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9.3 PCD: initial recognition and measurement
Publication date: 31 May 2022
us Loans & investments guide
ASC 326 has different initial recognition and measurement guidance for PCD assets than for non-PCD assets. The PCD guidance eliminates the asymmetrical treatment of increases and decreases in expected cash flows that existed in prior GAAP, as well as simplifies the calculation of interest income. These changes are intended to more closely align the accounting for these instruments in periods subsequent to acquisition with the accounting for originated assets and purchased assets that do not qualify as PCD.
For PCD assets, an allowance for credit losses will be recognized on initial recognition by estimating the expected credit losses of the purchased assets. Unlike the CECL model for financial assets that are not considered PCD, a reporting entity should not recognize the initial estimate of expected credit losses through net income. Rather, the initial estimate for credit losses would be recorded through an adjustment to the amortized cost basis of the related financial asset at acquisition (i.e., a balance sheet gross-up). As of the date of acquisition, the amount of expected credit losses is added to the purchase price of the financial asset to establish the initial amortized cost basis of the asset. Any difference between the amortized cost basis (purchase price + initial allowance for credit losses) and the unpaid principal balance (or par amount) of the asset is considered to be a non-credit discount/premium and will be accreted/amortized into interest income using the interest method (see LI 6 for more information on interest income recognition).
The theory behind this gross up is that the purchase price discount attributable to credit is eliminated through the adjustment to the amortized cost basis and as a result, the remaining discount is related to factors other than credit risk. Since any remaining discount is not credit related, it can be accreted into interest income following the model in ASC 310. However, ASC 310-10 was amended by ASU 2016-13 to clarify certain elements of the interest recognition guidance specific to PCD assets.
ASC 310-10-35-53B clarifies that only non-credit-related discounts or premiums are permitted to be accreted or amortized into interest income. As noted above, the initial credit-related discount is effectively eliminated through the adjustment to the amortized cost basis created when establishing the initial estimate for credit losses.
If the initial allowance for credit losses is determined on the pool basis as of the acquisition date, it must be allocated to the individual PCD assets within the pool. Entities should choose a method that is reasonable in the context of their facts and circumstances and should document the rationale for the method they chose to perform the allocation.
Example LI 9-1 illustrates the accounting for a PCD loan at acquisition.
EXAMPLE LI 9-1
Accounting for a PCD loan at acquisition
Accounting for a PCD loan at acquisition
Bank Corp purchases a loan with a par value of $100,000 for $83,000. The loan has experienced a more-than-insignificant deterioration in credit quality since origination. Therefore, Bank Corp determines that the loan meets the definition of a PCD asset.
At the date of acquisition, Bank Corp calculates an allowance for expected credit losses of $10,000.
How should Bank Corp record the loan at acquisition?
Analysis
Bank Corp should record the loan at an amortized cost basis of $93,000, which is the $83,000 purchase price plus the $10,000 expected credit loss.
Dr. Loan asset balance
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$100,000
|
|
Cr. Loan - non-credit discount
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$7,000
|
|
Cr. Allowance for expected credit losses
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$10,000
|
|
Cr. Cash
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$83,000
|
As a result, the loan has an amortized cost basis of $93,000 ($83,000 + $10,000 or $100,000 - $7,000). The non-credit discount of $7,000 (difference between the $100,000 par amount and the $93,000 amortized cost basis) will be accreted into interest income using the effective interest method.
Question LI 9-4 addresses whether the PCD gross up can result in an entity recording a premium.
Question LI 9-4
If a loan is purchased at a discount and deemed to be PCD, can the “PCD gross up” result in an entity recording a premium on the asset as of the date of acquisition?
If a loan is purchased at a discount and deemed to be PCD, can the “PCD gross up” result in an entity recording a premium on the asset as of the date of acquisition?
PwC response
Yes. The guidance in ASC 326-20-30-13 contemplates a scenario when the adjustment to the amortized cost basis may result in the acquired loan being reported at a premium by noting: “Any noncredit discount or premium resulting from acquiring a pool of purchased financial assets with credit deterioration shall be allocated to each individual asset” (emphasis added).
9.3.1 Calculating the allowance for credit losses for PCD assets
For PCD assets that are also within the scope of the CECL impairment model (e.g., financial assets carried at amortized cost, including HTM securities), the initial allowance may be estimated based on a discounted cash flow or non-discounted cash flow approach (consistent with the overall CECL model). The initial allowance will differ depending on whether a discounted cash flow or non-discounted cash flow approach is used to estimate expected credit losses.
For debt securities classified as available-for-sale that meet the definition of PCD and beneficial interests subject to ASC 325-40, the initial allowance must be estimated using the present value of cash flows (consistent with the AFS debt security impairment and ASC 325-40 models). See LI 14 for information on the accounting for beneficial interests subject to ASC 325-40.
9.3.1.1 Using a DCF method to estimate expected credit losses
A reporting entity is required to use a discounted cash flow approach to calculate the initial estimate of expected credit losses for AFS debt securities and beneficial interests subject to ASC 325-40. It may use a discounted cash flow approach to calculate the initial estimate of expected credit losses on amortized cost assets (e.g., loans) and HTM debt securities, but it is not required.
A reporting entity using a discounted cash flow approach to estimate the initial allowance for expected credit losses for PCD assets should follow the following steps:
- Step 1: Calculate the effective interest rate by (1) determining the expected cash flows of the instrument and (2) discounting those expected cash flows at a rate that results in a present value equal to the purchase price of the instrument, pursuant to ASC 326-30-30-3.
- Step 2: Calculate the initial allowance by discounting the cash flows not expected to be collected (i.e., the difference between contractual and expected cash flows) by the effective interest rate calculated in Step 1.
Example LI 9-2 illustrates how to calculate the effective interest rate for PCD assets using a discounted cash flow approach.
EXAMPLE LI 9-2
Determining the effective interest rate and initial allowance of a PCD asset using a discounted cash flow approach
Determining the effective interest rate and initial allowance of a PCD asset using a discounted cash flow approach
Assume Bank Corp. purchases a security with the following key terms and has determined it to be PCD.
Par amount: $100,000
Purchase price: $60,000
Remaining term: 2 years with principal due at maturity
Contractual coupon: 2%
Expected cash flows: $2,000 in year 1 and $72,000 at maturity
The effective interest rate used to calculate the allowance for credit losses is approximately 11.22%. This was calculated by solving for the discount rate such that the present value of the expected cash ($2,000 and $72,000) equals the purchase price of $60,000. Using this effective interest rate, the allowance for credit losses as of the date of acquisition is approximately $24,251. This was determined by taking $30,000 in year 2 (which is the difference between the total expected cash flows ($72,000) and the total contractual cash flows ($102,000), and discounting it using a discount rate of 11.22%.
Bank Corp would record the following entry at acquisition:
Dr. Loan – principal amount
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$100,000
|
|
Cr. Loan - non-credit discount
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$15,749
|
|
Cr. Allowance for expected credit losses
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$24,251
|
|
Cr. Cash
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$60,000
|
9.3.1.2 Using a non-DCF method to estimate expected credit losses
If a reporting entity uses an approach to estimate expected credit losses other than a discounted cash flow (DCF) model, such as a loss-rate approach, the initial estimate of expected credit losses should be calculated based on the unpaid principal balance as required under ASC-326-20-30-14. This was needed to avoid a potentially circular calculation in which the allowance is based on the collectibility of the amortized cost basis of an asset, but it also impacts the amortized cost basis through the PCD gross up. Under a loss-rate approach, the loss rate is applied to the par amount of the asset at initial recognition to determine the allowance.
Example LI 9-3 illustrates measurement of a PCD asset’s initial allowance using a loss rate approach.
EXAMPLE LI 9-3
Determining the initial allowance of a PCD asset using a loss rate approach
Determining the initial allowance of a PCD asset using a loss rate approach
Assume Bank Corp. purchases a security with the following key terms and has determined it to be PCD.
Par amount: $100,000
Purchase price: $60,000
Remaining term: 2 years with principal due at maturity
Contractual coupon: 2%
Expected cash flows: $2,000 in year 1 and $72,000 at maturity
Loss rate: 30%
Dr. Loan – principal amount
|
$100,000
|
|
Cr. Loan - non-credit discount
|
$10,000
|
|
Cr. Allowance for expected credit losses
|
$30,000
|
|
Cr. Cash
|
$60,000
|
Question LI 9-5 addresses if the effective interest rate for PCD assets can differ based on the method used to determine the expected credit losses.
Question LI 9-5
Will the effective interest rate for a PCD asset (carried at amortized cost) be different if expected credit losses are estimated using a discounted cash flow approach versus a loss-rate approach?
Will the effective interest rate for a PCD asset (carried at amortized cost) be different if expected credit losses are estimated using a discounted cash flow approach versus a loss-rate approach?
PwC response
Yes. Since the initial amortized cost basis is different for a PCD asset when a discounted or non-discounted approach is used, the effective interest rate will be different. The effective interest rate determined using a discounted cash flow approach is the rate that discounts the expected cash flows to the purchase price. In Example LI 9-2, this results in an effective interest rate of 11.22%. When using an approach other than a discounted cash flow approach to calculate the allowance, the effective interest rate is the rate that discounts the contractual cash flows to the initial amortized cost basis (i.e., the purchase price + allowance for credit losses). In Example LI 9-3, this results in an effective interest rate of 7.58%.
However, the higher effective interest rate resulting from using a discounted cash flow approach to calculate the allowance for credit losses on a PCD asset will be partially offset as, if expected cash flows do not change, the allowance for credit losses will increase due to the passage of time.
9.3.2 Estimating expected credit losses on beneficial interests
When calculating the expected credit losses on beneficial interests, ASC 325-40-35-7 requires an entity to use a present value of expected future cash flows to measure credit losses for a beneficial interest. Therefore, reporting entities that hold HTM securities that are beneficial interests subject to ASC 325-40 should estimate expected credit losses using a discounted cash flow approach. This differs from the usual guidance under ASC 326 for HTM securities that are not beneficial interests subject to ASC 325-40. HTM securities that are not beneficial interests should apply the general CECL model, which provides a reporting entity with the flexibility to decide which model they want to use to estimate expected credit losses.
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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