1. The purpose of this memo is to address questions raised by stakeholders on the guidance in Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments with respect to the accounting for contractual term extensions and short-term lending arrangements. Stakeholders have asked whether certain extensions should be considered when determining the contractual term of a financial asset in scope of Subtopic 326-20. Stakeholders also raised a question if an entity is precluded from considering future economic and other conditions (that is, measurement inputs) beyond the contractual term of a financial asset for short-term lending arrangements when estimating expected credit losses.

2. The staff will seek input from members of the Transition Resource Group for Credit Losses (TRG) on these implementation questions.

3. The amendments in Update 2016-13 require an entity to record an allowance for credit losses that results in presenting the net amount expected to be collected when the allowance is deducted from the financial asset’s amortized cost basis. To measure the required allowance, entities must estimate the amount of expected credit losses over the contractual term of the financial asset. The Board clarified in paragraph BC131 that Update 2016-13 “does not require an allowance for expected credit losses beyond the contractual term or beyond the point in which a loan commitment may be unconditionally cancelled by the issuer.”

4. Although Update 2016-13 does not define contractual term, the guidance does specify several elements that entities should consider or disregard when determining the contractual term, as discussed in the prepayments, extension, and renewals options section of this memo below. Additionally, paragraph BC131 further elaborates that the Board intended for the allowance for credit losses to reflect “the full contractual period over which an entity is exposed to credit risk via a present obligation to extend credit.” The Board noted in paragraph BC3 that “users supported an approach for the allowance for credit losses based on management’s expectations of credit losses over the contractual life of the financial assets.”

5. During outreach before the issuance of Update 2016-13, stakeholders asked whether the contractual term of a loan should consider potential prepayments, extensions, and renewals. Paragraph 326-20-30-6 provides guidance related to these issues, stating:

6. As indicated in the guidance above, entities must consider the effect of prepayments on the contractual term, but cannot consider expected extensions, renewals, and modifications unless they are part of a reasonably expected troubled debt restructuring. A troubled debt restructuring is defined as a restructuring of debt in which “the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.”

7. Stakeholders asked the staff about two issues. The first issue is whether certain contractual extension options should be considered in determining the contract term of the financial asset. The second issue is whether future economic and other information from periods beyond the contractual maturity may be considered in determining the estimate of expected credit losses. Although the DIEP submitted two separate papers, the staff believes that the issues have interdependencies and should be discussed in the same memo. The two issues are listed below:

8. Although paragraph 326-20-30-6 states in part that “…an entity shall not extend the contractual term for expected extensions, renewals, and modifications…,” stakeholders believe that considering extensions when determining the contractual term in certain situations would more closely align with the Board’s overall intent for Update 2016-13. The submission asks if stakeholders should consider extension options when determining the contractual term in the following four fact patterns:

9. The submission included several arguments for and against considering the various types of extension options when determining the contractual term. The opinions presented in the submission are summarized below:

10. During outreach before the November 2018 TRG meeting, stakeholders’ views on whether an entity should consider extensions in determining the contractual term of the financial asset were based upon the nature and holder of the extension option.

11. Nearly all outreach participants agreed that extension options in Scenario A should not be considered when determining the contractual term of a lending arrangement. Those stakeholders interpreted the guidance in paragraph 326-20-30-6 to preclude noncontractual extension options from the contractual term. In contrast, only one stakeholder expressed support for considering an entity’s prior behavior of granting noncontractual extensions when determining the contractual term of a loan.

12. Outreach participants generally agreed that extensions options in Scenario D should not be considered when determining the contractual term of a lending arrangement. The participating stakeholders explained that because the lender has complete control over the extension option, it does not have a present obligation to extend credit.

13. With regards to the extensions described in Scenarios B and C, stakeholders expressed mixed views with respect to whether the extensions should be considered in the contractual term.

14. Most outreach participants noted that borrower-controlled, unilateral extensions (Scenario B) should be considered when determining the contractual term of a loan. Those stakeholders noted that a loan with a borrower-controlled extension option is analogous to a loan with prepayments, which are considered in the contractual term of the loan. For example, a three-year loan with two borrower-controlled one-year extensions options is analogous to a five-year loan with the option to prepay at the end of years three or four.

15.Opponents of considering the extension options described in Scenario B in the contractual term interpret the guidance in paragraph 326-20-30-6 to preclude these extensions. Many outreach participants also explained loans that provide the borrower the unilateral right to an extension without accompanying contingent features are rarely issued in the marketplace. Several stakeholders expressed their belief that any loans with terms in Scenario B would comprise an insignificant fraction of the overall loan market, if these types of loans exist at all in practice.

16. Opponents of considering the extension options described in Scenario C in the contractual term noted that any loan extension outside the lender’s control should be considered in the contractual term. Those stakeholders noted that the stated maturity date does not reflect the economics of the lending relationship because the lender may have a contractual obligation to extend the loan. Some stakeholders mentioned that entities must consider both (a) the probability of the pre-specified conditions being satisfied and (b) the likelihood of the borrower exercising the extension option if the conditions are met. Many outreach participants mentioned that they underwrite loans with contingent borrower-controlled options (Scenario C), and that these types of loans are common in the marketplace.

17. Opponents of considering the extension options described in Scenario C in the contractual term stated that contingent extension options may implicitly represent a new underwriting. Because the Board intended for Update 2016-13 to align accounting guidance with issuer’s underwriting decisions, those stakeholders noted that contingent extension options should not be considered in the contractual term of a loan. Other stakeholders opposed to considering contingent extensions in the contractual term noted that the probability assessment would be complex and costly and supported maintaining the simplicity of the model.

18. Some stakeholders also expressed concerns about whether considering loan extensions in Scenario C would be operable. Those stakeholders questioned whether data related to these extensions are currently captured in risk management and accounting systems.

19. Aside from the specific views on these scenarios, some stakeholders also expressed general concerns that considering any extensions in the contractual term would move closer to a life of relationship concept, which the Board rejected in developing Update 2016-13. Those stakeholders generally noted that the guidance in Update 2016-13 is clear that an entity should not extend the contractual term of the financial asset unless there is a reasonable expectation of a troubled debt restructuring.

20. As noted in the background section, contractual term is not defined. Instead, Update 2016-13 provides guidance for certain factors that may impact the contractual term, including prepayments, extensions, renewals, and modifications. Furthermore, paragraph BC131 elaborates that the Board intended for the allowance for credit losses to reflect “the full contractual period over which an entity is exposed to credit risk via a present obligation to extend credit.” In considering the extensive feedback received from stakeholders and a review of Update 2016-13, the staff believes that the guidance precludes entities from considering extensions described in Scenario A or D and requires entities to consider extensions described in Scenario B when determining the contractual term of a financial asset when developing an estimate of expected credit losses.

21. The staff believes that noncontractual extensions (Scenario A) would not be permitted based on the guidance in paragraph 326-20-30-6. Specifically, the use of the phrase contractual term was intended to include conditions limited to the current legal terms of the contractual arrangement between the borrower and lender, not potential extensions negotiated after the initial underwriting.

22. The staff also believes that extension options for which the lender has the option to extend the contract (Scenario D) do not represent a present obligation to extend credit. Because the lender is not obligated to extend credit to the borrower, the lender can choose to avoid such credit exposure by not extending the contractual term. The estimate of expected credit losses seeks to quantify expected losses on credit that the lender has extended as of the balance sheet date, either in the form of a recognized financial asset or the present legal obligation to extend credit. Therefore, the staff believes that extension options held by the lender would not be considered when determining the contractual term.

23. The staff believes that extension options providing the borrower with the unilateral right to extend the loan (Scenario B) represent a present obligation to extend credit, in accordance with the terms of the contract. The staff notes that the contractual nature of the extension and the borrower’s complete control over the exercise of the extension indicate that the lender has a present legal obligation to extend credit to the borrower. Furthermore, the staff believes that the economics of a loan that provides the borrower with the unilateral right to extend the maturity is similar to a loan with a maturity date that includes the extension option that can be prepaid at the point the extension becomes exercisable. Therefore, the staff believes that extension options able to be unilaterally exercised by the borrower would be considered when determining the contractual term.

24. The staff noted that the Board intended for the contractual term referenced in paragraph 326-20-30-6 to consider credit risk exposures present in the terms of the contractual lending arrangement. This view aligns with the Board’s overall intent in Update 2016-13 to require entities to record expected credit losses on their present contractual obligations and to better align accounting guidance with lender’s underwriting decisions. The staff notes that there is a distinction between a contractual extension option explicitly provided during the initial underwriting (Scenario B) and a noncontractual extension option granted after the initial underwriting. While the guidance requires the former to be considered in the contractual term, the guidance explicitly precludes the latter on the basis of the guidance about “expected extensions” in paragraph 326-20-30-6.

25. The staff notes that several outreach participants mentioned the rarity of the loan structure described in Scenario B in the marketplace. If those types of loans are not commonly underwritten, the staff questions whether this issue would be pervasive enough to warrant further clarification in the guidance.

26.In considering Scenario C, the staff acknowledges that there are many arguments for and against the scenario described in the submission. The staff identified the following items for TRG members’ consideration in discussing this issue.

27. The second submission presented a question about whether entities should consider forecasted economic and other information beyond the contractual term of a loan when estimating credit losses. The submission provides an example in which some stakeholders stated that forecasting beyond the contractual term would be appropriate.

28. Although the fact pattern described above is specific, any short-term loan related to a project with a completion period that is expected to be longer than the duration of the loan agreement would be affected.

29. Given the interrelated nature of the financing arrangement and the construction project, stakeholders questioned whether the probability of borrower default should be considered beyond the maturity date of the short-term loan when forecasting expected credit losses. When assessing the probability of borrower default, future economic conditions that would influence the borrower’s ability to refinance the loan also may need to be considered.

30. The staff notes that Issue 2 only addresses which measurement inputs can be considered when determining expected credit losses and does not contemplate any adjustments to the contractual term of the financial asset. The contractual term for the fact pattern described in Issue 2 would be one year, consistent with the staff’s conclusions with respect to noncontractual extensions (Scenario A) in Issue 1. Stakeholders’ questions with respect to Issue 2 relate to whether entities should be allowed to incorporate measurement inputs that extend beyond the one-year contractual term when estimating expected credit losses over the one-year contractual term in accordance with paragraph 326-20-30-6.

31. In the submission, stakeholders expressed a diversity of views about whether an entity should consider the probability of borrower default for periods beyond the contractual term of the loan. Stakeholders presented the following three views:

32. The submissions provided arguments in favor of each of the views expressed above but did not provide arguments against these views. The opinions expressed in the submission are summarized below.

33. Proponents of View A note that the guidance in paragraph 326-20-30-6 explicitly precludes entities from considering possible extensions to the contractual term, unless part of a reasonably expected troubled debt restructuring. Stakeholders supporting View A also interpreted this guidance to suggest that a lender should not consider a potential refinancing with the borrower when estimating expected credit losses. Instead, these stakeholders noted that the probability of borrower default should be limited to the contractual term.

34. Supporters of View B reference paragraph 326-20-30-7, which directs entities to “consider available information relevant to assessing the collectability of cash flows,” including information relating to past events, current conditions, and reasonable and supportable forecasts. Many stakeholders noted that the relevant data would suggest that a refinancing with the original lender would be the most likely outcome of the possibilities listed in paragraph 24(b). To best reflect the probability of a future refinancing, supporters of View B noted that the probability of borrower default should be considered beyond the loan’s contractual term.

35. Proponents of View C agree with the conclusion reached in View A that the lender cannot consider possible refinancing events between itself and the borrower. However, those stakeholders noted that paragraph 326-20-30-7 still requires entities to consider other available information that may be beyond the contractual term, specifically the likelihood that the borrower will refinance the loan with another lender. Supporters of this view noted that a refinancing with a different lender is usually the second most likely possible outcome of the possibilities listed in paragraph 24(b). The borrower’s probability of default in subsequent periods directly influences the willingness of other lending institutions to provide financing to the borrower, which in turn affects the amount of losses the original lender expects on the loan. Because supporters of this view noted that expected financings with other lenders should be considered, they noted that the probability of borrower default beyond the maturity date should be considered as part of the original lender’s estimate of credit losses.

36. During outreach before the November 2018 TRG meeting, stakeholders expressed mixed views with respect to whether entities should forecast events beyond the contractual term of the loan. Many outreach participants also mentioned that they had mixed views internally with respect to this issue.

37. Outreach participants that support View A noted that this view best aligns with the contractual structure of the short-term lending arrangement. Those stakeholders explained that the lender could choose to demand repayment upon maturity and that the lender has no obligation to refinance the loan. Supporters of this view also noted that lenders consider any future refinancing risk when setting the terms of the short-term loan and that entities would not need to look beyond the contractual term to capture this risk. Some proponents of View A also expressed the belief that requiring entities to consider events beyond the contractual term imposes requirements that the Board had neither considered nor intended when deliberating Update 2016-13.

38. Outreach participants who opposed View A explained that not considering any refinancing events would lead to an allowance for credit losses that does not reflect the economics of the lending relationship. Those stakeholders questioned the usefulness of financial reporting under View A because it would not consider the most likely possible outcome for the lending relationship: a refinancing.

39. Outreach participants who supported View B noted that considering a possible refinancing with the borrower best aligns with the lender’s expectations upon entering into the lending arrangement. These stakeholders noted that many issuers view these arrangements as an underwriting for the entire construction project, not just the period covered by the lending arrangement. Therefore, those stakeholders noted that this view best reflects the risks considered in the underwriting process. Because the project has a distinct end date, those stakeholders noted that View B is fundamentally different from a life of relationship concept, which entails an indefinite time horizon.

40. Outreach participants who opposed View B emphasized their interpretation of the guidance in paragraph 326-20-30-6 as precluding the consideration of expected refinancing events between the borrower and the lender. Those stakeholders disagreed with supporters of View B and noted that considering possible refinancing events between the borrower and lender would introduce the life of relationship concept that the Board rejected. They noted that considering a refinancing event with the original lender does not have a contractual basis because the lender has no obligation to provide the refinancing.

41. Outreach participants who supported View C noted that it provides an outcome that reflects the economics of the relationship while also following the interpretation that the guidance in paragraph 326-20-30-6 precludes the consideration of the lender providing refinancing to the borrower. Those stakeholders noted that if the borrower can successfully refinance with another lender at market terms, then events after the contractual maturity should be considered when determining credit losses. On the other hand, some stakeholders noted that if the borrower could not successfully refinance with another lender at market terms, then the entity should not consider events after the contractual maturity date. Furthermore, the entity would need to consider whether the expected refinancing events constitute a reasonably-expected troubled debt restructuring.

42. Outreach participants that opposed View C were concerned about the implications of this view on other types of loans. While those stakeholders acknowledged that View C would provide a reasonable outcome for the fact pattern presented, they expressed concerns about potential abuse. These stakeholders wondered whether some entities might consider refinancing events in situations in which the borrower has no intention or incentive to refinance. Some stakeholders also mentioned that requiring entities to consider events beyond the contractual term would be very complex and difficult to operationalize.

43. During the initial review of the submission, the staff believed that Issues 1 and 2 were related. If the Board were to clarify or change the guidance to require entities to consider extensions when measuring the allowance for credit losses, entities would be able to measure the allowance by considering events or transactions that are expected to occur beyond the stated contractual term. However, the staff noted in Issue 1 that noncontractual extension options would not meet the guidance requirements when determining the contractual term, as described in paragraph 21.

44. The staff expects entities to use judgment when interpreting the guidance and that an entity should consider the facts and circumstances present when measuring the allowance for credit losses. While conducting outreach with stakeholders, it became evident that stakeholders were asking for guidance on what types of inputs could be used by entities when measuring the allowance for short-term lending arrangements.

45. Therefore, the staff believes that providing an interpretation on Issue 2 is fundamentally different from providing an interpretation on Issue 1. That is, the Board intended to prescribe the boundaries in determining a financial asset’s contractual term, as evidenced by the guidance in paragraph 326-20-30-6 requiring prepayments be considered and precluding expected extensions, renewals, or modifications unless an entity reasonably expects to execute a troubled debt restructuring. The staff believes that it was not the Board’s intent to provide explicit guidance on what inputs should be used when measuring the allowance for credit losses within the contractual term or boundaries of the contract. In accordance with paragraph 326-20-30-7, the Board intended that an entity should consider available information relevant to assessing the collectibility of cash flows, including information related to past events, current conditions, and reasonable and supportable forecasts. The guidance in paragraphs 326-20-30-8 through 30-9 further prescribes the threshold of reasonable and supportable forecast period to which the estimate and inputs must adhere and the reversion to historical requirement after the reasonable and supportable period. This guidance does not require or preclude specific inputs that may be used in determining the estimate.

46. Furthermore, the guidance in paragraph 326-20-55-7 reinforces this view that the Board did “not require a specific approach when developing the estimate of credit losses. Rather, an entity should use judgment to develop estimation techniques that are applied consistently over time and should faithfully estimate the collectability of the financial assets…The method(s) used to estimate expected credit losses may vary on the basis of the type of financial asset, the entity’s ability to predict the timing of cash flows, and the information available to the entity.”

47. The staff believes that considering future economic and other conditions beyond the contractual term of the financial assets does not, in and of itself, result in an extension of the contractual term. The staff believes that entities should consider available information that is relevant for assessing the collectibility of cash flows during the contractual term, which may include information from periods beyond the contractual term. Future economic and other conditions may inform an entity’s analysis of determining the inputs in developing expected credit losses over the contractual term of the financial asset.