The FASB recognized that the changes to the impairment model for debt securities would likely create a number of transition issues. Historically, an impairment of a debt security was recorded as a basis adjustment to the amortized cost basis of the instrument. Any subsequent improvements in cash flows following an impairment were reflected through an increased yield on the instrument. Reversing the impact of the prior accounting and replacing it with the establishment (or release) of an allowance for credit losses would require historical data that many reporting entities may not have available. As a result, retrospective adoption or calculating a cumulative effect would have been challenging. Therefore, the FASB decided to have the impairment guidance apply to debt securities that were previously impaired on a prospective basis.
Upon adoption, the amortized cost basis of debt securities is unchanged. Previous write-downs recorded on debt securities should not be reversed. In addition, the effective interest rate remains unchanged at initial adoption. The carrying amount and effective interest rate of the debt security will be utilized to apply the model prospectively. ASC 326-10-65
-1(e) also requires any amount previously recognized in AOCI that relates to improvements in cash flows to continue to be accreted into interest income over the remaining life of the debt security on a level-yield basis.
While the amortized cost basis of debt securities is unchanged, in certain circumstances an entity may be required to record an allowance for credit losses on its securities at transition. The prospective application required by ASC 326-10-65
-1(e) was specifically limited to the determination of the amortized cost basis. Therefore, an allowance recognized in connection with adopting the guidance in ASC 326
should be recognized as a cumulative effect adjustment to opening retained earnings in accordance with ASC 326-10-65
-1(c) for both HTM and AFS debt securities.
For securities that have experienced an improvement in cash flows subsequent to the adoption date, but experienced an impairment prior to the adoption date, the transition guidance in ASC 326-10-65
-1(e) requires recoveries of amounts written off before the adoption date relating to improvements in cash flows forecasted after the date of adoption to be recorded to income in the period received and not in the period in which the entity’s credit loss expectation changed. Therefore, the entity is required to wait to record the impact of any expected improvement in those cash flows until the cash is actually received.
A debt security could experience both (1) an impairment prior to adoption and (2) an incremental expected credit loss recorded as an allowance after adoption. When an entity subsequently forecasts collection of all contractual cash flows, we believe an entity could immediately reverse the allowance for credit losses recognized under ASC 326
. Any additional improvements in expected cash flows relating to an impairment recorded prior to adoption can only be recorded in the period when the cash is received. There may be additional considerations when an entity has write offs both before adoption and after adoption followed by an increase in expected recoveries.
Question LI 13-1 discusses whether an entity is expected to record an allowance for credit losses on HTM debt securities at transition.
Question LI 13-1
On transition to ASC 326-20
for HTM debt securities, is an entity expected to record an allowance for credit losses for a security that was previously impaired?
While the amortized cost basis of the debt security with previous impairment remains unchanged under the transition requirements, the credit loss model for HTM debt securities changed as a result of ASU 2016-13
. Therefore, an entity may be required to recognize an allowance for credit losses at adoption. For example, under previous GAAP, an entity’s impairment assessment of HTM debt securities was based on its best estimate of the present value of cash flows expected to be collected. ASC 326-20-30
-10 requires an entity to include a measure of the expected risk of credit loss even if that risk is remote. This could result in an allowance for credit losses being required upon transition. This specific example is not applicable for AFS debt securities as ASC 326-30-35
-7 requires an entity to use its best estimate of the present value of cash flows expected to be collected, which is consistent with previous GAAP.
In addition, under previous GAAP, an entity was required to use a discounted cash flow (DCF) method to estimate and recognize a credit loss impairment. For HTM debt securities, ASC 326-20
does not require the use of a particular method. While a DCF method is permitted, an entity may elect to use other methods (e.g., a loss rate or a probability-of-default/loss given default method). When a method other than a DCF method is used to estimate expected credit losses, an allowance for credit losses may be required upon transition. This specific example would not be applicable for AFS debt securities as ASC 326-30-35
-6 requires the use of a DCF method when estimating credit losses, which is similar to previous GAAP.