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13.3 Transition guidance — impairment
Publication date: 31 May 2022
us Loans & investments guide
The following sections describe the transition provisions of the impairment standard.
13.3.1 Impairment: Non-PCI debt securities (transition)
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
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?
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?
PwC response
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.
13.3.2 Impairment: Loans and receivables (transition)
The guidance in the impairment standard should be applied to loans (other than purchased loans with credit deterioration) using a modified retrospective approach. A reporting entity will be required to recognize the cumulative effect of initially applying the impairment standard as an adjustment to opening retained earnings in the period of initial application.
The CECL impairment model represents a significant change from previous guidance in calculating the allowance for credit losses. As a result, the cumulative effect adjustment will reflect the difference between today’s model and the CECL impairment model (except for purchased assets with credit deterioration).
Additional changes when applying the CECL model may include changes to how loans are pooled when applying the CECL impairment model compared to how they are pooled today for the purposes of calculating incurred losses. As the risk characteristics driving the calculation of the allowance for credit losses in a CECL impairment model may be different than those in the incurred loss model, reporting entities may need to develop loan pools based on different risk characteristics than in the past.
The amendments in ASU 2022-02 related to the recognition and measurement of TDRs (i.e., the elimination of TDRs) can be applied prospectively with the guidance applied to modifications occurring after the date of adoption of ASU 2022-02 or applied on a modified retrospective method, resulting in a cumulative-effect adjustment to retained earnings.
13.3.2.1 CECL transition relief for troubled debt restructurings – after the issuance of ASU 2022-02
Entities that have not adopted ASU 2016-13 (which introduced the CECL model) will be required to adopt ASU 2022-02 when they adopt ASU 2016-13. ASU 2016-13 is generally required to be adopted by means of a cumulative-effect adjustment to opening retained earnings. ASU 2022-02 provides for two methods of adopting the guidance relating to recognition and measurements of TDRs (i.e., the elimination of TDRs). The transition approach selected will impact the CECL transition relief for TDRs.
Prospective adoption of ASU 2022-02 for TDRs
For entities that have elected to adopt ASU 2022-02 on a prospective basis, the transition relief guidance for TDRs in ASU 2016-13 remains unchanged. The amendments in ASU 2022-02 relating to TDRs should be applied to modifications occurring after the date of adoption.
Modified retrospective adoption of ASU 2022-02
For entities that have elected to adopt ASU 2022-02 on a modified retrospective approach, the CECL transition relief for TDRs under ASU 2016-13 is no longer applicable as this adoption approach eliminates the concept of a TDR.
If an entity elects prospective adoption of ASU 2022-02 for TDRs, there is a potential that earnings could be impacted. Refer to LI 13.3.6 for further details around the transition for ASU 2022-02.
13.3.2.1 CECL transition relief for troubled debt restructurings – before issuance of ASU 2022-02
ASC 326-20 provides entities that use a DCF method to estimate expected credit losses with an accounting policy election (available in certain circumstances and required in others) to adjust the effective interest rate used to discount expected cash flows for the consideration of timing (and changes in timing) of expected prepayments. However, that guidance also states that when a loan is restructured through a troubled debt restructuring (TDR), the effective interest rate used to discount cash flows should not be adjusted because of subsequent changes in the expected timing of cash flows.
Stakeholders noted that it would be difficult in transition to calculate an effective interest rate to be used for discounting for loans that experienced a TDR prior to the adoption date of the credit loss standard by using prepayment assumptions in effect immediately before the restructuring. As a result, the FASB amended the transition guidance to allow an entity to make an accounting policy election to calculate the prepayment-adjusted effective interest rate used to discount cash flows on loans restructured through a TDR prior to the effective date using the prepayment assumptions that exist as of the date the entity adopts ASC 326-20.
13.3.3 Impairment: PCD assets (transition)
For purchased assets with credit deterioration, the transition to the new guidance is prospective. Upon adoption, reporting entities should not “reassess” the classification of existing assets to determine whether they met the definition of purchased assets with credit deterioration (PCD assets) when acquired. Assets that were previously accounted for as purchased credit impaired (PCI) under ASC 310-30 (including assets for which ASC 310-30 was applied by analogy) will be accounted for as PCD assets under the impairment standard.
When instruments that were accounted for as PCI are transitioned to the new PCD model, a “gross up” will need to be recorded to the amortized cost basis of the asset and the allowance for credit losses of these instruments. Any noncredit discount will be accreted to interest income using the interest method. The effective interest rate for the PCD instruments should be determined after the adjustment to the amortized cost basis at adoption.
Under ASC 310-30, if ASC 310-30 was applied on a pool basis, the pool was considered to be the unit of account for calculating both impairment and interest income. Under the CECL model, there is no such concept and (with the exception of an election at transition for existing pools) the guidance does not permit treatment of a pool of loans as a single unit of account that cannot be “broken” and instead requires an entity to pool assets based on similar risk characteristics at the reporting date. The impairment and interest income models for PCD assets are not part of a single integrated model. Therefore, the pools used for loan impairment and interest income recognition can differ.
For PCI pools that exist at the time of adoption, reporting entities may make one of the following accounting policy elections:
- Dissolve the existing PCI pools and calculate the “gross-up” on an individual loan basis at the adoption date. Subsequent to adoption, an entity is then required to pool assets based on similar risk characteristics at each reporting date in accordance with the new guidance.
- Maintain the existing PCI pools solely for the purposes of calculating the “gross-up” at the adoption date. The gross up would then be allocated to individual loans. The loans would be accounted for prospectively in accordance with the new guidance. If an entity elects to not maintain previous PCI pools on an ongoing basis, post transition an entity is required to pool assets based on similar risk characteristics at each reporting date.
- Maintain the existing PCI pools as a single unit of account subsequent to transition. The FASB staff has noted that when maintaining these pools, reporting entities should apply the following paragraphs relevant to the pool unit of account in previous GAAP (ASC 310-30-15-6, ASC 310-30-35-15, and ASC 310-30-40-1 through ASC 310-30-40-2).
As noted in ASC 326-10-65-1(d), reporting entities should not reassess whether modifications that occurred prior to the adoption of the guidance to individual acquired financial assets accounted for in PCD pools were troubled debt restructurings.
Existing instruments that were not accounted for as PCI under ASC 310-30 will not be considered PCD under the new standard. As such, they should follow the relevant transition provisions for non-PCD instruments.
Question LI 13-2
Assume an entity adopting ASU 2016-13 owns an AFS debt security previously accounted for under ASC 310-30. As a result, the security will be considered PCD upon transition. At the transition date, the fair value of the security is higher than its amortized cost basis. What should the entity record as part of its transition adjustment in adopting ASU 2016-13?
Assume an entity adopting ASU 2016-13 owns an AFS debt security previously accounted for under ASC 310-30. As a result, the security will be considered PCD upon transition. At the transition date, the fair value of the security is higher than its amortized cost basis. What should the entity record as part of its transition adjustment in adopting ASU 2016-13?
PwC response
ASC 326-10-65-1(d) provides transition guidance for AFS debt securities previously accounted for under ASC 310-30. It requires entities to consider these to be PCD and apply the guidance on a prospective basis, which will generally result in a “gross up” of the security’s amortized cost basis to reflect the addition of the allowance for credit losses. The initial recognition guidance for PCD AFS debt securities in ASC 326-30-30-2 requires that the initial allowance be computed in accordance with the AFS debt security impairment model in ASC 326-30-35-3 through ASC 326-30-35-10. This guidance states (in part) that an allowance for credit losses is limited by the amount that the fair value is less than the amortized cost basis. In addition, the AFS impairment model indicates that a security is only considered impaired if its fair value is less than its amortized cost.
For PCD AFS securities when the fair value exceeds amortized cost upon adoption of ASC 326, any allowance recorded at transition would increase the amortized cost basis and result in an allowance that exceeds the difference between the adjusted amortized cost basis and fair value of the security. We believe this would be inconsistent with the overall AFS impairment model guidance in ASC 326-30 that prohibits recording an allowance in these situations. We do not believe the transition guidance was intended to require recording an allowance that would be inconsistent with GAAP. Under this view, an entity should not record an allowance for credit losses nor should it record a “gross up” of a security’s amortized cost basis at transition in these circumstances. Therefore, the amortized cost basis at the transition date would remain unchanged.
Subsequent to adoption, if the PCD AFS security is subject to ASC 325-40, subsequent changes in cash flows would be accounted for in accordance with that Subtopic. Refer to LI 14.6 for further information. If the PCD AFS security is not subject to ASC 325-40, ASC 310-10-35-53B would prohibit any credit-related discount from being accreted into interest income.
13.3.4 Fair value option election at transition to ASC 326
ASC 326-10-65-1(i) allows an entity to irrevocably elect the fair value option on an instrument-by-instrument basis for certain financial instruments that are both within the scope of ASC 326-20 and eligible for the fair value option in ASC 825-10, Financial Instruments—Overall. However, this election does not apply to held-to-maturity debt securities. Entities choosing the fair value option upon transition to ASC 326-20 should subsequently apply the guidance in ASC 820-10 and ASC 825-10.
13.3.5 Impairment – transition disclosure overview
For specific disclosures required in the period of adoption and additional transition relief provided to public business entities that are not SEC filers, see LI 12.13.
13.3.6 ASU 2022-02 transition
For the changes to the recognition and measurement of TDRs (i.e., the elimination of TDRs), an entity has the option to apply a modified retrospective transition method, resulting in a cumulative-effect adjustment to retained earnings. If an entity elects a prospective approach for the elimination of recognition and measurement guidance on TDRs, the guidance is applied to modifications occurring after the date of adoption of ASU 2022-02. In addition, if an entity elects prospective adoption of ASU 2022-02 for TDRs, there is a potential that earnings could be impacted due to the elimination of the requirement to consider reasonably expected TDRs when estimating credit losses.
Question LI 13-3
Assume an entity adopts ASU 2022-02 using the prospective approach. Subsequent to the adoption of ASU 2022-02, the entity modifies a loan (the “current modification”) that was previously modified in a TDR prior to the adoption of ASU 2022-02. Should an entity apply the guidance in ASU 2022-02 to the current modification? ?
Assume an entity adopts ASU 2022-02 using the prospective approach. Subsequent to the adoption of ASU 2022-02, the entity modifies a loan (the “current modification”) that was previously modified in a TDR prior to the adoption of ASU 2022-02. Should an entity apply the guidance in ASU 2022-02 to the current modification? ?
PwC response
Yes. An entity that elects to apply ASU 2022-02 on a prospective basis should apply this guidance to any modification after its adoption date. As a result, the current modification should be analyzed to determine if it is a new loan or a continuation of the existing loan (see LI 10.2). This is required even if the borrower is currently experiencing financial difficulties.
In addition, the “once a TDR always a TDR” guidance that existed prior to the adoption of ASU 2022-02 is no longer applicable. As a result, in calculating the allowance for credit losses for this loan following the current modification, the entity is not required to use a DCF approach. If the entity elects to continue to use a DCF approach,
- the estimated cash flows should be based on the post-modification contractual terms, and
- the discount rate shall be based on the post-modification effective interest rate.
The new and amended disclosures should be applied prospectively beginning in the period of adoption. For the modification disclosures required in ASC 310-10-50-38 through ASC 310-10-50-44, information on modifications made prior to the adoption date do not need to be disclosed. Modifications made before the date of the adoption do not need to be included in the disclosures that require information about modifications made in the previous 12 months. Information related to gross writeoffs made prior to the adoption date required by ASC 326-20-50-6 do not need to be disclosed.
When comparative periods are presented, the disclosures related to prior periods that were required during those reporting periods (prior to the adoption of ASU 2022-02) should be carried forward. For example, the disclosures that were required in prior periods by GAAP that was superseded by ASU 2022-02 should be included in comparative financial statements.
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