Unfunded commitments, such as a loan commitment, require a reporting entity to extend credit to a counterparty under certain specified terms and conditions. Because they are often legally binding agreements to extend credit, loan commitments can expose an entity to credit losses.
For unfunded loan commitments, a reporting entity should first determine whether the commitment can be unconditionally (i.e., unilaterally and irrevocably) cancelled by the issuer. If this is the case, then as discussed in ASC 326-20-30-11
, the potential exposure of the unused or undrawn portion of the commitment would not be included in an entity’s estimate of expected credit losses. When the issuer does not have the unconditional right to cancel the commitment, an estimate of credit losses is required for the unfunded portion. The estimate of credit losses would include a determination of the likelihood that funding will occur, and if funded, the related expected credit losses under the CECL model. The estimate of expected credit loss for an unfunded commitment would be recorded as a liability.
In estimating expected credit losses for off-balance-sheet credit exposures, an entity shall estimate expected credit losses on the basis of the guidance in this Subtopic over the contractual period in which the entity is exposed to credit risk via a present contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the issuer. At the reporting date, an entity shall record a liability for credit losses on off-balance-sheet credit exposures within the scope of this Subtopic. An entity shall report in net income (as a credit loss expense) the amount necessary to adjust the liability for credit losses for management’s current estimate of expected credit losses on off-balance-sheet credit exposures. For that period of exposure, the estimate of expected credit losses should consider both the likelihood that funding will occur (which may be affected by, for example, a material adverse change clause) and an estimate of expected credit losses on commitments expected to be funded over its estimated life. If an entity uses a discounted cash flow method to estimate expected credit losses on off-balance-sheet credit exposures, the discount rate used should be consistent with the guidance in Section 310-20-35
Loan commitments can be either revolving (in which the amount of the overall commitment is re-established upon repayment of previously drawn amounts) or non-revolving (in which the amount of the overall commitment is not re-established upon repayment of previously drawn amounts). For revolving commitments, the estimate of expected credit losses is more complex, as the provider of the commitment will need to consider the probability of multiple future draws and repayments. See Question LI 7-12 for an example of these complexities.
Once a commitment has been funded, a reporting entity should apply the CECL impairment model as it would for any other recognized financial asset. See LI 7.3
When an unfunded commitment becomes funded, the expected credit loss for the liability would be reclassified as the allowance for the funded loan. An entity should also reassess whether the amount of the allowance is appropriate. The initial estimate of expected credit losses for the unfunded commitment would have considered the probability of the commitment not being funded. This same consideration is not relevant when determining the expected credit loss estimate for a funded loan and therefore, there could be a change in the estimate.
Question LI 7-23 discusses whether a loan commitment acquired in a business combination is in scope of the CECL impairment model.
Question LI 7-23
Is a loan commitment acquired as part of a business combination within the scope of the CECL impairment model?
Yes. As discussed above, unfunded commitments, such as a loan commitment that cannot be unconditionally (i.e., unilaterally and irrevocably) cancelled by the issuer, are in scope of the CECL impairment model. This is true regardless of whether the loan commitment was originated or acquired (including in a business combination). An estimate of credit losses would be required for the unfunded portion of the loan commitment (as well as for any funded component). As noted in LI 9.2
, the PCD asset guidance is not applicable to acquired unfunded loan commitments.
As a result of the application of ASC 805
, Business combinations, the acquirer will generally recognize identifiable assets acquired and liabilities assumed at fair value. This will generally include loan commitments. Certain loan commitments do not require the borrower to make ongoing payments at a market rate to the lender for the right to borrow under the loan commitment and, as a result, the application of ASC 805
will result in the recognition of a liability for the acquired loan commitment. Similar to the guidance in ASC 460-10-25-2
for guarantees, the expected credit losses for these commitments should be measured and accounted for in addition to and separately from the liability recognized for the acquired loan commitment. The initial recognition of the liability for the estimate of expected credit losses on the loan commitment (as well as subsequent changes in the estimate) are recognized in earnings as a credit loss expense. The liability recognized for the acquired loan agreement should be accounted for in accordance with the guidance in ASC 310-20
similar to a commitment fee.