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7.4 CECL-related practical expedients
Publication date: 31 May 2022
us Loans & investments guide
The CECL model provides practical expedients to simplify the estimate of credit losses on certain financial assets supported by collateral. These practical expedients relate to collateral-dependent assets and assets with collateral maintenance provisions.
7.4.1 Collateral-dependent CECL practical expedient
ASC 326-20-35-5 permits an entity to elect a practical expedient for its collateral-dependent assets, whereby estimated credit losses are based on the fair value of the collateral (less costs to sell, if applicable). The practical expedient can be applied to a financial asset if (1) the borrower is experiencing financial difficulty, and (2) repayment is expected to be provided substantially through the sale or operation of the collateral. However, if it is probable that an entity will foreclose on the collateral, the use of the fair value of the collateral to calculate the allowance for credit loss is required (see LI 7.3.6.6).
If applied, the estimate of expected credit losses is equal to the difference between the fair value of the collateral as of the balance sheet date and the amortized cost basis of the asset (excluding any fair value hedge accounting adjustments from active portfolio layer method hedges). If repayment is dependent on the sale of the collateral under the collateral-dependent practical expedient, the fair value used to measure the allowance should be adjusted for the costs to sell. Refer to LI 7.3.6.6 for information on costs to sell.
An entity may use, as a practical expedient, the fair value of the collateral at the reporting date when recording the net carrying amount of the asset and determining the allowance for credit losses for a financial asset for which the repayment is expected to be provided substantially through the operation or sale of the collateral when the borrower is experiencing financial difficulty based on the entity’s assessment as of the reporting date (collateral-dependent financial asset). If an entity uses the practical expedient on a collateral-dependent financial asset and repayment or satisfaction of the asset depends on the sale of the collateral, the fair value of the collateral shall be adjusted for estimated costs to sell. However, the entity shall not incorporate in the net carrying amount of the financial asset the estimated costs to sell the collateral if repayment or satisfaction of the financial asset depends only on the operation, rather than on the sale, of the collateral. When the fair value (less costs to sell, if applicable) of the collateral at the reporting date exceeds the amortized cost basis of the financial asset, an entity shall adjust the allowance for credit losses to present the net amount expected to be collected on the financial asset equal to the fair value (less costs to sell, if applicable) of the collateral as long as the allowance that is added to the amortized cost basis of the financial asset(s) does not exceed amounts previously written off. If the fair value of the collateral is less than the amortized cost basis of the financial asset for which the practical expedient has been elected, an entity shall recognize an allowance for credit losses on the collateral-dependent financial asset, which is measured as the difference between the fair value of the collateral, less costs to sell (if applicable), at the reporting date and the amortized cost basis of the financial asset. An entity also shall consider any credit enhancements that meet the criteria in paragraph 326-20-30-12 that are applicable to the financial asset when recording the allowance for credit losses.
An asset or liability that has been designated as being hedged and accounted for pursuant to this Section remains subject to the applicable requirements in generally accepted accounting principles (GAAP) for assessing impairment or credit losses for that type of asset or for recognizing an increased obligation for that type of liability. Those impairment or credit loss requirements shall be applied after hedge accounting has been applied for the period and the carrying amount of the hedged asset or liability has been adjusted pursuant to paragraph 815-25-35-1(b). A portfolio layer method basis adjustment that is maintained on a closed portfolio basis for an existing hedge in accordance with paragraph 815-25-35-1(c) shall not be considered when assessing the individual assets or individual beneficial interest included in the closed portfolio for impairment or credit losses or when assessing a portfolio of assets for impairment or credit losses. An entity may not apply this guidance by analogy to other components of amortized cost basis. Because the hedging instrument is recognized separately as an asset or liability, its fair value or expected cash flows shall not be considered in applying those impairment or credit loss requirements to the hedged asset or liability.
ASC 326-20-35-5 clarifies that the potential for a negative allowance also exists for collateral-dependent assets when the guidance requires the measurement of credit losses to be based on the fair value of collateral (i.e., when the collateral-dependent practical expedient is elected). For example, an entity may have elected the collateral-dependent practical expedient and recorded a write off based upon the fair value of the collateral because they deemed amounts in excess of the fair value of the collateral (less costs to sell, if applicable) uncollectible. However, in a subsequent period the fair value of the collateral increased. In these instances, the guidance would require this recovery to be recorded (to the extent it did not exceed amounts previously written off) and it may create a negative allowance (an allowance which when added to the amortized cost basis of the asset results in the net amount expected to be collected).
An entity should reassess its estimate of credit losses at each reporting date. This includes reassessing whether the collateralized asset continues to qualify for the practical expedient. If the entity no longer qualifies for the collateral-dependent practical expedient, an entity is required to estimate its credit losses using another technique. If foreclosure becomes probable, an entity is required to use the fair value of collateral to estimate expected credit losses (see LI 7.3.6.6).
Example LI 7-4 illustrates application of the collateral-dependent financial asset practical expedient.
EXAMPLE LI 7-4
Measurement of impairment on a collateral-dependent financial asset
Measurement of impairment on a collateral-dependent financial asset
Bank Corp originates a construction loan to Developer LLC for purposes of constructing a condominium. Developer LLC holds no assets other than the construction in progress and has no guarantor support. Bank Corp’s loan is collateralized with a first lien position on the underlying real estate and construction in progress.
In the current period, there has been a significant downturn in real estate values, including the condominium market in Developer LLC’s region. Developer LLC has told Bank Corp that the expected pre-sales of condominium units are significantly below expectations. As a result, at the reporting date, Bank Corp does not believe Developer LLC will be able to repay the loan. Bank Corp determines it will substantially recover its investment through the sale of the real estate, but it is not probable that Bank Corp will foreclose.
The amortized cost of the loan is $1,000,000, and the entity (which obtained a certified external appraisal) estimates the as-is value of the property at $600,000. Estimated costs to sell the property are $80,000.
Can Bank Corp elect to measure its expected credit losses associated with this loan using the collateral-dependent financial asset practical expedient?
Analysis
Yes. Bank Corp expects that due to Developer LLC’s financial difficulty, repayment of the loan will be through the sale of the collateral. As a result, Bank Corp can elect to measure impairment using the collateral-dependent financial asset practical expedient.
If Bank Corp elects to use the practical expedient, the impairment would be calculated as follows.
Amortized cost of the loan
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$1,000,000 |
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Fair value of the collateral
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600,000 |
|
Estimated costs to sell
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(80,000) |
|
520,000 |
||
Impairment
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$480,000 |
|
7.4.2 Collateral maintenance CECL practical expedient
ASC 326-20-35-6 provides a practical expedient for assets secured by collateral when the amount of collateral is continually adjusted as a result of changes in the fair value of the collateral. In these arrangements, a reporting entity may estimate the expected credit losses by comparing the fair value of the collateral as of the balance sheet date to the asset’s amortized cost basis (except for fair value hedge accounting adjustments from active portfolio layer method hedges). In situations when the fair value of the collateral is equal to or greater than the amortized cost, a reporting entity may determine that there are no expected credit losses.
For certain financial assets, the borrower may be contractually required to continually adjust the amount of the collateral securing the financial asset(s) as a result of fair value changes in the collateral. In those situations, if an entity reasonably expects the borrower to continue to replenish the collateral to meet the requirements of the contract, an entity may use, as a practical expedient, a method that compares the amortized cost basis with the fair value of collateral at the reporting date to measure the estimate of expected credit losses. An entity may determine that the expectation of nonpayment of the amortized cost basis is zero if the fair value of the collateral is equal to or exceeds the amortized cost basis of the financial asset and the entity reasonably expects the borrower to continue to replenish the collateral as necessary to meet the requirements of the contract. If the fair value of the collateral at the reporting date is less than the amortized cost basis of the financial asset and the entity reasonably expects the borrower to continue to replenish the collateral as necessary to meet the requirements of the contract, the entity shall estimate expected credit losses for the unsecured amount of the amortized cost basis. The allowance for credit losses on the financial asset is limited to the difference between the fair value of the collateral at the reporting date and the amortized cost basis of the financial asset.
An asset or liability that has been designated as being hedged and accounted for pursuant to this Section remains subject to the applicable requirements in generally accepted accounting principles (GAAP) for assessing impairment or credit losses for that type of asset or for recognizing an increased obligation for that type of liability. Those impairment or credit loss requirements shall be applied after hedge accounting has been applied for the period and the carrying amount of the hedged asset or liability has been adjusted pursuant to paragraph 815-25-35-1(b). A portfolio layer method basis adjustment that is maintained on a closed portfolio basis for an existing hedge in accordance with paragraph 815-25-35-1(c) shall not be considered when assessing the individual assets or individual beneficial interest included in the closed portfolio for impairment or credit losses or when assessing a portfolio of assets for impairment or credit losses. An entity may not apply this guidance by analogy to other components of amortized cost basis. Because the hedging instrument is recognized separately as an asset or liability, its fair value or expected cash flows shall not be considered in applying those impairment or credit loss requirements to the hedged asset or liability.
To evaluate whether the use of the practical expedient is appropriate, an entity should consider where the collateral is held, the legal terms of the arrangement, how often the collateral is replenished, whether the entity expects the borrower to continually replenish the collateral, and the liquidity of the collateral.
To qualify for the practical expedient, we believe the collateral should be highly liquid. Additionally, the collateral maintenance practical expedient guidance requires the borrower to continually replenish the collateral but does not provide a definition of “continually replenish.” We believe arrangements that require daily replenishments would qualify for the practical expedient. However, the less frequently the collateral is adjusted, the more challenging it will be to assert that the collateral is continually replenished. Further, when demonstrating that the borrower is able to continually replenish the collateral, the creditor need only demonstrate a reasonable expectation that a borrower is able to continually replenish the collateral. The creditor does not have to prove it is probable or consider remote scenarios.
Question LI 7-20
Some arrangements provide for “tolerance bands” that must be “breached” before the collateral is adjusted. For example, repurchase agreements may not provide for adjustments until the fair value of the collateral has dropped below 98% of the amount advanced (or exceeds 102% of the amount advanced). Can the collateral maintenance practical expedient be applied to agreements with tolerance bands?
Some arrangements provide for “tolerance bands” that must be “breached” before the collateral is adjusted. For example, repurchase agreements may not provide for adjustments until the fair value of the collateral has dropped below 98% of the amount advanced (or exceeds 102% of the amount advanced). Can the collateral maintenance practical expedient be applied to agreements with tolerance bands?
PwC response
It depends. The practical expedient can be applied in situations that provide for adjustments to the amount of collateral securing the financial assets if the terms of the agreements provide for narrow tolerance bands and highly liquid collateral. For example, we believe certain repurchase agreements with highly liquid collateral that have tolerance bands of 98% to 102% would be eligible to apply the practical expedient. We believe agreements that do not have narrow tolerance bands would not be able to apply the practical expedient.
Example LI 7-5 illustrates application of the practical expedient related to financial assets with collateral maintenance requirements.
EXAMPLE LI 7-5
Application of collateral maintenance practical expedient requirements
Application of collateral maintenance practical expedient requirements
Lender Corp enters into a reverse repurchase arrangement with Counterparty Corp, under which Counterparty Corp sells securities to Lender Corp with the requirement to repurchase them back at a specified date for a specified price. To mitigate credit risk, Lender Corp requires Counterparty Corp to post collateral, with daily valuation requirements and collateral maintenance requirements intended to ensure Counterparty Corp maintains the fair value of the collateral at an amount equal to or in excess of the amortized cost of the reverse repurchase asset.
How should Lender Corp consider the collateralized relationship of its arrangement with Counterparty Corp in estimating expected credit losses?
Analysis
Although Lender Corp appears to have a well-collateralized arrangement, it should consider the following:
- The nature of the collateral. For example, does the collateral consist of US treasuries, or does it consist of illiquid financial assets.
- The sufficiency of systems and controls over the data used to determine the collateral to value ratios for the collateral maintenance requirements
- Whether Counterparty Corp is expected to continue to be able to post collateral over the life of the contract
Considering these points, if Lender Corp can assert that it has access to liquid and marketable collateral and believes it has proper recourse to Counterparty Corp’s accounts, the relationship could be viewed as having a collateral maintenance arrangement that would permit the use of the practical expedient.
Figure LI 7-3 demonstrates how to calculate an allowance using the collateral maintenance practical expedient:
Figure LI 7-3
Calculating an allowance using the collateral maintenance practical expedient
Calculating an allowance using the collateral maintenance practical expedient
Scenario |
Application |
At the reporting date, the fair value of the collateral is equal to or greater than the amortized cost basis (excluding any fair value hedge accounting adjustments from active portfolio layer method hedges).
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Assuming the asset qualified for the collateral maintenance practical expedient, since the fair value of the collateral at the reporting date is equal to or greater than the amortized cost basis (excluding any fair value hedge accounting adjustments from active portfolio layer method hedges), the allowance is $0 as long as the creditor is able to demonstrate a reasonable expectation that the borrower is able to continually replenish the collateral.
Unlike what would usually be required in applying the CECL model, the creditor does not need to consider the possibility of the collateral falling in value after the reporting date. Under the expedient, a creditor is allowed to only consider the reporting period fair value of the collateral. As a result, credit losses are capped at the difference between the amortized cost basis (excluding any fair value hedge accounting adjustments from active portfolio layer method hedges) and the current fair value of the collateral.
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At the reporting date, the fair value of the collateral is $98, and the amortized cost basis (excluding any fair value hedge accounting adjustments from active portfolio layer method hedges) is $100.
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Assuming the asset qualifies for the collateral maintenance practical expedient (including the demonstration that the creditor has a reasonable expectation that the borrower is able to continually replenish the collateral), the financial asset should be evaluated as two separate components:
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PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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