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MEMO
Memo No.
Issue Date
Meeting Date(s)
6
August 25, 2017
TTRG Meeting June 12, 2017
Contact(s)
Shayne Kuhaneck
Assistant Director
203-956 5386
Andrew Thornburg
Co-Author
203 956-5344
Adam Kamhi
Co-Author
n/a
Seth Drucker
Co-Author
203 956-5327
Project
Transition Resource Group for Credit Losses
Project Stage
Post-Issuance
Issue(s)
June 2017 Meeting - Summary of Issues Discussed and Next Steps
Memo Purpose
1. The second public meeting of the Transition Resource Group for Credit Losses (TRG) was held on June 12, 2017. The purpose of the meeting was for the TRG members to inform the FASB about potential issues with implementing Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, to help the Board determine what, if any, action may be needed to address those issues.
2. The purpose of this memo is to provide a summary of (a) the issues discussed at the June 12, 2017 meeting, (b) the views expressed at the meeting by the TRG members, and (c) the planned next steps, if any, for each of those issues.
Background
3. The following topics were discussed at the June 12, 2017 meeting:
(a) Topic 1:Discounting Expected Cash Flows Using an Effective Interest Rate Adjusted for Prepayment Expectations
(b) Topic 2: Scope of Purchased Financial Assets with Credit Deterioration Guidance for Beneficial Interests within Subtopic 325-40, Investments—Other—Beneficial Interests in Securitized Financial Assets
(c) Topic 3: Transition Guidance for Pools of Financial Assets Accounted for under Subtopic 310-30, Receivables—Loans and Debt Securities Acquired with Deteriorated Credit Quality
(d) Topic 4: Accounting for Troubled Debt Restructurings
(e) Topic 5: Determining the "Estimated Life" of a Credit Card Receivable.
4. The staff's memos for each of these topics were made public to all stakeholders before the TRG meeting and are available on the FASB's website. A direct link to the staff papers also is included within each topic below. This summary should be read in conjunction with those staff memos, which contain a more detailed description of the issues, stakeholders' views, and the staff's analysis.
5. A replay of the entire meeting is available on the FASB's website.
Topic 1: Discounting Expected Cash Flows Using an Effective Interest Rate Adjusted for Prepayment Expectations Memo 1 and 1A
6. Before the TRG meeting on June 12, 2017, stakeholders informed the staff that there were questions about the amendments in Update No. 2016-13, regarding the outcome of using a loan's effective interest rate (EIR) to discount expected cash flows when applying a discounted cash flow (DCF) method to estimate credit losses.
7. Specifically, if expected cash flows are discounted based on the contractual EIR, the expectation of prepayments will always increase the allowance for credit losses for financial assets held at a premium, whereas the expectation of prepayments will always decrease the allowance for credit losses for financial assets held at a discount. Stakeholders consider these outcomes to be issues because credit risk is not isolated and the increase in, or offset to the allowance related to premiums or discounts respectively, can potentially be material in determining the amount of credit losses recorded depending on facts and circumstances.
8. The staff believes that an entity should not be required to use an EIR adjusted for prepayment expectations because (a) the staff understands that the issue exists today and is considered acceptable because discounts and premiums typically are immaterial relative to an entire portfolio, (b) a limited number of entities plan to calculate losses on performing portfolios using a DCF methodology, and (c) requiring an entity to use an EIR adjusted for prepayment expectations would introduce unnecessary complexity. Accordingly, an entity should be permitted to choose, through an accounting policy election at the class of financing receivable level for loan receivables, whether it will use an EIR adjusted for prepayment expectations when using a DCF method to determine the allowance for credit losses. The staff also notes that this election would not affect the EIR used to recognize interest income in accordance with Topic 310.
9. Overall, the TRG members supported the staff's view that would allow for an accounting policy election to use an EIR adjusted for prepayment expectations when using a DCF method to determine the allowance for credit losses. TRG members also noted that allowing an accounting policy election would be the preferred approach because the issue may be limited to a small population of entities.
The staff notes that upon making the accounting policy election, entities should update the adjusted EIR periodically based on changes in expected prepayments.
10. Several TRG members discussed whether the proposed accounting policy election was intended to alter the accounting for TDRs. The staff clarified that after the troubled debt restructuring (TDR) event, the EIR used should not be periodically updated for prepayment expectations.
11. Some TRG members questioned whether the issue noted in Memo 1 would be applicable to debt securities as well as loans because Memo 1 focused on examples that illustrated the effect on loans. The staff clarified that this issue also is applicable to debt securities and, similar to loans, entities should determine whether they are going to use an EIR adjusted for prepayment expectations through an accounting policy election (which would be applied at the major security type level).
12. The staff does not plan to perform any further work on this issue.
Topic 2: Scope of Purchased Financial Assets with Credit Deterioration Guidance for Beneficial Interests within Subtopic 325-40 (Memo 2)
13. The amendments in Update 2016-13 requires, in accordance with paragraph 325-40-30-1A, that beneficial interests within the scope of Subtopic 325-40 be recognized as purchased financial assets with credit deterioration (PCD assets) if one of the following criteria is met:
(a) There is a significant difference between the contractual cash flows and expected cash flows at the date of recognition
(b) The beneficial interest meets the definition of a PCD asset in accordance with Topic 326, Financial Instruments—Credit Losses.
14. Before the formation of the TRG, stakeholders expressed differing views about how an entity might determine a beneficial interest's contractual cash flows:
(a) View A: Contractual cash flows should not consider credit losses or prepayments.
(b) View B: Contractual cash flow should not consider credit losses but should consider prepayments that are expected to occur.
15. The TRG discussed the following question:
(a) How should contractual cash flows be determined when assessing whether a beneficial interest meets the criterion in paragraph 325-40-30-1A(a)?
16. The staff presented View B as the appropriate application of determining contractual cash flows in accordance with paragraph 325-40-30-1A(a). The staff thinks this methodology isolates credit risk as the driver behind accounting for beneficial interests as PCD assets. The staff also thinks this result is consistent with the Board's underlying rationale for the PCD methodology, which is to prevent the accretion of a significant credit discount, or limit subsequent improvements in credit, into interest income.
17. The staff clarified that to apply this view, an entity would determine contractual cash flows by first looking to the contractual terms of the security. In instances in which contractual payments of principal and interest are not specified by the security (for example, residual interests), an entity would consider the contractual terms of the underlying loans or assets. Additionally, the staff believes that, by extension, View B would also apply when determining the initial accretable yield for PCD assets in accordance with paragraph 325-40-30-2.
18. The staff acknowledged that this interpretation of contractual cash flows, specifically that all interest due is not contractually required because the instrument could be prepaid, generally is inconsistent with a literal interpretation of contractual cash flows in that prepayments are not contractually required. However, the staff notes that this interpretation of contractual cash flows is consistent with the current determination of the accretable yield on beneficial interests within the scope of Subtopic 325-40 because the accretable yield is based on expected cash flows. Therefore, considering prepayment estimates in determining contractual cash flows would be more consistent with the current interest income methodology within Subtopic 325-40.
19. The staff added that this interpretation likely would result in only tranches that are expected to absorb significant credit losses from the collateral meeting the criterion in paragraph 325-40-30-1A(a) (without also meeting the criterion in paragraph 325-40-30-1A(b) given that 30-1A(a) would capture beneficial interests at the origination of the instrument and not enough time would have passed for deterioration to occur), which the staff thinks also is consistent with the Board's intent.
20. TRG members agreed with the staff because View B isolates credit risk as the determining factor for whether a beneficial interest within the scope of Subtopic 325-40 should be recognized as a PCD asset. This view was also generally agreed upon because it limits the volume of beneficial interests within the scope of Subtopic 325-40 that would need to be accounted for as PCD assets. However, some TRG members expressed concern that this interpretation would isolate credit at the time of initial recognition, but that changes in prepayments could reduce the allowance subsequently unless future changes in expected cash flows attributable to prepayments and credit were somehow determined separately (that is, changes in credit would affect the allowance while changes in prepayments would affect yield), which typically is not done today.
21. Other TRG members reminded the group that before the adoption of the amendments in Update 2016-13, Subtopic 325-40 provides an integrated accounting model for the recognition of credit losses and the recognition of interest income. However, under the guidance before adoption of Update 2016-13, the accounting for beneficial interests in Subtopic 325-40 is asymmetrical in that it requires credit losses to be recognized as expected and improvements in credit to be recognized over time as prospective yield adjustments. Therefore, they do not think it was the Board's intention to change how entities consider prepayments and credit following initial recognition, but rather it was the intent to remove some of the asymmetry that exists under the current accounting. To align initial and subsequent accounting (that is, to apply View A) would result in nearly all beneficial interests being accounted for under Subtopic 325-40 as PCD assets post-adoption of Update 2016-13, which did not seem to be the Board's intention.
22. Consequently, TRG members noted that the concern expressed about View B was highlighted as a trade-off for answering the scoping question correctly and, therefore, was deemed acceptable. That is, once the amendments in Update 2016-13 are adopted, credit risk alone should drive whether beneficial interests within the scope of Subtopic 325-40 should be accounted for as PCD assets. Additionally, the initial measurement of credit losses for PCD assets should be based on the difference between expected cash flows and contractual cash flows (as defined under View B). Income will be recognized at the rate that accretes any non-credit related premiums or discounts into income over the estimated life of the security. Following initial recognition, the revised model in Update 2016-13 will be less asymmetrical because the combination of credit losses, improvements in credit and changes in timing (such as changes in prepayment expectations) will either increase or decrease the allowance. If the allowance is reduced to zero, then any further favorable changes in prepayment and default expectations will result in prospective yield adjustments. Therefore, while this revised model will not eliminate prospective yield adjustments entirely, it will significantly reduce them. More importantly, credit risk alone will determine which beneficial interests within the scope of Subtopic 325-40 will apply PCD accounting under the revised guidance in Update 2016-13.
23. The staff does not plan to perform any further work on this issue.
Topic 3: Transition Guidance for Pools of Financial Assets Accounted for under Subtopic 310-30 (Memo 3)
24. Stakeholders submitted questions about the transition guidance provided in the amendments in Update 2016-13 for pools of assets accounted for under Subtopic 310-30. Specifically, stakeholders questioned the intent of the transition guidance included in paragraph 326-10-65-1(d) related to an entity's ability to elect to maintain pools of loans accounted for under Subtopic 310-30 at adoption.
25. The TRG discussed the following question:
(a) Can entities apply the election to maintain pools accounted for under Subtopic 310-30 at the time of adoption only, or both at the time of adoption and on an ongoing basis?
26. The TRG discussed two views:
(a) View A: Maintain the Subtopic 310-30 pool at the time of adoption only. Under this view, after adoption, an entity may only continue to maintain the pools for credit loss measurement purposes to the extent the risk characteristics of the underlying assets are similar in accordance with paragraph 326-20-30-2.
(b) View B: Maintain the Subtopic 310-30 pool both at the time of adoption and on an ongoing basis. Under this view, an entity would maintain the integrity of the pool consistent with the guidance in Subtopic 310-30 for all applicable areas of accounting, which may include credit loss measurement, interest income recognition, writeoff determination, and TDR identification. Regarding interest income recognition, the prospective transition approach for PCD assets (that is, the "gross-up approach") would be applied at a pool level which would freeze the effective interest rate of the pool. Under this view, entities that elect to maintain pools would not be able to remove assets from the pool until they are paid off, written off, or sold.
27. TRG members generally agreed that the allocation of the allowance for credit losses and noncredit discount or premium to an individual asset level may be challenging for existing pools of financial assets accounted for under Subtopic 310-30.
28. However, some TRG members that represent large financial institutions observed that they would likely apply View A in transition, even if View B were available as an election. These stakeholders noted that having all financial assets within the scope of Subtopic 326-20 accounted for on the same basis (that is, an individual asset unit of account) is important to users of their financial statements, and, in their view, the benefits of applying View A would outweigh any incremental costs. It was noted that users of financial statements would likely prefer View A and may push some entities towards applying that approach if View B were available as an election.
29. Some TRG members (both preparers and practitioners) that represent small financial institutions and non-bank entities that hold assets accounted for under Subtopic 310-30 noted that they prefer View B. These stakeholders observed that the allocation of the allowance and noncredit discount to individual assets required under View A would be operationally burdensome and may require the collection of additional data for existing pools at the time of transition. These stakeholders noted that View B would allow them to continue many of their current accounting processes for these pools and would provide significant cost relief.
30. Overall, the discussion indicated that application of either View A and View B could be supported by the guidance in paragraph 326-10-65-1(d) as it is currently written. The staff agrees that View B may provide cost relief to smaller financial institutions and would allow these entities to focus on other implementation activities. The staff notes that View B would also be permitted for large financial institutions. The staff believes that the election to maintain pools under View A or View B should be determined on a pool-by-pool basis.
31. The staff notes that as part of complying with the disclosure requirements in paragraphs 326-20-5010 through 50-11, any entity that applies View B should evaluate the need for disclosure of their election to maintain pools and any additional qualitative or quantitative information that may be necessary for a financial statement user to understand the size and nature of former Subtopic 31030 pools. Additionally, an entity would need to consider disclosure of the accounting policies that are in place for these pools that are different from other assets held by the entity.
32. Some stakeholders noted that the Subtopic 310-30 accounting is not being carried forward in its entirety, and therefore requested clarification on which paragraphs an entity should apply under View B. The staff note that entities should only consider the paragraphs relevant to the pool unit of account when applying View B, which include paragraphs 310-30-15-6, 310-30-35-15, and 310-30-40-1 through 310-30-40-2.
33. The staff does not plan to do any further work on this issue.
Topic 4: Accounting for Troubled Debt Restructurings (Memo 4)
34. Before the TRG meeting on June 12, 2017, stakeholders informed the staff that there is a lack of clarity on the accounting for TDRs when assessing credit losses under the amendments in Update 2016-13. Specifically, the addition of paragraph 326-20-30-6 (in particular, the requirement to extend the contractual term for expected extensions, renewals, and modifications if an entity has a reasonable expectation at the reporting date that it will execute a TDR) coupled with the elimination of the concept of an individually impaired loan, has caused stakeholders to question the accounting for TDRs within the amendments in Update 2016-13.
35. The TRG discussed the following question:
(a) Should entities forecast all types of reasonably expected future TDRs on a portfolio basis and include the effect of those reasonably expected TDRs in the calculation of expected credit losses?
36. TRG members discussed various forms of TDRs as loss mitigating activities and noted that those activities may have a direct or indirect effect on its loss history; therefore, the expectation of successful or unsuccessful TDRs may already be captured in a portfolio's loss statistics given the effect on probabilities of default or inputs to other measurement methods. Consequently, some TRG members suggested that because of these factors, TDRs are already appropriately reflected in expectations of credit losses for performing loans.
37. Other TRG members noted that while some TDR activity is captured in an entity's credit loss history, the subsequent accounting for certain TDRs (for example, interest rate concessions) may result in not reflecting the actual accounting concession in an entity's credit loss history. In addition, given the additional flexibility in accounting for TDRs under the new guidance, some TRG members questioned how certain accounting concessions (for example, interest rate concessions) should be measured at the point there is a reasonable expectation the concession will occur. Some TRG members noted that the process for identifying TDRs should not change from today and that reasonable expectations occur when loans are evaluated individually when credit deterioration occurs.
38. Certain TRG observers noted that the process should change and any accounting concession that is not reflected in loss history or one's expectation of credit losses should be recognized upon origination. These TRG observers also expressed concern that waiting until TDRs are identified at the individual borrower level may defer losses on pools of loans, failing to achieve a key objective of the amendments. They further explained that this issue is especially acute for pools of bullet loans or balloon payment loans for which a certain percentage of loans within the pools are not expected to be repaid or renewed at market terms, thereby constituting defaulted loans.
39. Finally, TRG members discussed the ability for financial statement preparers to use various methods and not require a DCF model when estimating expected credit losses. DCF models explicitly consider interest rate and term extension concessions, and other models (for example, the loss rate method) do not, which potentially could result in a difference in estimate. TRG members requested clarity on whether all types of concessions need to be considered and whether specific methodologies are required to be applied.
40. The staff will discuss the issue further with the Board and determine next steps.
Topic 5: Determining the "Estimated Life" of a Credit Card Receivable (Memo 5 and 5A)
41. Before the TRG meeting held on June 12, 2017, some stakeholders informed the staff that they believe there are two views about how to determine the "estimated life" of a credit card receivable for purposes of assessing credit losses under the amendments in Update 2016-13. The staff presented these views to the TRG and asked the following question:
(a) Should all principal payments expected to be received after the measurement date (that is, payments after finance charges and fees assessed have been paid) be applied to the credit card receivable balance existing at the measurement date until that balance is exhausted or should those payments be allocated in some manner between the measurement date balance and future credit card receivables expected to be originated through subsequent usage of the unconditionally cancellable loan commitment associated with the credit card account?
42. TRG members generally noted that entities could either consider future credit card receivable balances or not consider future credit card receivable balances when determining how to allocate future payments for estimating the life of the credit card receivable balance so long as losses were not recorded for commitments that are unconditionally cancellable. These views would result in different outcomes when future credit card receivable balances are expected to have components that carry higher interest rates than the components of the measurement date receivable (in which case, if future credit card receivable balances are considered, payments would be allocated to the highest interest rate portion of the balance first consistent with the CARD Act, even if it is expected to occur in the future). In other cases when the different components of the balance carry the same interest rate, the views would result in similar outcomes (generally, a "first-in first-out" methodology). The staff observes that this question only addresses payment allocation, which means that it is assumed that the entire amount of expected future repayments would be considered under either view.
43. The staff plans no further work on the issue of payment allocation; however, a separate question arose during the discussion on how future repayment amounts should be determined. Some TRG members noted that entities may need to consider the effect of expected future credit card receivable balances when determining expected future repayment amounts. The staff will have additional discussions with those TRG members who raised the question to determine the appropriate next steps.

1The staff observes that only the unit of account guidance from Subtopic 310-30 would continue to apply (specific paragraphs that would apply are listed in paragraph 31). Other guidance (for example, Subtopic 326-20) would apply for all areas of accounting other than the unit of account.

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