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7.5 Application of CECL to off-balance sheet exposures
Publication date: 31 May 2022
us Loans & investments guide
CECL applies to off-balance sheet credit exposures not accounted for as insurance, such as unfunded revolving lines of credit, financial guarantees written that are not accounted for as derivatives, other unfunded loan commitments, and other similar instruments. Because off-balance sheet exposures are often legally binding agreements to extend credit under certain terms and conditions, they can expose an entity to credit losses.
The expected credit losses liability for off-balance sheet credit exposures should be estimated over the contractual period in which the entity is exposed to credit risk, unless that obligation is unconditionally cancellable by the issuer. The estimate of credit losses should consider the likelihood that funding will occur and if funded, the related estimate of expected credit losses.
The expected credit loss estimate for off-balance sheet credit exposures is recorded as a liability on the balance sheet (separate from any allowance for credit losses associated with recognized financial assets) with changes in the estimate reported as credit loss expense in the statement of net income each reporting period.
Question LI 7-21
Should an entity measure the expected credit loss liability on off balance sheet credit exposures on a pool basis?
Should an entity measure the expected credit loss liability on off balance sheet credit exposures on a pool basis?
PwC response
Yes. Similar to financial assets, when similar risk characteristics exist between off balance sheet credit exposures, the expected credit loss estimate should be measured on a collective (pool) basis. In a scenario when the off-balance sheet exposure does not share risk characteristics with other exposures, the expected credit losses should be measured on an individual basis using information available for that type of commitment.
Question LI 7-22
Is a forward commitment to purchase a loan that will subsequently be classified as held for investment within the scope of the CECL impairment model?
Is a forward commitment to purchase a loan that will subsequently be classified as held for investment within the scope of the CECL impairment model?
PwC response
It depends. Similar to a loan commitment, a forward commitment to purchase a loan (including a loan that is deemed to be a PCD asset) represents an off-balance sheet credit exposure in the scope of ASC 326 if the forward commitment is (1) not accounted for as a derivative and (2) is not unconditionally cancellable by the purchaser.
7.5.1 Credit losses on unfunded commitments
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
Is a loan commitment acquired as part of a business combination within the scope of the CECL impairment model?
Is a loan commitment acquired as part of a business combination within the scope of the CECL impairment model?
PwC response
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.
7.5.2 Credit losses related to financial guarantees
Financial guarantees in the scope of ASC 460, Guarantees, are in the scope of the CECL impairment model in ASC 326-20. Financial guarantees may be in the scope of ASC 460 if they are not required to be accounted for as derivatives under the guidance in ASC 815, Derivatives and Hedging. Insurance companies that issue financial guarantee contracts must assess whether they are within the scope of ASC 944, Insurance, before considering whether ASC 460 is applicable.
ASC 460-10-55-2 provides examples of financial guarantee contracts that may be in the scope of ASC 460.
Financial Guarantees
The following are examples of contracts of the type described in paragraph 460-10-15-4(a):
a. A financial standby letter of credit
b. A market value guarantee on either a financial asset (such as a security) or a nonfinancial asset owned by the guaranteed party
c. A guarantee of the market price of the common stock of the guaranteed party
d. A guarantee of the collection of the scheduled contractual cash flows from individual financial assets held by a special-purpose entity
e. A guarantee granted to a business or its owner(s) that the revenue of the business (or a specific portion of the business) for a specified period of time will be at least a specified amount.
Under ASC 460, a reporting entity must recognize a liability for the fair value of the obligation associated with a guarantee and record an associated asset (e.g., either cash or receivable depending on the contractual terms). In addition, the CECL model considers the credit risk of financial guarantees to be off-balance sheet exposures (e.g., unfunded commitments). Therefore, as described in ASC 460-10-30-5, a reporting entity should record both a guarantee obligation and an allowance for credit losses (calculated using the CECL impairment model) for financial guarantees in the scope of ASC 326. See FG 2.6 for information on the initial recognition and measurement of a guarantee obligation.
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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