Accounting for Credit Losses (ASC 326)
Along with the new revenue and lease standards, the new standard for credit losses represented a significant change to current accounting. As a result of the financial crisis of 2008, the delayed recognition of credit losses under the incurred loss model was deeply scrutinized. The FASB issued ASU 2016-13 (“ASU 2016-13”), Financial Instruments — Credit Losses (Topic 326) to address stakeholder concerns around the impairment of financial instruments. The primary change was that ASU 2016-13 introduced the current expected credit loss (“CECL”) model, which is driven by expected losses rather than incurred losses. The objectives of ASU 2016-13 were to simplify the credit impairment models that entities use and allow timely recognition of credit losses.
Although the new standard has a greater impact on financial institutions, most companies have financial instruments (e.g., trade receivables, lease receivables, contract assets, held-to-maturity (“HTM”) debt securities, financial guarantees, and loan commitments) that are affected.
Scope
ASC 326 applies to all entities and either introduced new accounting models or amended current accounting models for the following:
- Financial assets measured at amortized cost as well as certain off-balance-sheet credit exposures- CECL impairment model (ASC 326-20)
- Available-for-sale (“AFS”) debt securities (ASC 326-30)
- Purchased financial assets with evidence of credit deterioration (“PCD assets”)
- Beneficial interests in securitized financial assets
The FASB initially set out to establish a single model for measuring expected credit losses for financial assets that have contractual cash flows. However, the FASB determined that AFS debt securities require a separate credit loss model. Therefore, the CECL model does not apply to AFS debt securities, and they will continue to be assessed for impairment under ASC 320.
All financial assets measured at fair value through net income are excluded from ASC 326.
CECL Impairment Model (ASC 326-20)
The CECL model applies to: (1) financial assets measured at amortized cost, and (2) certain off-balance sheet credit exposures. These include loans, HTM debt securities, financing receivables, trade receivables, loan commitments (including lines of credit), financial guarantees, net investments in leases, as well as reinsurance receivables.
Unlike the incurred loss models previously, the CECL model does not require a threshold for recognizing an impairment. Under the CECL model, the allowance for credit losses is measured and recorded upon the initial recognition of a financial asset, regardless of whether it is originated or purchased. Credit impairment is recognized as an allowance (contra-asset), with the offset recognized as credit loss expense in earnings. Since an allowance is recorded at purchase and a credit loss expense is recognized in net income, companies may experience income statement volatility.
The CECL model requires entities to estimate the credit losses expected over the life of the exposure. The following summarizes the key considerations of the CECL model.
Key considerations | Accounting under ASC 326-20 |
Recognition threshold | No triggering event required. An allowance is recorded whenever lifetime credit losses are expected, which is virtually all cases.
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Unit of accounting | Financial instruments with similar risk characteristics are required to be grouped together (“pooled approach”) when estimating the allowance. Risk characteristics include past due status, credit ratings, collateral type, the borrower’s FICO score, term, industry of the borrower, subordination, and geographical location of the borrower, etc. |
Contractual Term | Contractual life should consider expected prepayments but not expected extensions, renewals and modifications unless the lender has no control over whether a contractual extension option will be exercised by the borrower. The longer the contractual term, the larger the allowance for credit losses. |
Amortized cost | The guidance requires that the allowance for credit losses be based on the financial asset’s amortized cost. Amortized cost includes discounts, premiums,deferred origination costs, as well as foreign exchange adjustments and fair value hedge accounting adjustments. However, the standard provides limited guidance regarding how companies should incorporate premiums/discounts into the allowance estimate and judgment will be involved. |
Reflect risk of loss | Generally, the standard requires entities to estimate expected credit losses for a financial asset, regardless if the risk of loss is remote. Assets that historically had a zero allowance will likely require an allowance under CECL.
In rare cases, the CECL model provides a practical expedient when an expectation of nonpayment of the amortized cost basis is zero as the amount of the expected loss is zero. |
Consider all available information | Historical loss data should be used as the starting point for determining the allowance for credit losses. This data should then be adjusted for asset-specific considerations, current information, current economic conditions and reasonable and supportable forecasts. |
Measurement methods | The standard does not require a specific method to estimate credit losses. Therefore significant judgment is required. The following are acceptable measurement approaches that a company may use to estimate the expected credit losses:
In assessing the appropriateness of using any of these methods, the company should consider whether the model faithfully reflects the net amount it expects to collect. Companies may consider common allowance models used in the industry for similar assets. The availability of data required by the model is a key consideration. |
Financial assets secured by collateral | If a financial asset is collateralized, the CECL model requires the company to consider the effects of the collateral arrangement, including the nature of the collateral, potential future changes in the collateral values and historical loss information for similarly collateralized financial assets. |
Loan commitments | The CECL model will apply to the funded portion of loan commitments.
If the unfunded portion is not unconditionally cancelable by the lender, the estimated credit losses are estimated considering the probability that funding will occur, and the related expected credit losses under the CECL model if funded. The estimate of credit loss for an unfunded commitment is recorded as a liability.
The unfunded portion that is unconditionally cancelable by the lender does not require an estimate of expected credit losses. |
Credit enhancements | Credit enhancements, such as guarantees, should also be taken into consideration when estimating the expected credit losses if they are embedded in the financial instrument. Determining whether a credit enhancement contract is freestanding or is embedded in another financial instrument requires judgment and consideration of all facts and circumstances. |
Subsequent accounting | The allowance is required to be assessed each period. Changes to the estimate (both negative and positive) will be recognized as an adjustment to the allowance, with the offset in earnings. |
Write-offs and recoveries | Companies are required to write-off financial assets in the period they are deemed uncollectible, and all means of recovering the loan balance have been exhausted. Recoveries are recorded when received. |
AFS Debt Security Impairment Model
The FASB decided that the CECL model should not apply to AFS debt securities because they are carried at fair value. Instead, the FASB made targeted amendments to the existing AFS debt security impairment model.
Similar to existing GAAP, the impairment model for AFS debt securities requires an allowance when the fair value is below the amortized cost of the asset. However, a key change is the length of time the fair value of an AFS debt security is below the amortized cost is no longer considered when determining whether a credit loss exists. In addition, recoveries or subsequent declines in fair value after the balance sheet date should not be considered in determining the estimate of expected credit losses. As a result of these changes, the AFS impairment model is no longer based on an impairment being “other-than-temporary.”
ASC 326-30 requires an investor to determine whether a decline in the fair value below the AFS debt security’s amortized cost basis is due to credit-related factors or noncredit-related factors. The key steps under the impairment model for AFS debt securities are as follows:
Key steps | Accounting |
Step 1: Is the AFS debt security’s fair value less than its amortized cost? | If the AFS debt security’s fair value is more than the amortized cost, then there is no impairment. The company would continue to recognize the unrealized gain in OCI.
If the AFS debt security’s fair value is less than the amortized cost, then proceed to step 2. |
Step 2: Does the company intend to sell the AFS debt security or will it more-likely-than-not be required to sell before recovery of its amortized cost? | If either of these are met, the company should record the entire impairment loss in earnings. The AFS debt security’s amortized cost basis is written down to its fair value. Subsequently, the difference between the amortized cost basis and the cash flows expected to be collected is accreted as interest income.
If neither of these are met, proceed to step 3. |
Step 3: Is a portion of the unrealized loss a result of a credit loss? | If “yes,” an allowance is required to be recognized for credit-related losses. The portion of a decline in fair value that is credit related is determined by comparing the present value of expected cash flows with the amortized cost basis. The company should recognize an allowance with the offset in earnings, limited to the difference between fair value and the amortized cost. Any portion that is not credit-related should be reported in OCI.
If “no,” the total unrealized loss is recognized in OCI. |
After recognizing a credit loss through an allowance, the company should continue to reassess the cash flows it expects to collect at each subsequent measurement date. If the measurement of credit losses increases or decreases, the company should adjust the allowance, with corresponding gains or losses recorded in net income. However, the allowance should never be reversed to a negative amount and should be limited by the amount that amortized cost exceeds fair value.
When all or a portion of an AFS debt security is deemed uncollectible, the company should write off the uncollectible amortized cost amount with a corresponding reduction to the allowance for credit losses. Companies may make an accounting policy election to reverse accrued interest deemed uncollectible through the provision for credit losses or as a reversal of interest income.
Purchased Financial Assets with Evidence of Credit Deterioration
ASC 326-20 replaced the concept of purchased credit impaired loans (PCI assets) with the concept of purchased financial assets with credit deterioration (PCD assets). PCD assets are assets that are both 1) purchased and 2) credit deteriorated (have experienced a more-than-insignificant deterioration in credit quality since origination). Beneficial interests may be considered a PCD asset or subject to the PCD asset model if the difference between their expected cash flows and contractual cash flows at the date of initial recognition is significantly different.
The standard provides a special Day 1 accounting model for PCD assets. The key considerations under the PCD impairment model are as follows:
Key Considerations | Accounting |
Unit of accounting | Individual instrument for AFS debt securities
Pooled level or individual instrument for assets subject to the CECL model |
Initial recognition | Establish an allowance for credit losses at inception. The company should recognize the allowance as an adjustment to the amortized cost basis at acquisition (i.e., gross-up the asset balance) and not through earnings. Both the recorded asset balance and the allowance are increased by the amount of the expected credit losses at acquisition.
If a discounted cash flow method is used, the allowance is calculated by discounting expected credit losses using the effective interest rate, which is the discount rate that equates the present value of the asset’s expected cash flows to the purchase price.
If a non-discounted cash flow method is used, the initial estimate of expected credit losses is based on the unpaid principal balance. |
Subsequent recognition | After initial recognition, treat PCD assets like all other assets and apply one of the following impairment models: • ASC 326-20 (CECL model) for instruments measured at amortized cost • ASC 326-30 (AFS model) for debt securities classified as AFS • ASC 325-40 model for certain beneficial interests
Under the PCD asset model, only the non-credit related discount is accreted into interest income.
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Certain Beneficial Interests in securitized financial assets
Beneficial interests are rights to receive specified cash inflows. The guidance in ASC 325-40, Beneficial Interests in Securitized Financial Assets (“ASC 325-40”) continues to apply to certain beneficial interests that are (1) not of high credit quality or (2) expose the holder to the risk that they will not recover substantially all of the initial investment. However, the new credit loss standard updates the accounting guidance in ASC 325-40. Under the new credit loss standard, the appropriate accounting treatment for beneficial interests depends on whether they are classified as HTM or AFS and whether they are PCD beneficial interests. Upon initial recognition, beneficial interests will apply the PCD asset guidance if either of the following conditions are met:
- the beneficial interest is considered a PCD asset, or
- the contractual cash flows and expected cash flows are significantly different at the date of recognition.
Key Considerations | Accounting |
Initial recognition- not PCD | Recognize at fair value (purchase price). No allowance for credit loss is recognized at purchase date.
At acquisition, the accretable yield is measured as the excess of all cash flows expected to be collected due to the beneficial interest over the fair value.
If there is a change in expected cash flows from the estimate of expected cash flows previously projected, recognize an allowance for credit losses through earnings determined using the ASC 326-20 (CECL) model for HTM securities or the ASC 326-30 model for AFS debt securities. |
Initial recognition- PCD | Establish an allowance for estimated credit losses at inception and add it to the purchase price or relative fair value (“gross up”) to arrive at the amortized cost of the instrument. Under the gross-up method, the initial estimate of expected credit losses is recognized as an allowance and there is no Day 1 credit loss expense.
At acquisition, the accretable yield is measured as the excess of contractual cash flows due to the beneficial interest over the amortized cost basis. |
Subsequent recognition | Recognize all changes in expected cash flows due to credit as an adjustment to the allowance with the offset in earnings.
If expectations of cash flows result in a reduction of the allowance to zero, prospectively adjust the effective interest rate for any additional improvements in expected cash flows.
The accretable yield determined at acquisition is recognized as interest income over the life of the beneficial interest. |