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Figure LI 14-2 provides a high-level summary of the subsequent measurement model for HTM and AFS securities subject to ASC 325-40.
Figure LI 14-2
ASC 325-40: High level summary of subsequent measurement

14.6.1 AFS beneficial interest: Intent to sell/required to sell

When a beneficial interest classified as available for sale is impaired (i.e., fair value is below the reference amount), the reporting entity should determine whether it has the intention to sell the security, or will more likely than not be required to sell the security before recovery of its amortized cost basis. If it is determined that an entity intends to sell, or more likely than not will be required to sell an AFS beneficial interest before recovery, the reporting entity should record the entire impairment loss in net income as a direct write-down of the amortized cost basis (see LI 8.2.3).
ASC 326-30-35-10 provides guidance on impairments of AFS securities if an entity intends to sell, or more likely than not will be required to sell a security before recovery of its amortized cost basis.

ASC 326-30-35-10

If an entity intends to sell the debt security (that is, it has decided to sell the security), or 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 debt security’s fair value at the reporting date with any incremental impairment reported in earnings. If an entity does not intend to sell the debt security, the entity shall consider available evidence to assess whether it more likely than not will be required to sell the security before the recovery of its amortized cost basis (for example, whether its cash or working capital requirements or contractual or regulatory obligations indicate that the security will be required to be sold before the forecasted recovery occurs). In assessing whether the entity more likely than not will be required to sell the security before recovery of its amortized cost basis, the entity shall consider the factors in paragraphs 326-30-55-1 through 55-2.

14.6.2 Changes in expected cash flows: AFS/HTM beneficial interests

A reporting entity should recognize accretable yield as interest income over the life of the beneficial interest for both PCD and non-PCD beneficial interests using the effective interest method. ASC 325-40 requires a reporting entity to periodically assess whether there have been favorable or adverse changes in either the timing or amount of cash flows expected to be collected regardless of whether the beneficial interest is classified as available for sale or held to maturity. Changes in expected cash flows may impact the allowance for credit losses, require the yield on the instrument to be updated, or both. The updated yield should be applied prospectively to the recognition of interest income and also applied as the discount rate when performing the net present value calculation.
ASC 325-40-35-5 through ASC 325-40-35-6 provide guidance on determining whether there has been a favorable (or an adverse) change in cash flows expected to be collected.

ASC 325-40-35-5

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.

ASC 325-40-35-6

The cash flows, including the assessment of expected credit losses, shall be discounted at a rate equal to the current yield used to accrete the beneficial interest.

ASC 325-40-35-4 provides guidance on accounting for changes in cash flows for beneficial interests classified as HTM within its scope and ASC 325-40-35-4A provides guidance for beneficial interests classified as AFS.

ASC 325-40-35-4

If upon evaluation of a held-to-maturity classified beneficial interest there is a favorable (or an adverse) change in cash flows expected to be collected from the cash flows previously projected, the investor shall first apply the guidance in Subtopic 326-20 on financial instruments measured at amortized cost to account for that favorable (or adverse) change. After application of the guidance in Subtopic 326-20, if the amount of the favorable (or adverse) change in cash flows expected to be collected from the cash flows previously projected is not reflected (either as an increase or as a decrease) in the allowance for credit losses in accordance with Subtopic 326-20, the investor shall recalculate the amount of accretable yield for the beneficial interest on the date of evaluation as the excess of cash flows expected to be collected over the beneficial interest’s reference amount.

ASC 325-40-35-4A

If upon evaluation of an available-for-sale classified beneficial interest there is a favorable (or an adverse) change in cash flows expected to be collected from the cash flows previously projected, the investor shall apply the guidance in Subtopic 326-30 on measuring credit losses on available-for-sale debt securities to account for that favorable (or adverse) change. After application of the guidance in Subtopic 326-30, if the amount of the favorable (or adverse) change in cash flows expected to be collected from the cash flows previously projected is not reflected (either as an increase or as a decrease) in the allowance for credit losses in accordance with Subtopic 326-30, the investor shall recalculate the amount of accretable yield for the beneficial interest on the date of evaluation as the excess of cash flows expected to be collected over the beneficial interest’s reference amount.

ASC 325-40-35-4B

The reference amount in paragraphs 325-40-35-4 through 35-4A is equal to the initial investment (or initial amortized cost basis for beneficial interests that apply the accounting for purchased financial assets with credit deterioration) minus cash received to date minus writeoff of amortized cost basis plus the yield accreted to date.

To determine whether there has been a change in expected cash flows, a reporting entity should compare the present value of the remaining expected cash flows as of the reporting date to the present value of expected cash flows at either the initial acquisition (or transaction) date or the last date on which the calculation was performed (e.g., previous reporting date). When performing the present value calculation, all cash flows should be discounted at the beneficial interest’s current accretable yield (i.e., effective interest rate). A reporting entity should the same date for the purposes of discounting.
The applicable expected credit loss guidance will depend on whether the beneficial interest is categorized as held to maturity or available for sale. The CECL impairment model should be applied to HTM beneficial interests (see LI 7) and the AFS impairment model should be applied to AFS beneficial interests (see LI 8).
Generally, when there is a change in expected cash flows, a reporting entity should first calculate an adjustment to the allowance for credit losses (or recognize an allowance for credit losses) pursuant to ASC 326-20 for beneficial interests classified as HTM or ASC 326-30 for beneficial interests classified as AFS. However, ASC 325-40 provides some specific rules in applying ASC 326-20 and ASC 326-30. ASC 325-40 requires changes in either the timing or amount of cash flows to be reflected as an adjustment to the allowance for credit losses in applying ASC 326-20 and ASC 326-30. In addition, when applying ASC 326-20 to a security subject to ASC 325-40, the use of a discounted cash flow method is required.
If the amount of the favorable (or adverse) change in cash flows is not fully captured as an adjustment to the allowance for credit losses, ASC 325-40 requires such change to be reflected through an adjustment of the accretable yield. This may occur in a number of situations, such as when there is favorable change in cash flows and the security does not have an allowance for credit losses. It may also occur with beneficial interests classified as AFS as a result of the application of the “fair value floor” in ASC 326-30. The application of the “fair value floor” may also result in the need for a reporting entity to adjust the allowance for credit losses and accretable yield even when the cash flows expected to be collected have not changed. 
Example LI 14-1 illustrates a situation when there has been an adverse change in cash flow due solely to a change in the timing of cash flows.
EXAMPLE LI 14-1
Adverse change – gross cash unchanged but timing is unfavorable
Transferor Corp owns a beneficial interest subject to the guidance in ASC 325-40. At the end of 20X1, Transferor Corp updates its cash flow estimates as shown in the following table. The updated estimate considers both the amounts expected to be collected in future periods and the timing of their receipt. Transferor Corp uses a discount rate of 15% in its evaluation, as this was the internal rate of return (accretable yield) used to recognize interest income on the beneficial interest during 20X1.
20X1
20X2
20X3
20X4
20X5
Gross cash
NPV at 15%
Original estimate
$25
$20
$20
$30
$0
$95
  Present value
$21.74
$15.12
$13.15
$17.15
$67.16
Revision at end of 20X1
$25
$15
$15
$20
$20
$95
  Present value
$21.74
$11.34
$9.86
$11.44
$9.94
$64.32
Has an adverse or favorable change occurred in the expected cash flows?
Analysis
The gross amount of cash flows expected to be received remains unchanged from the original estimate. However, the revised estimate indicates that there has been extension in the timing of the projected receipts. As a result, the NPV of the revised cash flow estimate ($64.32) is less than the original estimate ($67.16), which is an adverse change.
For HTM securities, this adverse change in cash flows would lead to the recognition of an allowance for credit losses (or an increase in the allowance for credit losses).
For AFS securities, if the fair value of the beneficial interest is greater than or equal to its reference amount, the change (decrease) in yield would be recognized prospectively. This is because an AFS security is not considered impaired unless its fair value is below its reference amount. However, if the fair value of the beneficial interest is less than its reference amount, an allowance for credit losses would be recognized, but may be limited by the fair value floor.

Example LI 14-2 illustrates a situation when there has been a favorable change in cash flows.
EXAMPLE LI 14-2
Favorable change – gross cash increase
Transferor Corp owns a beneficial interest subject to the guidance in ASC 325-40. At the end of 20X1, Transferor Corp updates its cash flow estimates as shown in the following table. The updated estimate considers both the amounts expected to be collected in future periods and the timing of their receipt. Transferor Corp uses a discount rate of 15% in its evaluation, as this was the internal rate of return (accretable yield) used to recognize interest income on the beneficial interest during 20X1.
20X1
20X2
20X3
20X4
20X5
Gross cash
NPV at 15%
Original estimate
$25
$25
$25
$25
$5
$105
  Present value
$21.74
$18.90
$16.44
$14.29
$2.49
$73.86
Revision at end of 20X1
$30
$25
$25
$25
$5
$110
   Present value
$26.09
$18.90
$16.44
$14.29
$2.49
$78.21
Has an adverse or favorable change occurred in the expected cash flows?
Analysis
The timing and amounts of cash flows expected to be received subsequent to 20X1 remains unchanged from the original estimate. However, cash received in 20X1 was $5 more than anticipated. As a result, the NPV of the revised cash flow estimate ($78.21) is greater than the original estimate ($73.86). The change (increase) in yield would be recognized prospectively assuming there is no existing allowance for credit losses (applicable to both AFS and HTM beneficial interests). If there were an existing allowance for credit losses, this increase in cash flows would first be reflected through a reduction of the allowance for credit losses and then, if applicable, a prospective yield adjustment.

14.6.3 AFS beneficial interests: fair value floor

As discussed in LI 8, the allowance for credit losses may be limited by the “fair value floor” contained in the available-for-sale debt security impairment model. The allowance for credit losses on an AFS debt security is limited to the excess of the reference amount above fair value. For scenarios in which the allowance for credit losses is limited (i.e., the decline in expected cash flows is not fully captured as part of the allowance for credit losses), a reporting entity should adjust accretable yield and apply the new effective interest rate prospectively.
In these situations, it is our understanding that the FASB’s intent was to not have the adverse change in cash flows “double counted” through the allowance for credit losses and a prospective yield adjustment. One method that could be used in calculating an updated prospective yield would be to calculate an updated yield as the excess of expected cash flows over the beneficial interest’s reference amount less the allowance for credit losses. However, absent further standard setting efforts by the FASB, other methods for adjusting yield may be appropriate. 
The updated yield should be applied prospectively to the recognition of interest income and also applied as the discount rate when performing the net present value calculation in the next period. A reporting entity should recognize future interest income based on the yield of the instrument applied to the amortized cost basis of the instrument (which does not include the allowance for credit losses).
The “fair value floor” contained in the AFS debt security impairment model may also impact how an entity calculates write offs. For example, if a reporting entity deems an originally expected cash flow (or a portion thereof) uncollectible, it would write off a portion of the allowance. However, the application of the fair value floor may result in situations when the entire impact of an uncollectible cash flow is not captured in the allowance. There may be various methods that are appropriate to calculate the write off of a portion of the allowance for credit losses limited by the “fair value floor.”
Example LI 14-3 illustrates the accounting for a beneficial interest classified as AFS.
EXAMPLE LI 14-3
Non-PCD beneficial interest classified as AFS
On 1/1/20X1, Bank Corp. purchases a beneficial interest for $110,000. Bank Corp. determines that the beneficial interest will be classified as available for sale, it is not deemed to be PCD, and is subject to ASC 325-40. Bank Corp. projects the expected cash flows of the beneficial interest through its expected life. At the date of acquisition, Bank Corp. determines the effective yield is 17.95%, which equals the market rate of return. Note that for the purposes of this example, certain amounts have been rounded.
Period
Expected cash flows
1/1/20X1
($110,000)
12/31/20X1
$30,000
12/31/20X2
$50,000
12/31/20X3
$40,000
12/31/20X4
$30,000
12/31/20X5
$20,000
Effective yield
17.95%
Bank Corp. would record the following entry at acquisition:
Dr. AFS Investment – BI
$110,000
Cr. Cash
$110,000
At the end of the first reporting period (12/31/20X1), Bank Corp. receives $30,000 as expected at acquisition and updates its expectation of future cash flows. Bank Corp. projects an adverse change (i.e., a shortfall) in expected cash flows compared to the expected cash flows at acquisition in periods 2, 3, and 5. However, due to a decline in interest rates, the market rate of return for the security has declined to 16%. As a result of the decline in expected cash flows, Bank Corp. determines the present value of the revised expected cash flows discounted at the beneficial interest yield (17.95%) would result in allowance for credit losses of $14,009. However, since the beneficial interest is an available-for-sale security, the allowance is limited to the fair value amount below the carrying amount ($11,158). In other words, the allowance is limited by the fair value floor.
12/31/20X1
Beginning reference amount
Interest Income
Cash received
Ending reference amount
$110,000
$19,750
$30,000
$99,750
Period
Revised expected cash flows
Original expected cash flows
Change in expected cash flows
NPV of revised expected cash flows discounted at market rate (fair value)
NPV of revised expected cash flows discounted at EIR
12/31/20X2
$45,000
$50,000
($5,000)
$38,793
$38,150
12/31/20X3
$30,000
$40,000
($10,000)
$22,295
$21,562
12/31/20X4
$30,000
$30,000
$0
$19,220
$18,280
12/31/20X5
$15,000
$20,000
($5,000)
$8,284
$7,749
Market yield
16.00%
Total
$88,592
$85,741
Bank Corp. would calculate the allowance for credit losses as follows:
Present value of expected cash flows
Reference amount
$99,750
NPV of expected cash flows at EIR
$85,741
Allowance (pre FV “floor”)
$14,009
Calculation of “fair value floor”
Reference amount
$99,750
Fair value
$88,592
Fair value floor
$11,158
Bank Corp. would record the following entries at 12/31/20X1:
Dr. Cash
$30,000
Cr. Interest Income
$19,750
Cr. AFS Investment - BI
$10,250
To record the cash received and interest income
Dr. Credit Loss Expense
$11,158
Cr. Allowance for Credit Losses - AFS
$11,158
To record the allowance for credit losses
Since the decline in expected cash flows was not fully captured as part of the allowance for credit losses, Bank Corp. determines a new effective yield based on the revised future expected cash flows and the reference amount, net of the allowance for credit losses. Bank Corp. determines a new effective yield of 16%, which should be applied prospectively. Since the net carrying amount of the security (reference amount/amortized cost basis of $99,750 less the allowance for credit losses of $11,158) equals the fair value of the security ($88,592), the security is on the balance sheet at fair value and as such there are no amounts reported in AOCI.
Updated accretable yield calculation
Reference amount, net of allowance for credit losses
Period
Original expected cash flow
Shortfall in cash flow
Expected cash flows
$88,592
12/31/20X2
$50,000
($5,000)
$45,000
12/31/20X3
$40,000
($10,000)
$30,000
12/31/20X4
$30,000
$0
$30,000
12/31/20X5
$20,000
($5,000)
$15,000
Updated accretable yield
16.00%
At the end of the second reporting period (12/31/20X2), Bank Corp. receives $45,000. However, this is an adverse change (i.e., a shortfall) of $5,000 as compared to the original expected cash flow of $50,000 at acquisition. Bank Corp. determines this amount is uncollectible and records a write-off of $4,030, which is less than the $5,000 shortfall that was deemed uncollectible. This is because the allowance for credit losses (which included the $5,000 shortfall) was limited by the “fair value floor.” Bank Corp. applied a reasonable and rational method of allocating the impact of the “fair value floor” to expected cash shortfalls. The method that Bank Corp. used was based upon a pro-rata allocation to periods with a shortfall in cash flows after considering the impact of discounting and time value of money.
Bank Corp. updates its expectation of future cash flows and determines that its estimated cash flows have not changed from its previous estimate. Bank Corp. determines the allowance for credit losses of $8,913 by taking the excess of the reference amount (subsequent to the $4,030 write-off) over the net present value of the revised expected cash flows, discounted at the updated effective yield of 16%. Since the changes in cash flows were fully captured in the allowance for credit losses, Bank Corp. determines that a prospective yield adjustment is not necessary.
12/31/20X2
Beginning reference amount
Beginning allowance for credit losses
Reference amount, net of allowance for credit losses
Interest Income
Cash received
Write off
Ending reference amount
$99,750
$11,158
$88,592
$15,960
$45,000
$4,030
$66,680
Period
Revised expected cash flows
Original expected cash flows
Shortfall
NPV of revised expected cash flows discounted at market rate
(fair value)
NPV of revised expected cash flows discounted at EIR
12/31/20X3
$30,000
$40,000
($10,000)
$25,862
$25,862
12/31/20X4
$30,000
$30,000
$0
$22,295
$22,295
12/31/20X5
$15,000
$20,000
($5,000)
$9,610
$9,610
Market yield
16.00%
Total
$57,767
$57,767
Bank Corp. would calculate the allowance for credit losses as follows:
Present value of expected cash flows
Reference amount
$66,680
NPV of expected cash flows at EIR
$57,767
Allowance (pre FV "floor")
$8,914
Calculation of “fair value floor”
Reference amount
$66,680
Fair value
$57,767
Fair value floor
$8,914
Allowance 12/31/X1
$11,158
Write off
($4,030)
Current period credit loss expense
$1,785
Allowance 12/31/X2
$8,914
Bank Corp. would record the following entries at 12/31/20X2:
Dr. Allowance for Credit Losses - AFS
$4,030
Cr. AFS Investment - BI
$4,030
To record the write-off of $4,030 which is a portion of the cash flows deemed uncollectible
Dr. Cash
$45,000
Cr. Interest Income
$15,960
Cr. AFS Investment - BI
$29,040
To record the cash received and interest income
Dr. Credit Loss Expense
$1,785
Cr. Allowance for Credit Losses – AFS
$1,785
To record additional credit loss expense (driven by passage of time). The calculation of credit loss expense is illustrated above as the change in the allowance for credit losses after the adjustment for write-offs.
Since the net carrying amount of the security (comprised of the reference amount/amortized cost basis of $66,680 less the allowance for credit losses of $8,914) equals the fair value of the security ($57,767), the security is on the balance sheet at fair value and as such there are no amounts reported in AOCI.

14.6.4 Change in expected cash flows: Trading beneficial interest

The requirement to periodically assess whether there has been a favorable or adverse change in expected cash flows and to record interest income is not limited to beneficial interests classified as available for sale or held to maturity, it applies to beneficial interests recorded at fair value with changes in fair value recognized in income if an entity separately presents interest income.
Question LI 14-2 addresses the application of ASC 325-40 to instruments carried at fair value with changes in fair value reported in current earnings.
Question LI 14-2
How should interest income be calculated for beneficial interests within the scope of ASC 325-40 that are measured at fair value with changes in fair value recorded in current earnings?
PwC response
At the November 1, 2018 TRG meeting (TRG Memo 14: Cover Memo and TRG Memo 18: Summary of Issues Discussed and Next Steps), the FASB staff noted that the guidance in ASC 325-40 applies to beneficial interests measured at fair value with changes in fair value recorded in current earnings for the purposes of interest income recognition. The FASB staff noted that they believe that entities will need to apply reasonable judgment to determine the amount of accretable yield for beneficial interests measured at fair value with changes in fair value recorded in current earnings.
We believe that either of the following methods is appropriate for recognizing interest income on beneficial interests in the scope of ASC 325-40 that are measured at fair value with changes in fair value recorded in current earnings:
  • Reflect all changes in estimated cash flows as a prospective yield adjustment. However, there are additional considerations if this would result in a negative yield.
  • Maintain a “shadow allowance for credit losses” solely for the purposes of calculating interest income. The “shadow allowance” used for determining accretable yield would be calculated in accordance with the amended applicable guidance for AFS beneficial interests in ASC 325-40-35-4A (see LI 14.6.2). In summary, subsequent declines in expected cash flows may not create yield adjustments and subsequent improvements in cash flows would first reduce the “shadow allowance” before a prospective yield adjustment. Note that the “shadow allowance” is an operational account for the purposes of determining and calculating accretable yield and would not be recorded in an entity’s financial statements.

Question LI 14-3 discusses whether a reporting entity should apply PCD accounting to a beneficial interest recognized at fair value with changes in fair value recorded in current earnings when it elects to maintain a shadow allowance for the purposes of calculating interest income.
Question LI 14-3
If a reporting entity maintains a shadow allowance for the purpose of recognizing interest income on a beneficial interest in scope of ASC 325-40 that is measured at fair value with changes in fair value recorded in earnings, should the reporting entity apply PCD accounting?
PwC response
No. Although the beneficial interest may have been considered PCD if it was classified as AFS or HTM, we do not believe a reporting entity should apply PCD accounting to a beneficial interest that will be measured at fair value with changes in fair value reported in current earnings.

14.6.5 Changes in expected cash flows: Plain-vanilla BIs

ASC 325-40-35-9 provides some relief from the credit loss impairment requirements for “plain-vanilla” beneficial interest subject to ASC 325-40.

ASC 325-40-35-9

However, unless the guidance in Topic 326 indicates that a credit loss has occurred, changes in the interest rate of a plain-vanilla, variable-rate beneficial interest generally should not result in the recognition and measurement of a credit loss (a plain-vanilla, variable-rate beneficial interest does not include those variable-rate beneficial interests with interest rate reset formulas that involve either leverage or an inverse floater).

For “plain-vanilla” variable-rate beneficial interests, a reporting entity would not record an allowance for credit losses based on applying the guidance in ASC 325-40-35-4 if it concludes that:
  • the adverse change in cash flows on the beneficial interest is solely due to changes in interest rates,
  • there are no adverse changes related to credit or the timing of cash flows,
  • it still expects to receive all contractual payments of principal and interest when due, and
  • it has the ability and intent to hold the beneficial interest; that is, it does not intend to sell the investment, and it is not more likely than not that it will be required to sell the beneficial interest before it recovers its investment.
The determination of what would be considered a “plain-vanilla” variable rate beneficial interest requires judgement.

14.6.6 Nonaccrual status of beneficial interests

The guidance on determining when a beneficial interest should be placed on nonaccrual status is consistent for both non-PCD and PCD beneficial interests. Beneficial interests within the scope of ASC 325-40 are required to use the cost recovery method when designated as nonaccrual, as stated in ASC 325-40-35-16. These beneficial interests are placed on nonaccrual status when an entity can no longer reliably estimate cash flows. See LI 6 for information on the cost recovery method.

> Nonaccrual Status-Cash Flows Not Reliably Estimable

ASC 325-40-35-16 This Subtopic does not address when a holder of a beneficial interest would place that interest on nonaccrual status or when a holder cannot reliably estimate cash flows. However, for beneficial interests placed on nonaccrual status or when a holder cannot reliably estimate cash flows, the cost recovery method shall be used

14.6.7 Writeoffs of beneficial interests

Consistent with the guidance in ASC 326-20-35-8 for HTM securities and ASC 326-30-35-13 for AFS securities, write offs of beneficial interests, which may be full or partial write offs, are recorded in the period in which such amounts are deemed uncollectible.
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