If an entity intends to sell an impaired debt security or MLTN will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the impairment is other than temporary and should be recognized currently in earnings in an amount equal to the entire difference between fair value and amortized cost. If not, companies should determine whether a credit loss exists.

If a credit loss exists (because the present value of cash flows expected to be collected is less than the amortized cost basis of the impaired security), but an entity does not intend to sell the impaired debt security and is not more likely than not to be required to sell before recovery, the impairment is other than temporary and should be separated into (i) the estimated amount relating to credit loss and (ii) the amount relating to all other factors. Only the estimated credit loss amount (i.e., present value of cash flows expected to be collected less amortized cost basis of the security) is recognized currently in earnings, with the remainder of the loss amount recognized in other comprehensive income.

The previous amortized cost basis less the other-than-temporary impairment recognized in earnings becomes the new amortized cost basis of the investment. The new amortized cost basis should not be adjusted for subsequent recoveries in fair value. However, the amortized cost basis must be adjusted for accretion and amortization.

For a held-to-maturity security, total OTTI (including credit and non-credit components) is equal to the excess carrying value of the security over its fair value before recognizing any additional impairment. When an OTTI is recognized, the carrying amount of an HTM security is adjusted to fair value at that time. As the security's amortized cost is only adjusted for the portion of the OTTI recognized in earnings, a difference between the security's amortized cost and carrying value is created whenever a portion of the OTTI is not recognized in earnings (i.e., is recognized in OCI). The carrying value of an HTM security subsequent to OTTI recognition will equal that security's amortized cost less any unrecognized OTTI remaining in OCI at the current measurement date. Accretion of the non-credit component of an OTTI adjusts the carrying value of an HTM security but not its amortized cost.

For a held-to-maturity security, the portion of an other-than-temporary impairment not related to a credit loss will be recognized in a new category of other comprehensive income and accreted over the remaining life in a prospective manner on the basis of the amount and timing of future estimated cash flows. ASC 320 does not provide guidance on what method should be used to accrete this amount. Accretion of the non-credit component of an OTTI adjusts the carrying value of an HTM security, but not its amortized cost. We believe that the effective yield income recognition model would be applied in some fashion to the amortized cost basis and AOCI component of a security. However, in certain circumstances, as a practical matter, the application of the straight-line method to the OTTI that is recognized in OCI may result in amounts that are not materially different from the effective rate method.

For impaired securities which management does not intend to sell and is not MLTN required to sell before recovery, ASC 320-10-35-33C states: "If an entity does not expect to recover the entire amortized cost basis of the security, the entity would be unable to assert that it will recover its amortized cost basis even if it does not intend to sell the security. Therefore, in those situations, an other-than-temporary impairment shall be considered to have occurred. In assessing whether the entire amortized cost basis of the security will be recovered, an entity shall compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis of the security, the entire amortized cost basis of the security will not be recovered (that is, a credit loss exists), and an other-than-temporary impairment shall be considered to have occurred."

The methodology for loans receivable described in ASC 310-10 is one way of estimating the present value of cash flows expected to be collected from the debt security. Other methods may be appropriate. Any method for measuring a credit loss should be consistent with the Board's intent that "cash flows expected to be collected should represent the cash flows that an entity is likely to collect after a careful assessment of all available information." In measuring the present value of cash flows expected to be collected, we believe that the decision to use either a single best estimate or a probability-weighted methodology is a policy election. This election should be documented, disclosed, and consistently applied. Methodologies that implicitly or explicitly recognize changes in cash flows that are not due to credit would generally not be appropriate.

If a probability-weighted measure of cash flows is used to determine cash flows expected to be collected, it would be inappropriate to use the effective interest rate implicit in the debt security at the date of acquisition. This rate represents the contractual interest rate adjusted for any costs, premium, or discount that existed at the acquisition date and is essentially comprised of a risk-free rate adjusted for credit spread and liquidity premium. This rate equates the cost of the debt security to the debt security's expected cash flows over its remaining term. By its nature, this rate reflects expectations about potential future defaults. It would, therefore, not be appropriate to use it to discount a probability-weighted measure of cash flows, because the cash flow projections already reflect assumptions about future defaults.

When estimating the present value of cash flows expected to be collected and evaluating OTTI, management is required to consider all relevant facts and circumstances. The market's view of the likelihood and amount of future cash flows which is embedded in the current fair value measure under ASC 820, Fair Value Measurements and Disclosures, is one important source of evidence that should be considered. However, ASC 320 does not require entities to use the same inputs and assumptions when measuring fair value under ASC 820 and credit losses under ASC 320-10-35, nor to place exclusive reliance on market participant assumptions of future cash flows. The implied yield approach may be helpful in estimating expected future cash flows. As declines in fair value increase in severity and duration, and in the absence of explicit evidence to the contrary, the level of analysis and objective evidence needed to support a difference between management's estimate of cash flows expected to be collected and the cash flows implied in a current fair value measurement also increases.

Typically, use of fair value as a practical expedient for determining the credit loss on a debt security would be inconsistent with the underlying objective of the guidance in ASC 320-10-35. The use of fair value, which includes assumptions regarding interest rate, liquidity and other market risks, in addition to perceived credit risk, would not isolate a credit-related decrease in estimated cash flows. However, in certain limited circumstances, the fair value of a debt security may represent an entity's best estimate of the present value of cash flows expected to be collected within acceptable materiality limits. Also note that, while fair value cannot be used as practical expedient for measurement of a credit loss, this does not affect the requirement to measure OTTI as the difference between a debt security's fair value and amortized cost if the entity intends to sell the debt security, or more likely than not will be required to sell the debt security, before recovery of its amortized cost basis (less any current period credit loss).

It is not necessary that a detailed cash flow analysis be performed on every impaired debt security to determine whether a credit loss exists. Management is required to determine whether the present value of cash flows expected to be collected is less than the amortized cost basis of the impaired security (i.e., whether a credit loss exists). Under certain circumstances, a qualitative determination of whether a credit loss exists may be based on evaluation of all available information, including the conditions outlined in ASC 320-10-35-33F. If, based on this qualitative assessment, a credit loss is determined to exist, such loss should be measured in accordance with the guidance (i.e., quantitatively).

A decrease in cash flows expected to be collected on an asset-backed security that results from an increase in prepayments on the underlying assets must be considered in the estimate of present value of cash flows expected to be collected. We understand that the guidance in ASC 320-10-35 about the treatment of prepayments was intended to provide clarification for determining the "cash flows expected to be collected" on interest-only securities and other similar securities that can be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of the investment. These securities are generally accounted for in accordance with ASC 325-40 if they are not considered derivatives within the scope of ASC 815, Derivatives and Hedging. ASC 325-40 requires that an entity estimate cash flows expected to be collected based on all available information, including prepayments. We do not believe that the impairment guidance in ASC 320-10-35 changes the accounting for prepayments under existing accounting models, including ASC 310-20, Nonrefundable Fees and Other Costs, ASC 325-40, Beneficial Interests in Securitized Financial Assets, or ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, or that decreases in expected cash flows as a result of contractual prepayments that were typically considered yield adjustments under those models should now be considered potential credit losses.

ASC 310-20 states that, if prepayments are not anticipated, and prepayments occur, a proportionate amount of the purchase premium or discount shall be recognized in income so that the effective rate implicit in the debt security remains unchanged (commonly referred to as the contractual method). The amount of the prepayment recognized in income is considered an adjustment to interest income. Considering prepayments when determining expected cash flows under the impairment guidance, but not when determining the security's effective yield or amortized cost basis under the contractual method, could result in a computed credit loss when changes in cash flows relate solely to items that are treated as yield adjustments under the contractual method.

When there is a decrease in expected cash flows for a security accounted for under the contractual method of ASC 310-20, an entity must determine whether that decrease relates to prepayments that will be reflected as yield adjustments or to actual credit losses (i.e., failure to collect all contractual amounts due). If the decrease in expected cash flows is due to a failure to collect all contractual amounts due, we believe the credit loss for that security is equal to the entire difference between expected cash flows (including the impact of prepayments) and the security's current amortized cost.

ASC 310-20 Securities – effective yield retrospective method:

Under ASC 310-20-35-26, interest income on purchased debt securities should be recognized in a way that produces a constant effective yield based on contractual cash flows. An entity may elect, in certain cases, to include estimated prepayments on debt securities that are contractually prepayable in its estimate of cash flows that is used to determine the effective yield. When estimated cash flows include a prepayment assumption, a difference may arise between the prepayments anticipated and actual prepayments, and expectations about future prepayments may change over time. When this occurs, the effective yield is adjusted to reflect actual payments to date and anticipated future payments, and the security's amortized cost is adjusted to the amount that would have existed had the new effective yield been applied since acquisition (commonly referred to as the retrospective method).

When the retrospective method is used, the current effective yield may not be equal to the effective interest rate implicit in the security at the date of acquisition, as described in ASC 310-10-35. Use of the original effective yield to determine and measure credit losses may result in a computed credit loss when the changes in cash flows relate solely to changes in prepayment experience and expectations that have historically been recognized as yield adjustments under ASC 310-20. As discussed above, we do not believe that the guidance changes the accounting for prepayments under existing accounting models. As a result, the current effective yield, after updating for current period actual prepayments and changes in anticipated future prepayments, should be used to determine whether a credit loss exists. Conceptually, this is consistent with the view that ASC 310-20 results in a restatement of the effective yield to the rate that would have been in effect at acquisition had the information known at the current measurement date been known at the acquisition date.

ASC 310-20 conventional variable rate securities

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For purposes of this discussion, a "conventional variable rate debt security" generally does not include more complex securities than those based on an index or rate (i.e., prime rate or LIBOR), and that may be accounted for under ASC 310-30 or ASC 325-40, including certain beneficial interests whose underlying assets may include variable rate debt securities or loans.

ASC 310-20 allows the constant effective yield of a conventional variable rate debt security to be computed based either on the factor (i.e., the index or rate) that is in effect at the inception of the security or on the factor as it changes over the life of the security.

ASC 310-10-35 states that, when measuring the impairment of a variable rate loan, the present value of expected cash flows can be calculated using the effective interest rate as it changes over the life of the loan, or the effective rate may be fixed at the rate in effect at the date the loan meets the ASC 310-10-35 impairment criteria. As the guidance explicitly mentions the approach described in ASC 310-10-35 as an acceptable approach for calculating the present value of cash flows expected to be collected from a debt security, we believe the ASC 310-10 guidance related to variable rate loans may also be applied to conventional variable rate debt securities when computing expected cash flows for impairment purposes. Both ASC 310-20 and ASC 310-10 state that future changes in the variable rate may not be projected. Management should establish a policy for determining the discount rate for conventional variable rate debt securities, and should consistently apply that policy to those securities.

Refer to ARM 5010.4517 for additional discussion on accounting for debt securities with evidence of credit deterioration and ARM 5010.4518 for debt securities accounted for as beneficial interests.

Question: May an entity recognize a credit loss in excess of the unrealized loss on an impaired debt security?

Interpretive response: Yes, an entity may recognize a credit loss in excess of the unrealized loss on an impaired security in specific market conditions. If the OTTI is being recognized because (1) the entity intends to sell the debt security or (2) because it is MLTN that the entity will be required to sell the debt security before recovery, the amount of OTTI recognized in the income statement will equal the unrealized loss on the impaired debt security. However, in all other cases, it is possible for a debt security's amortized cost to be written down below fair value. In these other instances, a portion of the credit loss recognized in the income statement is offset by an unrealized gain in comprehensive income such that the carrying value of the debt security will always be its fair value. This could occur even if a market participant's view of future expected cash flows is consistent with management's expectations, because other factors affect fair value, and changes in fair value due to those factors may offset the decline in fair value due to a decrease in expected future cash flows. For example, a decrease in risk-free interest rates would result in an offsetting increase to fair value even when future estimated cash flows have declined. This decrease in risk-free interest rates would not be reflected in the determination of the credit loss in accordance with an ASC 310-10 methodology (which would be computed using the effective interest rate implicit in the debt security at the date of acquisition). However, we are aware that there is an alternative view that the security's amortized cost should not be written down below its fair value. Therefore, we believe this would be a policy election that should be consistently applied, and any change must be accounted for as a change in accounting principle in accordance with ASC 250, Accounting Changes and Error Corrections.