ASC 325-40 requires an investor to calculate a beneficial interest’s accretable yield, which is based on expected cash flows and results in the rate to be applied to the carrying amount of the beneficial interest to measure interest income under the effective interest method. See LI 6 for information on applying the effective yield method more generally.

Upon acquiring a beneficial interest subject to ASC 325-40, an investor is required to determine the excess of all cash flows expected to be collected over the interest’s initial investment, i.e., the fair value of the beneficial interest as of the acquisition (transaction) date. That excess (the accretable yield) is recognized as interest income over the life of the beneficial interest using the effective yield method. ¹ The accretable yield calculated at the acquisition date is subject to periodic reassessment, as discussed in the following section. See LI 6 for additional information on calculating the effective yield of a debt instrument.

Based on the guidance in ASC 325-40-35-1, the holder of a beneficial interest subject to ASC 325-40 is required to continually update its estimate of cash flows expected to be collected over the life of the beneficial interest. ASC 325-40-35-2 clarifies that when estimating cash flows expected to be collected, the holder must consider both the amount and timing of anticipated estimated principal and interest cash flows based on its best estimate of current information and events. It is important to note that, when evaluating whether a change in a beneficial interest’s estimated cash inflows has occurred, both the timing and amount of those inflows should be taken into account. Accordingly, the investor should consider anticipated credit-related losses on, and prepayments of, the underlying securitized financial assets, as well as provisions in the controlling indenture (or similar agreements) that could affect the timing and amounts to be received.

If, after updating its assessment, the holder of a beneficial interest concludes that its expectation of future cash inflows (collections) has changed, then the investor should recalculate the amount of accretable yield. Any adjustment to the accretable yield of the beneficial interest resulting from a change in the cash flow estimate should be accounted for prospectively as a change in estimate in accordance with the provisions of ASC 250. That is, a holder would calculate a new internal rate of return (accretable yield), taking into consideration the current “reference amount” of the beneficial interest ² and the revised estimate of future cash flows, and prospectively accrue interest income based on that new rate. The new internal rate of return must be recalculated each time expected future cash inflows on the beneficial interest change.

As discussed in ARM 5010.2212, an investor’s calculation of an updated accretable yield may take place at the same time an-other-than-temporary impairment of the beneficial interest is recognized. In that case, the write-down (corresponding to the charge to earnings) will impact the reference amount used to determine the beneficial interest’s new accretable yield.

Interest income recognized on a beneficial interest may reflect an effective yield (internal rate of return) that differs from the market discount rate used to measure (or implied by) the beneficial interest’s fair value. This stems from the fact that the market discount rate used to measure the fair value of the beneficial interest (or implicit in the fair value) will incorporate various market factors (e.g., changes in credit spreads and liquidity risk) that are not considered in the determination of the beneficial interest’s internal rate of return. The internal rate of return is calculated based on the beneficial interest’s reference amount, whose current carrying amount may reflect the cumulative interaction of debits and credits to the balance unrelated to the interest’s current fair value (see footnote 2). A beneficial interest’s effective yield (internal rate of return) for financial accounting purposes and the market discount rate used to measure (or implicit in) the fair value of the beneficial interest should be the same at the acquisition date of the beneficial interest. They will also be the same when the reference amount of the beneficial interest is required to be written down to its fair value. Otherwise, these two rates may not be the same.

ASC 325-40-35-16 acknowledges that there may be instances when a holder of a beneficial interest concludes that the investment should be placed on non-accrual status or when the investor concludes that it cannot reliably estimate cash flows. ASC 325-40 does not provide guidance to assist a holder in making these determinations. However, ASC 325-40-35-16 requires that the investor apply the cost recovery method if the beneficial interest is placed on non-accrual status, or if the holder cannot reliably estimate future cash flows to be received.