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ASU 2016-13 introduces new accounting models related to how credit losses on financial instruments are determined. These new models apply to:
  • Loans, accounts receivable, trade receivables, and other financial assets measured at amortized cost
  • Loan commitments and certain other off-balance sheet credit exposures
  • Debt securities and other financial assets measured at fair value through other comprehensive income
  • Beneficial interests in securitized financial assets
Figure LI 1-2 summarizes some of the significant changes in ASU 2016-13 and related codification improvements.
Figure LI 1-2
Changes to the accounting for impairments of financial assets
Topic
Guidance
Observations
Recognition of expected credit losses under current expected credit loss (CECL) impairment model
The CECL model requires a reporting entity to estimate credit losses expected over the "life" of an asset (or pool of assets). The estimate of expected credit losses should consider historical information, current information, and the reasonable and supportable forecasts of future events and circumstances, as well as estimates of prepayments.
The CECL model will apply to: (1) financial assets measured at amortized cost and (2) certain off-balance sheet credit exposures. Examples of instruments subject to the CECL model include loans, held-to-maturity (HTM) debt securities (including corporate bonds, mortgage backed securities, municipal bonds and other fixed income instruments), loan commitments (including lines of credit), financial guarantees accounted for under ASC 460, Guarantees, and net investments in leases, as well as reinsurance and trade receivables.
Initial recognition of expected credit losses (on assets not considered to be PCD)
The CECL model requires the recognition of expected credit losses upon initial recognition of a financial asset. With the exception of certain purchased assets with credit deterioration, (PCD), this day-one recognition of the allowance for credit losses is recorded with an offset to net income.
Originated and purchased financial assets (not considered to be PCD) include compensation for credit risk in the yield or investment return of the assets. The recognition of the effective yield of the instrument (including compensation for credit risk) will occur over time through the application of the interest income models under GAAP. Since estimated credit losses will be recognized in net income on day one, this creates a mismatch in the timing of the recognition of expected credit losses and the recognition of the compensation for credit risk.
Grouping of financial assets when applying the CECL model
Financial instruments with similar risk characteristics should be grouped together when estimating expected credit losses.
Risk characteristics used as a basis for pooling may include past due status, collateral type, borrower’s FICO score, internal and external credit ratings, maturity (term), industry of the borrower, subordination, origination vintage, geographical location of the borrower, or other factors.
Reporting entities should carefully consider the attributes utilized to create pools of similar risk characteristics and consider what inputs drive the credit risk measurement used in credit loss modelling.
Recoveries
Under CECL, expected recoveries of amounts previously written off and expected to be written off shall be included in the estimate of the allowance for credit loss. These amounts should not exceed the aggregate of amounts previously written off and expected to be written off. This may result in a “negative allowance,” which when added to the amortized cost basis of the asset reflects the amount that an entity expects to collect.
The impairment model applicable to available-for-sale investments prohibits the recognition of a “negative allowance”.
As of the content cutoff date of this publication, the FASB has not issued an accounting standards update regarding the applicability of the guidance on recoveries to PCD assets. Financial statements preparers and other users of this publication are therefore encouraged to monitor the status of this project and when the accounting standard update is issued, evaluate the effective date of the guidance and the implications on the accounting for PCD assets.
Troubled debt restructuring (TDR)
Loans subject to a TDR will be assessed for impairment using the CECL model.
In measuring an impairment on an instrument that has been restructured through a TDR, the value of certain concessions made by the creditor should be reflected in the allowance for credit losses.
If a TDR is reasonably expected to occur, the expected life of a financial asset should consider any extensions that may result from the TDR.
Impairment of available-for-sale (AFS) debt securities
The impairment model for AFS debt securities will require an estimate of expected credit losses only when the fair value is below the amortized cost of the asset.
The credit-related impairment amount will be recognized in net income; the remaining impairment amount is recognized in OCI. Credit losses are recognized through the use of an allowance for credit losses account and subsequent improvements in expected credit losses are recognized as a reversal of the allowance account.
The AFS impairment model is no longer based on an impairment being “other-than-temporary.”
Unlike the CECL model, the impairment model for AFS debt securities does not permit pooling of securities and requires an entity to use a discounted cash flow approach when estimating the expected credit losses.
Purchased assets with credit deterioration (PCD assets)
An investor will need to recognize an allowance for credit losses upon initial recognition of a PCD asset by estimating the expected credit losses. Unlike the CECL model for other financial assets, the initial estimate of expected credit losses should be recognized as an adjustment to the amortized cost basis of the related financial asset at acquisition (i.e., a balance sheet gross-up) rather than through net income.
Subsequently, the accounting for PCD assets will follow the CECL model or AFS debt security impairment model (as appropriate) with all adjustments to the allowance for credit losses recognized in net income.
This guidance is intended to simplify the accounting for PCD assets from the purchased credit impaired (PCI) asset model in ASC 310-30 and also creates a model whereby the establishment of an initial allowance does not impact earnings. The PCD model is also meant to more closely align the accounting in periods subsequent to acquisition with the accounting for originated assets.
Beneficial interests subject to ASC 325-40
Beneficial interests that meet the definition of a PCD asset or have a significant difference between their expected cash flows and contractual cash flows at the date of initial recognition are subject to the PCD asset guidance.
When expected cash flows change from projected cash flows, a reporting entity should first apply the CECL or AFS impairment model and then prospectively adjust the accretable yield if changes in expected cash flows not accounted for under those models.
Both favorable and adverse changes in cash flows will be recorded through changes in the allowance for credit losses and recognized in net income.
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