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Financial instruments — Impairment

Background

In late 2012, the FASB issued a proposed Accounting Standards Update (ASU) to obtain feedback on its current expected credit loss (CECL) model. Under the CECL model, an entity would recognize as an allowance its estimate of the contractual cash flows not expected to be collected. The FASB believes that the CECL model will result in more timely recognition of credit losses and will reduce complexity of U.S. GAAP by decreasing the number of different credit impairment models for debt instruments.1

Under the existing impairment models (often referred to as incurred loss models), an impairment allowance is recognized only after a loss event (e.g., default) has occurred or its occurrence is probable. In assessing whether to recognize an impairment allowance, an entity may only consider current conditions and past events; it may not consider forward-looking information.

The CECL model

Scope

The CECL model2 would apply to most3 debt instruments (other than those measured at fair value through net income (FVTNI)), trade receivables, lease receivables, reinsurance receivables that result from insurance transactions, financial guarantee contracts, and loan commitments. However, available-for-sale (AFS) debt securities would be excluded from the model’s scope and would continue to be assessed for impairment under ASC 320.

Recognition of expected credit losses

Unlike the incurred loss models in existing U.S. GAAP, the CECL model does not specify a threshold for the recognition of an impairment allowance. Rather, an entity would recognize an impairment allowance equal to the current estimate of expected credit losses (i.e., all contractual cash flows that the entity does not expect to collect) for financial assets as of the end of the reporting period. Credit impairment would be recognized as an allowance — or contra-asset — rather than as a direct write-down of the amortized cost basis of a financial asset. An entity would, however, write off the carrying amount of a financial asset when it is deemed uncollectible, which is consistent with existing U.S. GAAP.

Thinking it through

Because the CECL model does not have a minimum threshold for recognition of impairment losses, entities will need to measure expected credit losses on assets that have a low risk of loss (e.g., investment grade held-to-maturity (HTM) debt securities). However, the FASB tentatively decided at its September 17, 2013, meeting that an “entity would not be required to recognize a loss on a financial asset in which the risk of nonpayment is greater than zero [but] the amount of loss would be zero.” U.S. Treasury securities and certain highly rated debt securities may be assets the FASB contemplated when it tentatively decided to allow an entity to recognize zero credit losses on an asset, but the Board decided not to specify the exact types of assets. Nevertheless, the requirement to measure expected credit losses on financial assets whose risk of loss is low is likely to result in additional costs and complexity.

Measurement of expected credit losses

An entity’s estimate of expected credit losses represents all contractual cash flows it does not expect to collect over the contractual life of the financial asset. When determining the contractual life of a financial asset, the entity would consider expected prepayments but would not be allowed to consider expected extensions unless it “reasonably expects” that it will execute a troubled debt restructuring.

The entity would consider all available relevant information in making the estimate, including information about past events, current conditions, and reasonable and supportable forecasts and their implications for expected credit losses. The entity is not required to forecast conditions over the contractual life of the asset. Rather, for the period beyond the period that the entity can make reasonable and supportable forecasts, the entity would revert to an unadjusted historical credit loss experience.

Thinking it through

Measuring expected credit losses will most likely be a significant challenge for financial institutions. As a result of moving to an expected loss model, such entities could incur one-time and recurring costs when estimating expected credit losses, some of which may be related to system changes and data collection. While the costs associated with implementing the CECL model will vary by entity, nearly all entities will incur some costs when using forward- looking information to estimate expected credit losses over the contractual life of an asset.

Unit of account

The CECL model would not prescribe a unit of account (e.g., an individual asset or a group of financial assets) in the measurement of expected credit losses. However, an entity would be required to evaluate financial assets that are within the scope of the model on a collective (i.e., pool) basis when similar risk characteristics are shared. If a financial asset does not share similar risk characteristics with the entity’s other financial assets, the entity would evaluate the financial asset individually. If the financial asset is individually evaluated for expected credit losses, the entity would not be allowed to ignore available external information such as credit ratings and other credit loss statistics.

Thinking it through

The FASB’s tentative decisions would require an entity to collectively measure expected credit losses on financial assets that share similar risk characteristics (including HTM securities). While the concept of pooling and collective evaluation currently exists in U.S. GAAP for certain loans, the FASB has not specifically defined “similar risk characteristics.” As a result, it remains to be seen whether the FASB expects an aggregation based on “similar risk characteristics” to be consistent with the existing practice of pooling purchased credit-impaired (PCI) assets on the basis of “common risk characteristics.” Entities may need to make systems and process changes to capture loss data at more granular levels than they do now, depending on the expectations of market participants such as standard setters, regulators, and auditors.

Practical expedients for measuring expected credit losses

The FASB tentatively decided to permit the use of practical expedients in measuring expected credit losses for two types of financial assets:

  1. Collateral-dependent financial assets — In a manner consistent with existing U.S. GAAP, an entity would be allowed to measure its estimate of expected credit losses for collateral-dependent financial assets as the difference between the financial asset’s amortized cost and the collateral’s fair value.
  2. Financial assets for which the borrower must continually adjust the amount of securing collateral (e.g., certain repurchase agreements and securities lending arrangements) — The estimate of expected credit losses would be measured consistently with other financial assets within the scope of the CECL model but would be limited to the difference between the amortized cost basis of the asset and the collateral’s fair value (adjusted for selling costs, when applicable).

AFS debt securities

Under the proposed ASU, the CECL model would have applied to AFS debt securities. However, in August 2014, the FASB tentatively decided that AFS debt securities would not be included within the scope of the CECL model. Instead, the impairment of AFS debt securities would continue to be accounted for under ASC 320. However, the FASB tentatively decided to revise ASC 320 by:

  • Requiring an entity to use an allowance approach (vs. permanently writing down the security’s cost basis).
  • Removing the requirement that an entity must consider the length of time fair value has been less than amortized cost when assessing whether a security is other-than-temporarily impaired.
  • Removing the requirement that an entity must consider recoveries in fair value after the balance sheet date when assessing whether a credit loss exists.

Thinking it through

The Board did not revise (1) step 1 of the existing other-than-temporary impairment model (i.e., an “investment is impaired if the fair value of the investment is less than its cost”) and (2) the requirement under ASC 320 that entities recognize the impairment amount only related to credit in net income and the noncredit impairment amount in OCI. However, the FASB did tentatively decide that entities would use an allowance approach when recognizing credit losses (as opposed to a permanent write down of the AFS security’s cost basis). As a result, in both of the following instances, an entity would reverse credit losses through current-period earnings on an AFS debt security:

  1. If the fair value of the debt security exceeds its amortized cost in a period after a credit loss had been recognized through earnings (because fair value was less than amortized cost), the entity would reverse the entire credit loss previously recognized and recognize a corresponding adjustment to its allowance for credit losses.
  2. If the fair value of the debt security does not exceed its amortized cost in a period after a credit loss had been recognized through earnings (because fair value was less than amortized cost) but the credit quality of the debt security improves in the current period, the entity would reverse the credit loss previously recognized only in an amount that would reflect the improved credit quality of the debt security.

The FASB’s tentative decisions to revise the impairment model in ASC 320 could result in earlier recognition of impairment.

PCI assets

For PCI assets, as defined4 in the proposed ASU, an entity would measure expected credit losses consistently with how it measures expected credit losses for originated and purchased non-credit-impaired assets. Upon acquiring a PCI asset, the entity would recognize as its allowance for expected credit losses the amount of contractual cash flows not expected to be collected. After initial recognition of the PCI asset and its related allowance, a reporting entity would continue to apply the CECL model to the asset. Consequently, any subsequent changes to its estimate of expected credit losses — whether unfavorable or favorable — would be recorded as impairment expense (or reduction of expense) during the period of change.

Thinking it through

Under the current accounting for PCI assets, an entity recognizes unfavorable changes in cash flows as an immediate credit impairment but treats favorable changes in cash flows that are in excess of the allowance as prospective yield adjustments. The CECL model’s proposed approach to PCI assets eliminates this asymmetrical treatment in cash flow changes. In addition, under the CECL model, the discount embedded in the purchase price attributable to expected credit losses as of the date of acquisition must not be recognized as interest income, which is consistent with current practice.

An acquired asset is currently considered credit-impaired when it is probable that the investor would be unable to collect all contractual cash flows due to deterioration in the asset’s credit quality since origination. Under the FASB’s tentative approach, a PCI asset is an acquired asset that has experienced significant deterioration in credit quality since origination. Consequently, entities will most likely need to use more judgment than they do under current U.S. GAAP in determining whether an acquired asset has experienced significant credit deterioration.

Certain beneficial interests within the scope of ASC 325-40

The FASB tentatively decided at its June 11, 2014, meeting that an impairment allowance for “purchased or retained beneficial interests for which there is a significant difference between contractual and expected cash flows” should be measured in the same manner as PCI assets under the CECL model. Therefore, at initial recognition, a beneficial interest holder would present an impairment allowance equal to the estimate of expected credit losses (i.e., the estimate of contractual cash flows not expected to be collected). In addition, the FASB indicated that “changes in expected cash flows due to factors other than credit would be accreted into interest income over the life of the asset (that is, the difference between contractual and expected cash flows attributable to credit would never be included in interest income).”5

Thinking it through

Under the CECL model, an entity would be required to determine the contractual cash flows of beneficial interests in securitized transactions. However, there may be certain structures in which the beneficial interests do not have contractual cash flows (e.g., when a beneficial interest holder receives only residual cash flows of a securitization structure). In these situations, an entity may need to use a proxy for the contractual cash flows of the beneficial interest (e.g., the gross contractual cash flows of the underlying debt instrument).

Disclosures

Many of the disclosures required under the proposal are similar to those already required under U.S. GAAP as a result of ASU 2010-20. Accordingly, entities would be required to disclose information related to:

  • Credit quality.6
  • Allowance for expected credit losses.
  • Policy for determining write-offs.
  • Past-due status.
  • PCI assets.
  • Collateralized financial assets.

In addition, the FASB affirmed the provision in the proposed ASU that would require an entity to provide a rollforward of its allowance for expected credit losses for assets measured at amortized cost and AFS debt securities. However, in a change from the proposed ASU, an entity would not be required to provide rollforward disclosures of the amortized cost balances of its debt instruments. Instead, an entity would be required to disclose credit-quality indicators for each asset class, disaggregated by vintage, for a period not to exceed five years. For more information on the proposed disclosure requirements, see Deloitte’s March 13, 2015, Heads Up.

Other topics addressed

The Board also made tentative decisions on the following topics:

  • Write-offs.
  • Modified financial assets.
  • Loan commitments.
  • Transition.

For more information regarding these tentative decisions, see Deloitte’s March 13, 2015, Heads Up.

Next steps

An effective date for the final guidance has not yet been proposed but will be determined at a future FASB meeting. The FASB directed its staff to prepare a draft of the final ASU to stakeholders (including financial statement users, preparers, and auditors) to obtain feedback on the proposed amendments (“fatal flaw review”).

Thinking it through

Measuring expected credit losses will most likely be a significant challenge for financial institutions. As a result of moving to an expected loss model, such entities could incur one-time and recurring costs when estimating expected credit losses, some of which may be related to system changes and data collection. While the costs associated with implementing the CECL model will vary by entity, nearly all entities will incur some costs when using forward- looking information to estimate expected credit losses over the contractual life of an asset.

Today, financial institutions use various methods to estimate credit losses. Some apply simple approaches that take into account average historical loss experience over a fixed time horizon. Others use more sophisticated “migration” analyses and forecast modeling techniques. Under the CECL model, for any approach that is based solely on historical loss experience, an entity would need to consider the effect of forward-looking information over the remaining contractual life of a financial asset. In addition, the FASB tentatively decided at its August 13, 2014, meeting that when an entity is “developing its estimate of expected credit losses . . . for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts, [the] entity is allowed to revert to its [unadjusted] historical credit loss experience.”

For instance, assume that an entity uses annualized loss rates to determine the amount of probable unconfirmed losses on its homogeneous pools of loans as of the reporting date. When moving to the CECL model, the entity may need to revise its allowance method by adjusting the fixed time horizon (i.e., annualized loss rates) to equal a period that represents the full contractual life of the instrument. Entities using a probability-of-default (PD) approach may need to revise their PD and loss-given-default (LGD) statistics to incorporate the notion of lifetime expected losses. Today, an entity’s PD approach might be an estimate of the probability that default will occur over a fixed assessment horizon, which is less than the full contractual life of the instrument (often one year). Similarly, an entity would need to revise its LGD statistic to incorporate the notion of lifetime expected losses (i.e., the percentage of loss over the total exposure if default were to occur during the full contractual life of the instrument).

FASB project information

For further information on the impairment project, see the FASB's Web site.

Contacts

Adrian Mills
Partner, Deloitte & Touche LLP
+1.203.761.3208

Stephen McKinney
Director, Deloitte & Touche LLP
+1.203.761.3579

           

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1 Although impairment began as a joint FASB and IASB project, constituent feedback on the boards’ “dual-measurement” approach led the FASB to develop its own impairment model. The IASB, however, continued to develop the dual-measurement approach and issued final impairment guidance based on it as part of its July 2014 amendments to IFRS 9. For more information about the IASB’s impairment model, see Deloitte’s August 8, 2014, Heads Up.

2 This discussion of the CECL model reflects the FASB’s redeliberations to date, including tentative decisions made at the February 11, 2015, Board meeting.

3 The CECL model would not apply to the following debt instruments:

  • Loans made to participants by defined contribution employee benefit plans.
  • Policy loan receivables of an insurance entity.
  • Pledge receivables (promises to give) of a not-for-profit entity.
  • Loans and receivables between entities under common control.

4 The proposed ASU defines PCI assets as “[a]cquired individual assets (or acquired groups of financial assets with shared risk characteristics at the date of acquisition) that have experienced a significant deterioration in credit quality since origination.”

5 Quoted text is from a handout for the June 11, 2014, FASB meeting.

6 Short-term trade receivables resulting from revenue transactions within the scope of ASC 605 and reinsurance receivables are excluded from these disclosure requirements.

7 The FASB’s tentative decision to require this tabular disclosure has not been exposed for public comment. As a result, the Board directed its staff to conduct significant outreach activities to obtain feedback from financial statement users, preparers, and other stakeholders on the proposed requirement.

 

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