Disclaimer: This paper has been prepared for discussion at a public meeting of the Transition Resource Group for Credit Losses. It does not purport to represent the views of any individual members of the Board or staff. Comments on the application of generally accepted accounting principles (GAAP) do not purport to set out acceptable or unacceptable application of GAAP. Stakeholders are strongly encouraged to listen to feedback about this staff paper from TRG members and Board members during the TRG meeting and to read the meeting summary, which will be prepared by the staff after the meeting.
1. The purpose of this memo is to provide a summary of the following:
(a) The documents presented to the Transition Resource Group (TRG) members for the November 1, 2018 TRG for Credit Losses meeting
(b) Outreach that the staff performed in preparing the memos for the TRG meeting
(c) Technical inquiries that the staff has recently answered regarding the amendments in Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses: Measurement of Credit Losses on Financial Instruments.
(d) Other TRG submissions that will be discussed at the meeting that do not have an individual staff memo.
Documents for the Meeting
2. The following memos have been published and distributed to the TRG members in advance of the meeting:
(a) Memo No. 15, “Contractual Term: Extensions and Measurement Inputs”
(b) Memo No. 16, “Vintage Disclosures for Revolving Loans”
(c) Memo No. 17, “Recoveries.”
3. The staff received a TRG submission relating to the accounting for subsequent increases in the fair value of collateral for collateral dependent loans. This issue will be discussed as part of the discussion related to recoveries (Memo 17).
4. The staff will introduce each of these topics for discussion at the meeting.
Staff Outreach Performed
5. In preparing Memo 15 and 16 for the TRG meeting, the staff reviewed the initial submissions from the AICPA’s Depository and Lending Institutions Expert Panel (DIEP) and performed separate outreach with seven preparers and six auditors to gain a better understanding of the issues and how they relate to each stakeholder group. This does not include outreach performed with stakeholders to solicit feedback on recoveries (see Memo 17 for a summary of stakeholders who participated in outreach).
Recent Technical Inquiries
6. Paragraphs 326-20-50-5 through 50-6 require public business entities to disclose in the footnotes to the financial statements the amortized cost basis of financial assets by class of financing receivable or major security type, credit quality indicator, and year of origination to meet the disclosure objective in paragraph 326-20-50-4. Paragraph 326-20-55-79 (Example 15) illustrates how an entity might meet the disclosure requirements in the implementation guidance. In addition to providing amortized cost basis by origination year, the illustration also provides a line item for gross writeoffs and recoveries for each origination year. A stakeholder asked whether gross writeoffs and recoveries are required to be included in the credit quality disclosure, similar to Example 15, because the requirement is not dictated by the guidance contained within paragraphs 326-20-50-5 through 50-6.
7. In reviewing the objectives of the credit quality disclosures (described in paragraph 326-20-50-4), the information in these disclosures should enable a financial statement user to “assess the quantitative and qualitative risks arising from the credit quality” of an entity’s financial assets. The staff further recognizes the required disclosures are intended to help “users of the financial statements in understanding…management’s estimate of expected credit losses…and changes in the estimate of expected credit losses that have taken place during the period,” as described in paragraph BC106. The staff also notes that in accordance with paragraph 326-20-50-11, an entity is required to disclose “reasons for significant changes in the amounts of writeoffs by portfolio segment and major security type” to comply with the disclosure objective for the allowance for credit losses detailed in paragraph 326-20-50-10.
8. The staff believes that the Board intended to provide financial statement users with insight into management’s estimates of the allowance for credit losses and how the individual components of the allowance (like writeoffs) are changing each reporting period. The staff notes that displaying gross writeoff and recovery information by vintage year allows financial statement users to better understand management’s initial and revised expected loss estimates, the overall intent of the required disclosures. The staff also notes that gross writeoff and recovery information by vintage year enables financial statement users to track cyclical trends and create loss curves that can be compared to an entity’s expected loss estimates. The staff believes that omitting the information needed to track management estimates in this way would significantly decrease the confirmatory value of the financial information provided in the vintage disclosure.
9. Based on the reasons listed above, the staff believes that gross writeoff and recovery information displayed by vintage year is critical to a financial statement user’s understanding of the risks associated with an entity’s financial assets. Given the Board’s intentional inclusion of gross writeoff and recovery information in Example 15, the staff believes that the Board intended to include these amounts to comply with the disclosure requirements. Therefore, the staff believes that gross writeoffs and recoveries should be presented by origination year within the credit quality disclosures described in paragraphs 326-20-50-5 and 50-6.
10. The staff plans no further work on this issue.
Other TRG Submissions
11. In addition to the three topics presented in the memos listed in paragraph 2, the staff received three other TRG submissions from the DIEP. The staff decided not to address these other topics in separate TRG memos because (a) the staff believes the current guidance is clear and no amendments are needed or (b) the submission is beyond the scope of the TRG. The topics not addressed in TRG Memos 15-17 are described below:
Discounting Inputs When Using a Method Other Than a DCF
12. The guidance in Update 2016-13 does not prescribe a single method for developing an estimate of expected credit losses. Paragraph 326-20-30-3 states that entities may use various methods when determining the allowance for credit losses, including a discounted cash flow (DCF) method, loss-rate methods, roll-rate methods, probability-of-default methods, or methods that utilize an aging schedule.
13. Stakeholders have questioned whether discounting certain inputs in estimating credit losses would be permitted when an entity uses a method other than a DCF method, such as a probability-of-default credit loss method. These stakeholders questioned whether discounting certain inputs to a date other than the reporting date also would be permitted. Stakeholders also noted that using inputs and other data that may be readily available for regulatory reporting purposes would reduce the cost and effort needed to comply with Update 2016-13 by more closely aligning accounting and regulatory reporting. Although these stakeholders acknowledged that many other adjustments must be made between regulatory requirements and GAAP, they believe minimizing the number of adjustments to loss data would ease the burden of adopting Update 2016-13.
14. Regulatory agencies may require financial institutions to report in certain regulatory filings financial information in accordance with the rules issued by the Basel Committee on Banking Supervision (the Basel Rules). For example, the Basel Rules provide guidance for determining the amount of a loss given default.
To comply with this rule, certain cash flows expected to occur after the default date in determining the loss given default are required to be discounted to the default date using a discount rate appropriate to the risk of the defaulted exposure. In instances in which the default date is expected to occur after the reporting date, the Basel Rules would require the expected cash flows to be discounted to the default date, rather than an entity’s reporting date (referred to as “partial discounting”).
15. The staff reviewed the TRG submission and received feedback from outreach participants. The majority of outreach participants expressed concerns that permitting entities to selectively discount certain inputs and not others when estimating expected credit losses using a method other than a DCF method could be misleading and result in potential abuse. Most stakeholders also raised concerns that this approach would be difficult for financial statement users to understand and may result in diversity in practice. Some stakeholders noted that they currently discount inputs when measuring the allowance for credit losses when utilizing a non-DCF method. However, these stakeholders made it clear that they discount all inputs used in the measurement of the allowance for credit losses. These stakeholders noted that their modeling will continue to utilize these discounting techniques when measuring the allowance, but these stakeholders objected to the notion of selectively discounting some inputs when measuring the allowance for credit losses, regardless of the method utilized.
16. Outreach participants who supported the use of discounting certain inputs when using a method other than a DCF method in determining expected credit losses noted that the guidance does not specifically prohibit discounting of individual inputs. One stakeholder explained that permitting discounting of certain inputs, such as recovery cash flows, would result in a more precise expected credit loss amount. The stakeholder also noted that discounting (or partially discounting) recoveries would not be abusive because a discounted (or partially discounted) recovery would result in a larger estimate of expected credit losses.
17. Although the Board intended to provide flexibility when estimating the allowance for credit losses, the staff believes the Board did not intend to align regulatory reporting requirements with the amendments in Update 2016-13.
18. In addition, the staff believes the guidance is clear that if an entity were to discount cash flows or inputs used to measure the allowance for credit losses, the effect of discounting would have to be measured as of the reporting date, not an arbitrary default date. Paragraph 326-20-30-4 states, in part, that the allowance should reflect the difference between the amortized cost basis and present value of expected cash flows. The reference to amortized cost basis, is intended to mean the amount reported on the balance sheet date as of the reporting period. Similarly, paragraph 326-20-30-5 states, in part, “the allowance for credit losses shall reflect the entity’s expected credit losses of the amortized cost basis of the financial asset(s) as of the reporting date.”
19. The staff believes that partial discounting would not provide users with decision-useful information, as it would create additional complexity in understanding the accounting model. In addition, it would not be possible for the staff to determine which inputs should or should not be discounted because the guidance does not provide specificity on which inputs should be considered when measuring the allowance for credit losses.
20. For these reasons, the staff believes partial discounting is prohibited and believes that if an entity wants to discount the inputs used to measure the allowance for credit losses, the entity should discount all the inputs used in the measurement.
1 See US Rule (2007) p. 69402 of the Risk-based Capital Standards: Advanced Capital Adequacy Framework - Basel II
Accounting for Changes in Foreign Exchange Rates for Foreign-Currency-Denominated Available-for-Sale Debt Securities
21. Stakeholders questioned the timing of when unrealized losses related to changes in foreign exchange rates from an investment in a foreign-currency-denominated available-for-sale (AFS) debt security should be recognized in earnings.
22. The amendments in Update 2016-13 superseded the impairment guidance for an AFS debt security that required an impairment to be recorded as an adjustment to the amortized cost basis of the security if an entity identified an other-than-temporary impairment (OTTI). In contrast, the amendments in Update 2016-13 require the estimate of credit losses to be reflected through a valuation account that is deducted from the amortized cost basis of the financial asset, which is evaluated each reporting period.
23. As a consequential amendment to Subtopic 320-10 to supersede the OTTI methodology, the amendments in Update 2016-13 amended and superseded the guidance related to the accounting for fair value changes of foreign-currency-denominated AFS debt securities, which states:
change in the fair value of foreign-currencydenominated available-for-sale debt securities, excluding the amount recorded in the allowance for credit losses, shall be reported in other comprehensive income. See Subtopic 326-30 for measuring credit losses on available-for-sale debt securities. In accordance with the guidance in Subtopic 326-30, an entity shall report credit losses on available-for sale debt securities in the statement of financial performance as credit loss expense.
An entity holding a foreign-currency-denominated availablefor-sale debt security is required to consider, among other things, changes in market interest rates and foreign exchange rates since acquisition in determining whether an other than temporary impairment has occurred.
24. Before Update 2016-13, entities were required to consider changes in foreign exchange rates for foreign-currency-denominated AFS debt securities in determining whether an OTTI exists. The amended guidance above requires the change in fair value of a foreign-currency-denominated AFS debt security that is not credit related (e.g., changes in foreign currency rates) to be recorded in other comprehensive income (OCI). The change in fair value that is related to the allowance for credit losses is recognized in earnings and measured in accordance with the guidance in Subtopic 326-30.
25. Subtopic 326-30 provides guidance to determine whether impairments are recorded in earnings or OCI. Specifically, paragraph 326-30-35-10 states, in part, “[i]f an entity intends to sell the debt security (that is, it has decided to sell the security), or is 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 security’s fair value at the reporting date with any incremental impairment recognized in earnings.”
26. The staff believes the guidance is clear that unrealized losses related to changes in foreign exchange rates from an investment in a foreign currency denominated AFS debt security reported in OCI are 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 amortize cost basis.
27. During outreach before the November 2018 TRG meeting, stakeholders generally agreed with the staff's view. However, outreach participants expressed concerns that the amendments in Update 201613 will result in delayed loss recognition because unrealized losses related to foreign exchange rates will not be recognized until one of the criteria in paragraph 21 are met. The staff understands the stakeholders’ concerns but believes that this topic is beyond the scope of the Credit Losses TRG because the topic relates to reporting changes in fair value related to foreign exchange rates. Furthermore, the staff notes that entities may separately disclose the amount of changes in fair value from foreign exchange rates reported in OCI.
28. Stakeholders may submit an agenda request if they believe the Board should consider amending the guidance on reporting changes in fair value related to foreign exchange rates for foreign-currency denominated AFS debt securities.
29. The staff plans no further work on this issue.
Beneficial Interests Classified as Trading
30. Stakeholders asked whether an entity should maintain an allowance for credit losses for a beneficial interest in the scope of Subtopic 325-40 that is classified as trading.
31. The Master Glossary of the FASB Accounting Standards Codification® defines the term beneficial interests as follows:
Rights to receive all or portions of specified cash inflows received by a trust or other entity, including, but not limited to, all of the following:
a. Senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through
b. Premiums due to guarantors
c. Commercial paper obligations
d. Residual interests, whether in the form of debt or equity.
32. Beneficial interests are often created through the securitization of a pool of fixed-income financial assets. Securitization is a process in which the cash flows and related risks of a group of financial assets are transferred from one entity to another. Mechanically, this is accomplished by aggregating a pool of fixed-income financial assets (the collateral pool), selling the collateral pool to a special purpose entity (SPE) established for the sole purpose of securitizing the respective fixed income financial assets, and having this SPE issue new securities collateralized by the collateral pool. Those new securities are beneficial interests.
33. The issue raised by stakeholders is relevant only to beneficial interests within the scope of Subtopic 325-40. Subtopic 325-40 is an integrated accounting model that provides interest income and initial and subsequent measurement guidance for certain beneficial interests that are generally of low credit quality.
The discussion in the remainder of this memo will be in the context of those securities.
34. Interest income for beneficial interests subject to Subtopic 325-40 is based upon the accretable yield of the beneficial interest and is recognized using the effective yield method. The amount of the accretable yield is initially determined as the excess of all cash flows expected to be collected attributable to the beneficial interest estimated at the acquisition transaction date (the transaction date) over the initial investment. That is, the amount of all cash flows the holder expects to collect over its initial investment is recognized as interest income using the effective yield method. All cash flows expected to be collected are determined as the holder’s estimate of the amount and timing of estimated future principal and interest cash flows, including prepayments and credit, used to determine the purchase price or the holder’s fair value determination for purposes of determining gains and losses under Topic 860.
35. After initial measurement, beneficial interest holders are required to continually update the expectation of cash flows to determine if there is a favorable or adverse change in cash flows expected to be collected from the cash flows previously projected. Determining whether there has been a favorable or an adverse change in cash flows expected to be collected from the cash flows previously projected taking into consideration both the timing and amount of the cash flows expected to be collected, involves comparing the present value of the remaining cash flows expected to be collected at the initial transaction date (or at the last date previously revised) against the present value of the cash flows expected to be collected at the current financial reporting date.
36. If the present value of the original estimate at the initial transaction date (or the last date previously revised) of cash flows expected to be collected is less than the present value of the current estimate of cash flows expected to be collected, the change is considered favorable. That is, an OTTI has not occurred. The accreditable yield is adjusted and accounted for prospectively as a change in estimate in conformity with Topic 250, with the amount of periodic accretion adjusted over the remaining life of the beneficial interest.
37. If the present value of the original estimate at the initial transaction date (or the last date previously revised) of cash flows expected to be collected is greater than the present value of the current estimate of cash flows expected to be collected, the change is considered adverse. That is, an OTTI occurred. The beneficial interest should be written down to fair value with the resulting change being recognized in accordance with Section 320-10-35.
38. Update 2016-13 amended the subsequent measurement guidance for beneficial interests in the scope of 325-40
and requires entities to account for credit losses on beneficial interest classified as held-tomaturity (HTM) and AFS in accordance with Topic 326. Subtopic 325-40 also was amended to include subsequent measurement guidance on determining the accretable yield for HTM and AFS beneficial interests, which may be affected if the HTM or AFS beneficial interest recorded an allowance for credit losses. Paragraph BC96 of Update 2016-13 states:
The Board also acknowledged that practice related to interest income recognition on beneficial interests in the scope of Subtopic 325-40 will be different when an allowance for credit losses is present. When a beneficial interest within the scope of Subtopic 325-40 has an allowance for credit losses, favorable or unfavorable changes in cash flows must first be considered as an adjustment to the allowance for credit losses. Only the remaining portion of the favorable or unfavorable changes in the cash flows would be reflected in the accretable yield.
39. As noted above, the scope of Subtopic 325-40 applies to all entities and Update 2016-13 retained the interest income guidance for trading classified beneficial interest in 325-40-15-7, which states:
For income recognition purposes, beneficial interests classified as trading are included in the scope of this Subtopic because it is practice for certain industries (such as banks and investment companies) to report interest income as a separate item in their income statements, even though the investments are accounted for at fair value.
40. The staff believes that the guidance in paragraph 325-40-15-7 clearly includes beneficial interests classified as trading within the scope of Subtopic 325-40 for interest income recognition. The staff also believes the scope of Subtopic 326-20 clearly excludes financial assets measured at fair value through net income. Therefore, the staff believes the guidance is clear that an entity is not required to maintain an allowance for credit losses for beneficial interests classified as trading.
41. The staff notes that Update 2016-13 does not include specific guidance for determining the subsequent measurement of the accretable yield for beneficial interests classified as trading similar to the guidance for HTM and AFS beneficial interests as noted in paragraph 39. However, the staff believes that the guidance on recognition of interest income for beneficial interests in the scope of Subtopic 325-40 classified as trading is beyond the scope of the TRG. The staff believes that entities will need to apply reasonable judgment in determining the amount of accretable yield for beneficial interests classified as trading.
42. During outreach before the November 2018 TRG meeting, certain outreach participants provided an alternative view that beneficial interests classified as trading should be excluded from the scope of Subtopic 325-40. The staff believes that this alternative is beyond the scope of the TRG and would require standard setting by the Board. The staff believes that supporters of this view should submit an agenda request if they believe that the issue warrants additional consideration.
43. The staff plans no further work on this issue.
1 See US Rule (2007) p. 69402 of the Risk-based Capital Standards: Advanced Capital Adequacy Framework - Basel II
Specifically, those beneficial interests that do not have both of the following characteristics: (a) They are of high credit quality (b) They cannot contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment.
3 The amendments in Update 2016-13 require certain beneficial interests to apply the model for purchased financial assets with credit deterioration (PCD). Beneficial interests classified as trading do not apply the PCD accounting guidance. The discussion in the remainder of this memo exclude purchase financial assets with credit deterioration.
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