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Journal entry — Financial instruments — FASB makes tentative decisions on credit impairment

Published on: Jun 16, 2014

Last week, the FASB met to discuss how an entity would (1) measure loans and securities that are subsequently identified for sale and (2) account for certain beneficial interests in securitized financial assets. The Board made tentative decisions related to the following:

  • Loans subsequently identified for sale — Under current U.S. GAAP, when a loan is reclassified as held for sale, it is carried at the lower of cost or market on the date of the transfer. For a loan that was previously classified as held for investment and subsequently identified for sale, the Board tentatively decided that on the transfer date an entity should, in calculating the valuation allowance, retain as the cost basis the amortized cost basis of the loan. Accordingly, any amount by which the amortized cost basis of the loan (excluding the allowance for expected credit losses) exceeds the fair value would be recorded as a valuation allowance.
  • Debt securities subsequently identified for sale — For debt securities previously classified as either held to maturity or available for sale and subsequently identified for sale, the Board tentatively decided that on the transfer date, any impairment allowance should be measured as the amount that the amortized cost basis exceeds the security’s fair value. This impairment loss should be recognized in earnings.
  • Certain beneficial interests in securitized financial assets — As noted in the handout for the meeting, “the estimate of expected credit losses under the [current expected credit losses (CECL)] model is based on contractual cash flows and not expected cash flows as required under Subtopic 325-40.” At the meeting, the FASB discussed whether the CECL model should apply to beneficial interests that are within the scope of that guidance and tentatively decided 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 purchase-credit-impaired 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, “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).”

See the appendix below for a comparison of current U.S. GAAP, the FASB’s proposed ASU1 on impairment, and tentative Board decisions reached to date during redeliberations.

Appendix — Comparison of Impairment Models

The table below compares current U.S. GAAP on impairment with the FASB’s proposed ASU on impairment and its tentative decisions to date.

Current U.S. GAAP

Proposed ASU

Tentative Decisions Reached

Recognition threshold

Depending on the nature of the financial asset, credit losses must be either probable or other than temporary before recognition.

No recognition threshold. However, the FASB decided to provide a practical expedient for financial assets measured at fair value through other comprehensive income (FV-OCI).2

No changes from the proposed ASU.

Measurement approach

Varies depending on the nature of the financial asset and unit of account.

Some approaches used in practice include:

  • Fair value measurement.
  • Present value of expected cash flows.
  • Fair value of the underlying collateral.

Not prescribed; however, the estimate of current expected credit losses must:

  • Reflect all reasonable and supportable information.
  • Incorporate the time value of money.
  • Reflect at least two possibilities: (1) that a credit loss exists and
    (2) that no credit loss exists. (The proposal notes that an "estimate of expected credit losses shall neither be a worst-case scenario nor a best-case scenario [but rather should be based on] current conditions, and reasonable and supportable forecasts" about the future.
  • Reflect how credit enhancements (other than those that are freestanding contracts) mitigate expected credit losses.

The Board tentatively decided that the CECL model would be based on the proposal’s measurement principles and would apply to financial assets measured at amortized cost. Financial assets measured at FV-OCI would be subject to a variation of the CECL model that incorporates the model’s principles but limits credit loss to the amount, if any, that amortized cost exceeds fair value. Specifically, for financial assets measured at
FV-OCI, entities would determine credit loss as follows:

  1. If fair value ≥ amortized cost, do not recognize expected credit losses.
  2. If fair value < amortized cost, apply the CECL model but limit application (i.e., any impairment) to the difference between the financial asset’s fair value and its amortized cost basis.

In estimating expected credit losses, entities would:

  1. Use historical average loss experience for future periods beyond which the entity is able to make or obtain reasonable and supportable forecasts.
  2. Consider all contractual cash flows over the life of the related financial assets.
  3. When determining the contractual cash flows over the life of the related financial assets, consider expected prepayments but not expected extensions, renewals, and modifications unless there is a reasonable expectation of a troubled debt restructuring (TDR) with the borrower.

The expected credit loss estimate should always reflect the risk of loss, even when that risk is remote. However, there is no requirement to recognize a loss on a financial asset when the risk of nonpayment is greater than zero but the amount of loss would be zero.

In responses to frequently asked questions on the proposed ASU, the Board noted that an “entity may use any method that reflects the time value of money explicitly (such as a discounted cash flow technique) or implicitly” to estimate expected credit losses. The Board clarified that an entity would not be prohibited from estimating credit losses on the basis of loss-rate methods, roll-rate methods, probability-of-default methods, or a provision matrix using loss factors.

The final standard will include implementation guidance on the factors to consider in adjusting historical loss experience for current conditions and reasonable and supportable forecasts.

For loans subsequently identified for sale, the transfer date cost basis is the loan’s amortized cost basis.

For debt securities subsequently identified for sale, the impairment allowance amount recognized, if any, should be the amount that the amortized cost exceeds the fair value.

For beneficial interests in securitized financial assets, when there is a significant difference between contractual and expected cash flows under the CECL model, an entity would present an impairment allowance that is equal to the estimate of expected credit losses (i.e., the estimate of contractual cash flows not expected to be collected). In addition, “changes in expected cash flows due to factors other than credit should 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 not be included in interest income).”

Impairment reversal

Loans: valuation allowance is adjusted.

Debt securities: reversal is not permitted.

Required if there is a favorable change in the estimate of current expected credit losses.

No changes from the proposed ASU.

Purchased credit-impaired assets

No allowance is initially recorded.

Impairment is generally recognized if there is a decrease in the estimate of expected cash flows to be collected.

If there is a significant increase in the estimate of expected cash flows to be collected, the effective interest rate is adjusted prospectively.

An allowance is initially recognized for the contractual amounts not expected to be collected.

Impairment is recognized if there is an increase in current expected credit losses.

If there is a decrease in expected credit losses (i.e., an increase in cash flows expected to be collected), the impairment allowance is reversed; no adjustment is made to the effective interest rate.

No changes from the proposed ASU.

Nonaccrual accounting

The practice of nonaccrual accounting stems from regulatory guidance.

Requires the use of nonaccrual accounting if “it is not probable that the entity will receive substantially all of the principal or substantially all of the interest.”

Guidance on when an entity should stop accruing interest income will not be included in the final standard.

TDRs

Treated as the continuation of an old loan. Impairment is recorded as an allowance, not a write-off.

Treated as the continuation of an old loan. Impairment from the restructuring is recorded as a write-off. Given the new series of cash flows, an entity is required to adjust the cost basis of the modified asset (with a corresponding adjustment to the allowance for expected credit losses) so that the effective interest rate on the modified asset continues to be the original effective interest rate. The basis adjustment will be calculated as the amortized cost basis before modification less the present value of the new series of contractual cash flows (discounted at the original effective interest rate).

No changes from the proposed ASU.

____________________

1 Proposed FASB Accounting Standards Update, Credit Losses

2 Under the practical expedient, entities would not be required to record an impairment allowance for such assets if the fair value of the financial asset exceeds its amortized cost.

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