ASC 320 requires that, subsequent to the recognition of an other-than-temporary impairment loss for debt securities, an investor shall account for the security as if the debt security had been purchased on the measurement date of the other-than-temporary impairment at an amortized cost basis equal to the previous amortized cost basis less the other-than-temporary impairment recognized in earnings. That is, a discount or reduced premium would be recorded based on the new cost basis, and future changes in the fair value of an available-for-sale security would be recognized in other comprehensive income until disposal of the security, or until another impairment in the security is considered other than temporary.

Both ASC 325-40 and ASC 310-30 provide models that address income recognition for debt securities with changes in expected cash flows. However, the appropriate model for a given debt security depends on the characteristics and circumstances of that specific investment. Questions sometimes arise about whether a beneficial interest in securitized financial assets should be accounted for under ASC 325-40 or ASC 310-30 when, at acquisition, the security is both "of low credit quality" (ASC 325-40) and it is not probable that the investor will be able to collect all contractual cash flows (ASC 310-30). ASC 325-40-15-3(d) notes that the guidance in ASC 325-40 applies to beneficial interests that are not within the scope of ASC 310-30. Therefore, a beneficial interest in securitized financial assets that meets the criteria in ASC 310-30 at acquisition should be accounted for in accordance with that guidance, even if it otherwise meets the scope set forth in ASC 325-40.

Further, a security that was within the scope of ASC 325-40 at acquisition shall not subsequently become subject to the guidance of ASC 310-30. The determination of whether a security is within the scope of ASC 325-40 or ASC 310-30 is made at (a) acquisition, (b) "completion of a transfer" as defined in ASC 310-30, or (c) on the OTTI date. If the security meets the scope of ASC 310-30 and ASC 325-40, the guidance in ASC 310-30 must be applied. The investor must perform a new scope assessment on the OTTI date, and if the security does not meet the scope criteria of ASC 310-30 at that date, the investor may apply ASC 325-40 after the OTTI, such as when a non-credit OTTI was recognized, because the entity intends to sell or, more likely than not, is required to sell the security before recovery. However, because ASC 310-30 is explicitly defined as the model to be used when an incurred credit loss exists at acquisition, recognition of a credit related OTTI will likely result in the application of ASC 310-30 to the security after such an OTTI.

Since both ASC 325-40 and ASC 310-30 provide complete models that address income recognition and impairment due to changes in expectations of future cash flows and changes in fair value, there is no need to change models after initial application. Furthermore, we do not believe that a change away from the application of ASC 325-40 can be supported as "preferable" under the requirements of ASC 250-10, Accounting Changes and Error Corrections.

When a beneficial interest accounted for as a debt security is not within the scope of ASC 325-40 at acquisition and a credit-related other-than-temporary impairment occurs, the investor should account for subsequent changes in cash flows expected to be collected in accordance with ASC 310-30. If, however, a non-credit OTTI is recognized for a beneficial interest accounted for as a debt security that was not within the scope of ASC 325-40 at acquisition, we believe that the entity has a policy election to account for the debt security in accordance with the ASC 325-40 guidance (provided it meets the scope of this guidance at this date as if it were any other purchased security) or ASC 310-30 (i.e., when a noncredit other-than-temporary impairment occurs).

Regardless of which method is employed, the security will continue to be subject to the company’s process for identifying further other-than-temporary impairments.

After an other-than-temporary impairment is recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected must be accreted. For beneficial interests in securitized financial assets accounted for as debt securities in accordance with ASC 325-40 at acquisition, significant increases or decreases in the cash flows expected to be collected, or actual cash flows significantly greater than or less than cash flows previously expected, should be treated as prospective adjustments to the accretable yield, even when an OTTI is not recognized, in accordance with ASC 325-40-35. ASC 325-40 allows an entity to recognize interest income on a beneficial interest "even if the net investment in the security is accreted to an amount greater than the amount at which the beneficial interest could be settled, if prepaid immediately in its entirety." See further guidance in ARM 5010.22.

For debt securities that are not accounted for within the scope of ASC 325-40 after an OTTI, a significant increase in cash flows expected to be collected or cash flows significantly greater than cash flows previously expected should be treated as prospective adjustments to accretable yield in accordance with ASC 310-30. For these securities, subsequent declines in estimated cash flows generally will not result in a yield adjustment, but may result in additional OTTI (if the debt security is impaired). Under ASC 310-30, a decrease in expected cash flows due to a decline in credit quality does not result in an adjustment to the amount of accretable yield unless the security is impaired. In addition, ASC 310-30-35-3 states that "interest income should not be recognized to the extent that the net investment of the loan would increase to an amount greater than the pay-off amount." This guidance primarily relates to a loan with a contractually increasing rate whose effective yield may exceed the contractual rate at certain times. In that situation, application of a pure effective yield approach may result in a carrying value that exceeds the payoff amount at certain times.

Also see ARM 5010.24 for additional information on the interest income recognition model applicable to certain structured notes, applicable when the embedded feature in the structured note is not required to be accounted for under ASC 815-15.

ASC 320 does not address when a holder of a debt security would place the security on nonaccrual status or how to subsequently report income on a debt security that is placed on nonaccrual status. ASC 310-30 and TIS Section 2130.25 through TIS Section 2130.26 state that, if an investor can reasonably estimate cash flows, an accretable yield should be recognized and the loan is considered an accruing loan. Any discount or reduced premium should be accreted over the remaining life of the debt security. Accordingly, we believe that management should use its best effort to obtain and apply appropriate market and internal data to determine estimated future cash flows on a debt security. However, when the timing and amount of cash flows is not reasonably estimable, we believe that companies should follow their existing accounting policy for reporting interest income on those securities (e.g., cost recovery method or cash basis method). Under the cash basis method, payments of interest received by the debt security holder are recorded as investment income, provided the amount does not exceed that which would have been earned at the historical effective interest rate. Alternatively, under the cost recovery method, which is required for beneficial interests accounted for under ASC 325-40, any interest or principal received is recorded as a direct reduction of the recorded investment in the debt security. When the recorded investment has been fully collected, any additional amounts collected are recognized as interest income.

Placement of an impaired security on nonaccrual status automatically results in an OTTI. Since a security should only be placed on nonaccrual status when the timing and amount of cash flows expected to be received is not reasonably estimable, an impairment loss equal to the difference between amortized cost and fair value at that date should be recognized in the income statement. That is, in order to avoid an OTTI, management must be able to make an assertion that the entity expects to recover the entire cost basis of the debt security, even if there is no present intent to sell the security and it is not considered more likely than not that the entity will be required to sell the security before recovering its amortized cost basis. Such an assertion is not possible when management is not able to reasonably estimate future cash flows for the debt security. In addition, any subsequent decline in the fair value of a debt security placed on nonaccrual status will trigger an additional OTTI in the income statement.

Further, in order to recognize a portion of an OTTI as a non-credit loss, management must be able to estimate future cash flows. When a debt security is placed on non-accrual status, management has asserted that it is unable to reasonably estimate future cash flows. Therefore, an OTTI equal to the difference between the security's amortized cost and its fair value should be recognized in earnings.

Question: If an other-than-temporary impairment is recognized because the entity intends to sell the debt security, or it is more likely than not it will be required to sell the debt security before recovery of its amortized cost, must a credit loss be computed for post-OTTI accounting purposes?

Interpretive response: An OTTI is not limited to credit loss when an entity intends to sell an impaired debt security or when it is more likely than not the entity will be required to sell the impaired debt security before recovery of its amortized cost basis. In that circumstance, the amount of OTTI is equal to the difference between the debt security's fair value and its amortized cost, and the credit loss is not required to be separately presented in the financial statements. Regardless of the reason an OTTI is recognized, the difference between the new amortized cost basis and the cash flows expected to be collected should be accreted as interest income in accordance with existing guidance. As a result, the analysis of future expected cash flows is technically required for all securities for which an OTTI is recognized. However, given that a sale is generally expected to occur within a reasonably short time period after a decision to sell has been made, subsequent accretion may not be material, depending on an entity's particular facts and circumstances.

Question: Should a decrease in an index or rate on a conventional variable rate debt security result in a decrease in the accretable yield under ASC 310-30 and ASC 325-40?

Interpretive response: It depends. ASC 310-30-35-14 indicates that an investor should prospectively adjust the accretable yield when there is a decrease in the index or rate on a variable rate debt security. Additionally, ASC 325-40-35-9 states that, absent other indicators, a decrease in expected cash flows due to a change in the index of a plain vanilla beneficial interest should not result in an OTTI, implying that such a change should result in a decrease in accretable yield. However, we believe that under both accounting models, when the effect of a change in the variable rate index or rate cannot be separated from the overall decline in expected cash flows, the investor should account for the decline in cash flows as an OTTI. The application of ASC 325-40 and ASC 310-30 to more complex or nonconventional securities may require significant judgement, primarily in isolating the components of changes in overall expected cash flows (e.g., changes due to prepayments, changing index or rate, etc.).