rojections of changes in the factor shall not be made for purposes of determining the effective interest rate or estimating expected future cash flows” (emphasis added). Since the issuance of the ASU, however, stakeholders have questioned whether it was inconsistent to prohibit an entity from projecting changes in the factor that leads to changes in the financial asset’s contractual interest rate while requiring the entity to consider projections when estimating expected cash flows.

As a result, the FASB clarified in ASU 2019-04 that an entity is permitted to consider projections of changes in the factor as long as the projections are the same as those used to estimate expected future cash flows.

Specifically, ASC 326-30-35-11 states:

If the security’s contractual interest rate varies based on subsequent changes in an independent factor, such as an index or rate, for example, the prime rate, the London Interbank Offered Rate (LIBOR), or the U.S. Treasury bill weekly average, that security’s effective interest rate (used to discount expected cash flows as described in paragraph 326-30-35-7) may be calculated based on the factor as it changes over the life of the security or is projected to change over the life of the security, or may be fixed at the rate in effect at the date an entity determines that the security has a credit loss as determined in accordance with paragraphs 326-30-35-1 through 35-2. The entity’s choice shall be applied consistently for all securities whose contractual interest rate varies based on subsequent changes in an independent factor. An entity is not required to project changes in the factor for purposes of estimating expected future cash flows. If the entity projects changes in the factor for the purposes of estimating expected future cash flows, it shall use the same projections in determining the effective interest rate used to discount those cash flows. In addition, if the entity projects changes in the factor for the purposes of estimating expected future cash flows, it shall adjust the effective interest rate used to discount expected cash flows to consider the timing (and changes in the timing) of expected cash flows resulting from expected prepayments in accordance with paragraph 326-30-35-7A. Subtopic 310-20 on receivables — nonrefundable fees and other costs provides guidance on the calculation of interest income for variable rate instruments.

Note that a change in cash flows due solely to a change in a variable interest rate on a plain-vanilla debt instrument does not result in a credit loss. Therefore, an entity would need to determine whether changes in estimated cash flows on a variable-rate AFS debt security should be considered a credit loss or are caused only by changes in expected contractual interest payments that resulted from changes in interest rates.

7.2.4 Subsequent Measurement

7.2.4.1 Accounting for Debt Securities After an Impairment

ASC 326-30

35-12 An entity shall reassess the credit losses each reporting period when there is an allowance for credit losses. An entity shall record subsequent changes in the allowance for credit losses on available-for-sale debt securities with a corresponding adjustment recorded in the credit loss expense on available-for-sale debt securities. An entity shall not reverse a previously recorded allowance for credit losses to an amount below zero.

35-13 An entity shall recognize writeoffs of available-for-sale debt securities in accordance with paragraph 326-20-35-8.

35-13A If for the purposes of identifying and measuring an impairment the applicable accrued interest is excluded from both the fair value and the amortized cost basis of the available-for-sale debt security, an entity may make an accounting policy election, at the major security-type level, to write off accrued interest receivables by reversing interest income or recognizing credit loss expense, or a combination of both. This accounting policy election shall be considered separately from the accounting policy election in paragraph 326-30-30-1B. An entity that elects this accounting policy shall meet the disclosure requirements in paragraph 326-30-50-3D. An entity may not analogize this guidance to components of amortized cost basis other than accrued interest.

An entity must continually assess its expectation of credit losses on an AFS debt security. If its expectation changes, the entity is required to recognize that change as an adjustment to the allowance for expected credit losses and an adjustment to credit loss expense. However, the allowance for credit losses cannot be reversed to an amount less than zero. In addition, the entity is required to assess whether the AFS debt security has become uncollectible. If so, the entity must apply the guidance in ASC 326-20-35-8 to write off the uncollectible portion of the security and the allowance for expected credit losses. For more information about write-offs, see Section 4.5.1.

7.2.4.2 Accounting for Debt Securities After a Write-Down

ASC 326-30

35-14 Once an individual debt security has been written down in accordance with paragraph 326-30-35-10, the previous amortized cost basis less writeoffs, including non-credit-related impairment reported in earnings, shall become the new amortized cost basis of the investment. That new amortized cost basis shall not be adjusted for subsequent recoveries in fair value.

35-15 For debt securities for which impairments were reported in earnings as a writeoff because of an intent to sell or a more-likely-than-not requirement to sell, the difference between the new amortized cost basis and the cash flows expected to be collected shall be accreted in accordance with existing applicable guidance as interest income. An entity shall continue to estimate the present value of cash flows expected to be collected over the life of the debt security. For debt securities accounted for in accordance with Subtopic 325-40, an entity should look to that Subtopic to account for changes in cash flows expected to be collected. For all other debt securities, if upon subsequent evaluation, there is a significant increase in the cash flows expected to be collected or if actual cash flows are significantly greater than cash flows previously expected, those changes shall be accounted for as a prospective adjustment to the yield. Subsequent increases in the fair value of available-for-sale securities after the write-down shall be included in other comprehensive income. (This Section does not address when a holder of a debt security would place a debt security on nonaccrual status or how to subsequently report income on a nonaccrual debt security.)

As is the case under existing U.S. GAAP, and as discussed in Section 7.2.2, if an entity intends to sell an AFS debt security or it is more likely than not that the entity will be required to sell the security before recovery of the security’s amortized cost basis, the entity must write down the amortized cost basis to its fair value, write off any existing allowance for credit losses, and recognize in earnings any incremental impairment.

After such a write-down, the entity must consider the security’s fair value to be its new amortized cost basis in accordance with ASC 326-30-35-14 and 35-15. Any subsequent decreases in expected cash flows are recognized as additional impairments, while increases in expected cash flows are recognized as a prospective adjustment to the security’s accretable yield.

7.2.5 PCD Considerations Related to AFS Debt Securities

ASC 326-30

30-2 A purchased debt security classified as available-for-sale shall be considered to be a purchased financial asset with credit deterioration when the indicators of a credit loss in paragraph 326-30-55-1 have been met. The allowance for credit losses for purchased financial assets with credit deterioration shall be measured at the individual security level in accordance with paragraphs 326-30-35-3 through 35-10. The amortized cost basis for purchased financial assets with credit deterioration shall be considered to be the purchase price plus any allowance for credit losses. See paragraphs 326-30-55-1 through 55-7 for implementation guidance.

30-3 Estimated credit losses shall be discounted at the rate that equates the present value of the purchaser’s estimate of the security’s future cash flows with the purchase price of the asset.

30-4 An entity shall record the holding gain or loss through other comprehensive income, net of applicable taxes.

35-16 An entity shall measure changes in the allowance for credit losses on a purchased financial asset with credit deterioration in accordance with paragraph 326-30-35-6. The entity shall report changes in the allowance for credit losses in net income as credit loss expense (or reversal of credit loss expense) in each reporting period.

As discussed at the beginning of Chapter 6, upon acquiring a PCD asset, an entity will recognize its allowance for expected credit losses as an adjustment that increases the asset’s amortized cost basis (the “gross-up” approach) rather than as an immediate credit loss expense in the income statement. After initially applying the gross-up approach, the entity will recognize as a credit loss expense (or reversal of credit loss expense) any changes in the allowance. To determine whether an AFS security is a PCD asset, an entity must consider the factors in ASC 326-30-55-1, which are the same factors that an investor uses to identify whether a credit loss exists on an AFS debt security. ASC 326-30-55-1 states:

The extent to which the fair value is less than the amortized cost basis
Adverse conditions specifically related to the security, an industry, or geographic area; for example, changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, changes in the financial condition of the underlying loan obligors. Examples of those changes include any of the following:
1. Changes in technology
2. The discontinuance of a segment of the business that may affect the future earnings potential of the issuer or underlying loan obligors of the security
3. Changes in the quality of the credit enhancement.
The payment structure of the debt security (for example, nontraditional loan terms as described in paragraphs 825-10-55-1 through 55-2) and the likelihood of the issuer being able to make payments that increase in the future
Failure of the issuer of the security to make scheduled interest or principal payments
Any changes to the rating of the security by a rating agency.

An entity would not use the same criteria for AFS debt securities as it does for HTM debt securities when assessing whether it is required to apply PCD accounting to those securities.

As described above, for an AFS debt security, an entity would consider the factors in ASC 326-30-55-1 to determine whether a credit loss exists on the acquisition date. If so, the investor would use the gross-up approach described in Section 6.3.2 to initially account for the PCD AFS debt security. By contrast, when evaluating whether to apply the PCD model to an HTM debt security, an entity must consider whether there has been a more-than-insignificant deterioration in the security’s credit quality since its origination.

In addition, the unit of account differs depending on whether the entity is evaluating the applicability of the PCD model to an HTM or AFS debt security. While an entity can evaluate the applicability of the PCD model to HTM debt securities on a collective basis if the securities share similar risk characteristics (see Section 6.2.6), it is not permitted to determine whether PCD accounting applies to AFS debt securities on a collective or pool basis. Rather, it must make that determination on the basis of each individual AFS debt security.

Changing Lanes

FASB Proposed ASU on Purchased Financial Assets

On June 27, 2023, the FASB issued a proposed ASU that would broaden the population of financial assets that are within the scope of the gross-up approach currently applied to PCD assets under ASC 326. While the scope of assets subject to the gross-up approach would generally be expanded to include more acquired financial assets, the gross-up approach would no longer apply to AFS debt securities. See Section 10.2.4 for further discussion of the proposed ASU.

7.2.5.1 Differences Between ASC 325-40 and PCD Accounting for BIs Classified as AFS Debt Securities

The sections below summarize how the guidance in ASC 325-40 on non-PCD BIs differs from the PCD models for BIs classified as AFS debt securities.

7.2.5.1.1 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 upon 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.

7.2.5.1.2 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.

If there has not been an adverse change in the cash flows expected to be collected but the BI’s fair value is significantly below its amortized cost basis, the entity is required to assess whether it intends to sell the BI or it is more likely than not that it will be required to sell the interest before recovery of the entire amortized cost basis. If so, the entity would be required to write down the BI to its fair value in accordance with ASC 326-30-35-10.

7.2.5.1.3 Initial Accounting Under the PCD Model in ASC 326-30

Under the PCD accounting model in ASC 326-30 for AFS debt securities, entities are required to gross up the cost basis of a PCD asset by the estimated credit losses as of the acquisition date 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).

7.2.5.1.4 Subsequent Accounting Under the PCD Model in ASC 326-30

For a PCD asset within the scope of ASC 325-40 that is classified as an AFS debt security, 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 the accounting under the normal ASC 325-40 model, as amended by ASU 2016-13). However, the allowance is limited to the difference between the AFS debt security’s fair value and its amortized cost. If any adverse change in cash flows cannot fully be reflected in the allowance because of the “fair value floor,” prospective yield should be adjusted downward to incorporate the amount of the adverse change in cash flows that was not reflected in the allowance. In that case, prospective interest income should be recognized at the yield implied by the fair value of the beneficial interest. Favorable changes in expected cash flows would first be recognized as a decrease to the allowance for credit losses (recognized currently in earnings). Such changes would be recognized as a prospective yield adjustment only when the allowance for credit losses is reduced to zero. A change in expected cash flows that is attributable solely to a change in a variable interest rate on a plain-vanilla debt instrument does not result in a credit loss and would be accounted for as a prospective yield adjustment.

7.2.6 Accounting for Changes in Foreign Exchange Rates for Foreign-Currency-Denominated AFS Debt Securities

When determining whether an impairment exists on an AFS debt security that is denominated in a foreign currency, an entity compares the security’s fair value (measured in the entity’s functional currency at the current exchange rate) with its amortized cost basis (measured at the historical exchange rate). If the fair value of the security is below its amortized cost, the security is impaired. Before adopting ASU 2016-13, an entity that determines an AFS debt security to be other-than-temporarily impaired would recognize in earnings an impairment loss equal to the entire difference between the security’s fair value and its cost basis.

ASC 326-30-35-10 is consistent with this guidance. Specifically, this paragraph states, in part, that “[i]f an entity intends to sell the debt security (that is, it has decided to sell the security), or more likely than not will be required to sell the security before recovery of its amortized cost basis, any allowance for credit losses shall be written off and the amortized cost basis shall be written down to the debt security’s fair value at the reporting date with any incremental impairment reported in earnings.” Accordingly, under ASU 2016-13, an entity would continue to recognize in earnings the entire change in the fair value of an AFS debt security if (1) it intends to sell the impaired security or (2) it is more likely than not that it will be required to sell the impaired security before recovery.

In addition, ASC 320-10-35-36 (as amended by ASU 2016-13) states, in part, that “[t]he change in the fair value of foreign-currency-denominated available-for-sale debt securities, excluding the amount recorded in the allowance for credit losses, shall be reported in other comprehensive income.” As a result, if the entity does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery of its amortized cost basis, the entity would recognize in OCI the change in the security’s fair value related to the changes in foreign exchange rates.

Connecting the Dots

Recognizing Unrealized Losses in Earnings

In light of the amendments made by ASU 2016-13, stakeholders have questioned when unrealized losses related to changes in foreign exchange rates on an AFS debt security should be recognized in earnings and whether the guidance will delay loss recognition. Consequently, at the TRG’s November 2018 meeting, the FASB staff confirmed that unrealized losses related to foreign exchange rates should be reported in OCI and recognized in earnings “(a) at the maturity of the security, (b) upon the sale of the security, (c) when an entity intends to sell, or (d) when an entity is more likely than not required to sell the security before recovery of its amortized cost basis.”5 In addition, the staff said that the concern that the amendments made by ASU 2016-13 will result in delayed loss recognition “is beyond the scope of the Credit Losses TRG because the topic relates to reporting changes in fair value related to foreign exchange rates.”

We acknowledge that there is diversity in how an entity may translate its credit loss expense to reflect changes in the spot rate. For example, an entity may translate its credit loss expense at the end of the reporting period by using the spot rate that existed when the asset was acquired or the spot rate that exists at the end of the current reporting period. We believe that either approach is acceptable.

The example below illustrates the accounting for an impairment of a foreign-currency-denominated AFS debt security after adoption of ASU 2016-13. In this example, the impairment is calculated on the basis of the spot rate that existed as of the date of acquisition of the security.

Example 7-4

Impairment of a Foreign-Currency-Denominated AFS Debt Security

Investor Co, a U.S. registrant whose functional currency is the U.S. dollar, holds an investment in an AFS debt security that is denominated in British pound sterling (£). On December 31, 20X2, Investor Co’s balance sheet date, the fair value of the debt security is £675,000 and its amortized cost is £900,000. Furthermore, the present value of the expected cash flows to be collected is £650,000. Assume that the exchange rates in effect on December 31, 20X2, and the date on which Investor Co acquired the investment are £1 = $1.2 and £1 = $1.5, respectively.

After determining that the security’s fair value is less than its amortized cost, in accordance with ASC 326-30, Investor Co concludes that an impairment loss exists. The table below summarizes the related computation.

Assume that Investor Co reaches the following conclusions:

It does not intend to sell the debt security.
It is not more likely than not that it will be required to sell the debt security before recovery of the security’s amortized cost.

Therefore, Investor Co concludes that the impairment loss should be recognized, limited by the difference between fair value and amortized cost, with changes in foreign exchange rates recognized in OCI. Note that Investor Co will translate its credit loss expense at the end of the reporting period by using the spot rate that existed as of the acquisition date of the security. In such circumstances, Investor Co would record the following journal entry to recognize the impairment loss:

7.2.7 High-Level Comparison of Credit Loss Models for HTM and AFS Debt Securities

The table below compares the credit loss model for HTM securities with that for AFS securities.

	HTM Debt Security (ASC 326-20)	AFS Debt Security (ASC 326-30)
Unit of account	Pool-level, if similar risk characteristics exist; otherwise, at the individual debt security level	Individual debt security level
Measurement of credit losses	The amount needed to reduce the amortized cost basis to reflect the net amount expected to be collected	The excess of the amortized cost basis over the present value of the best estimate of expected future cash flows
Recognition threshold	Recognize a credit loss upon acquisition of the security	Recognize a credit loss when amortized cost exceeds fair value
Recognition of credit loss	Apply an allowance approach	Apply an allowance approach
Write-offs	Write off security when it is deemed uncollectible	Write off security when it is deemed uncollectible

Footnotes

It is assumed that an independent investment adviser has discretion to sell debt securities without management approval. To the extent that agreements with independent investment advisers give management discretion to hold or sell at the individual security level, management’s intent will also be relevant. These agreements are often tailored to meet the needs of management as well as any regulatory requirements, and an entity must thoroughly understand the agreements’ terms and conditions to determine whose intent is relevant.

This may be the case for more complex ARSs issued by trusts in which the underlying collateral of the trust is made up of asset-backed securities, including securities backed by subprime mortgage loans. Given the complexity of many ARSs and the credit profile and other risks associated with the underlying collateral, the potential exists for a failed auction.

ASC 326-30-35-6 states that when “assessing whether a credit loss exists, an entity shall compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security.”

The factors are not necessarily relevant to every credit loss determination and may be helpful in attributing an impairment to something other than credit losses. Note that one or more of these factors may be more relevant to the analysis than others, and an entity must consider all available information about past events, current conditions, and reasonable and supportable forecasts to conclude that a credit loss related to a debt security does not exist. An entity must evaluate all facts and circumstances associated with the debt security and use significant judgment in performing such an assessment.

See TRG Memo 14.