The video below introduces the first impairment model, the “current expected credit loss model,” under ASC 326. This is arguably the most challenging of the impairment models under ASC 326, and associated accounting issues will be highlighted after the video.
Current expected credit losses model
The current expected credit losses model, “CECL” for short, is applied to most financial assets measured at amortized cost under U.S. GAAP. This includes debt securities classified as held-to-maturity (HTM), loans receivable, notes receivable, trade accounts receivable, contract assets under ASC 606, lease receivables, and several others. It does not apply to investments accounted for under the equity method, loans held for sale, receivables between entities under common control, and several others.
The goal of the CECL model is to present, in the financial statements, the net amount of the asset to be collected, via the use of an allowance for credit losses. Instead of just accounting for losses an entity estimates have occurred, the CECL model requires the consideration of all losses expected during the full life of the asset. Any resulting allowance for credit losses is adjustable as conditions change. Reassessment is required each reporting period.
The expected loss model requires consideration, over the contractual life of the instrument, of the past (historical data), the present (current conditions), and the future (reasonable and supportable forecasts). ASC 326 does not prescribe a specific valuation approach, and any approach used may vary across different entities and across different financial instrument types at the same entity as long as it is consistently applied. ASC 326 does provide the following qualitative factors to consider:
Entities are not required to search for all possible information, only information that is reasonably available without undue cost and effort. For periods beyond which the entity is able to make or obtain reasonable and supportable forecasts, an entity should revert to historical loss information. As noted above, ASC 326 requires the estimation of expected losses over the contractual life of an asset. In determining the contractual life of the asset, features such as prepayment options, extensions, and renewal options are required to be considered. ASC 326 also includes guidance on when expected credit losses can be measured on a collective basis and when they must be measured on an individual asset basis.
An allowance for credit losses is recognized as a contra-asset with the offset in the income statement. The allowance needs to be assessed and measured each reporting period and adjusted, as necessary. This means that a previously recorded allowance and corresponding loss should be reversed in the future if circumstances change. It is important to recognize that under ASC 326, there is no threshold for recognition. This means that all probabilities of loss must be considered, no matter how small or remote. However, ASC 326 does include one exception. An entity is not required to measure expected credit losses on a financial asset (or group of financial assets) in which historical credit loss information adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the amortized cost basis is zero. No further elaboration on this exception is given in the standard, but the assumption is that this applies only to “risk free” investments such as U.S. Government securities.
Available-for-sale debt securities impairment model
As a quick reminder, available-for-sale debt securities are accounted for at fair value with changes in fair value recorded in other comprehensive income (OCI). As a result, a separate impairment model for these instruments is necessary. Under this model, a debt security is impaired if the fair value of the investment is less than its amortized cost basis. Impairment is assessed at the individual security level. How the impairment (i.e., the amount by which fair value is less than amortized cost) is recorded depends on what factors are causing the impairment. Any amount of impairment resulting from credit losses is recorded as an allowance for credit losses with the offset in the income statement. Any amount of impairment arising from other factors continues to be recorded in other comprehensive income. While there is no specific prescribed methodology, ASC 326 provides some example factors to consider when determining if impairment is related to credit losses.
Any credit loss allowance recognized for available-for-sale debt securities is subject to reversal in the future if conditions change. Like other financial assets for which an allowance for credit losses is established, expected cash flows should continue to be monitored and the allowance adjusted accordingly as expectations change.
The following decision tree summarizes the guidance for impairment of available-for-sale debt securities:
Purchased credit deteriorated assets
ASC 326 includes specific guidance for purchased credit deteriorated (PCD) assets. It is important to note that this guidance applies to acquired (purchased) assets, and only those that have experienced a more-than-insignificant deterioration in credit quality since origination. It may require significant judgment upon purchase to determine whether assets have experienced a more-than-insignificant deterioration in credit quality since their origination.
The purchase price of a PCD asset will be less than its par value due to the existence of credit deterioration. Therefore, in order to establish a credit loss allowance upon recognition, ASC 326 requires the “gross-up” approach, as follows:
In addition, any associated non-credit premiums or discounts are allocated to the assets on an individual basis at initial recognition.
Subsequent accounting is similar to other models where interest income is recognized by applying the effective interest rate to the unamortized principal balance. This approach maintains a constant effective yield throughout the asset’s life. Any subsequent changes to expected cash flows is accounted for via adjustments to the credit loss allowance with the offset to income.
Accounting Differences: ASC 326 vs. IFRS 9
The key differences are:
The differences noted above are not the only differences between ASC 326 and IFRS 9. For more comprehensive coverage of differences between the two, refer to the thought leadership provided by the Big 4 accounting firms. See the Accounting Resources section below for links.
Join the Revolution with GAAP Dynamics!
GAAP Dynamics training courses are designed to help leading accounting firms and multinational companies move beyond the training status quo. Our courses are continually updated and new courses are constantly being added, so check back often! Below are a few of our courses related to impairment of financial instruments under both U.S. GAAP and IFRS:
Credit Losses: Introduction to the CECL Model - Does the thought of having to estimate credit losses on loans and other assets have you searching for a way to predict the future? No time machines needed here! In this CPE-eligible, eLearning course (1.5 CPE) we break down the key concepts of the new current expected credit loss (CECL) model within ASC 326 Credit Losses to help bring you back down to Earth. Once we determine what instruments are within the scope of ASC 326, we launch into an overview of the initial recognition accounting, subsequent measurement, and required disclosures associated with the CECL model in accordance with ASC 326. This online course also covers the key considerations of forming an estimate of expected credit losses, as well as accounting for purchased credit deteriorated assets.
Investments: Debt Securities - Many companies choose to hold debt securities in their portfolio. Because of the prominence of debt securities across a wide variety of industries and portfolios, understanding the proper recognition and measurement in accordance with ASC 320 Investments - Debt Securities, as well as accounting for credit losses and impairment of debt securities in accordance with ASC 326 Financial Instruments - Credit Losses, is important! In this CPE-eligible eLearning course (1.5 CPE), we dive into the accounting for debt securities under U.S. GAAP, including the classification of debt securities as trading, available for sale, or held to maturity. We then walk through the initial recognition and subsequent measurement of debt securities based on their classification in accordance with ASC 320. You then learn about assessing impairment and recognizing credit losses on debt securities in accordance with ASC 326. This online course concludes with a review of the disclosure requirements for debt securities.
Financial Instruments: Overview of IFRS 9 - IFRS 9 Financial Instruments is a robust standard that brings together guidance on the accounting for financial instruments. While there is a lot of accounting guidance covered in IFRS 9, don’t be overwhelmed! In this CPE-eligible (1.0 CPE), eLearning course, you are provided with an overview of all the pieces of accounting for financial instruments, including classification and measurement of financial instruments, impairment of financial instruments, hedge accounting, and derecognition accounting for financial assets and liabilities.
There are numerous resources available on impairment of financial assets under both U.S. GAAP and IFRS. To save you time searching, we have compiled a list of resources below to assist you in your research.
Resources from GAAP Dynamics:
We have written several blogs on a variety of specific impairment of financial asset accounting topics which are listed below. Click on the links to view the full blog post.
CECL: Forecasts Under ASC 326 and Q1 2020 COVID-19 Impacts
ASC 326 requires forecasts be considered in an entity’s CECL estimate. This post discusses forecasts and the impacts of COVID-19 on banks’ reserves.
CECL: Recent Happenings with ASC 326
Need an update on recent news with ASC 326? We cover effective dates, the CARES Act delay, implementation effects, and impact of COVID-19 in this post.
Analysis of CECL Impacts (ASC 326) – 20 Banks with Varying Results
What’s the impact of the new current expected credit losses (CECL) model? We’ve analyzed the impact of ASC 326 on 20 banks. Check it out!
Implementing ASC 326: Reversion to Historical Data Under CECL Model
Impairment has been a hot topic recently. So exactly how do you calculate an impairment loss under ASC 326? This post walks you through the guidance.
Potential Quantitative Impact of CECL on Banks: Learning from IFRS 9
How much will allowances increase for CECL? While differences exist between the models, CECL adopters can learn from IFRS 9 implementation results.
CECL Conundrums: Credit Card Considerations
Applying the CECL model to credit cards can be complex! This post will provide you with questions to consider when estimating expected credit losses.
Credit-impaired Differences Between U.S. GAAP and IFRS
What are the accounting differences between IFRS 9’s purchased or originated credit-impaired and ASC 326’s purchased credit deteriorated assets?
Impairments of Financial Instruments are Changing under IFRS 9
Under IFRS 9, impairments are now recognized based on an expected credit loss model vs. an incurred loss model under previous guidance (IAS 39).
ASC 326: Accounting for Purchased Assets with Credit Deterioration
ASC 326 changes the accounting for credit losses. Let’s take a look at the impact on purchased financial assets with credit deterioration.
CECL: Can There Be Zero Expected Credit Losses Under ASC 326?
The new CECL model requires an entity to record lifetime expected credit losses for financial instruments, but can that expectation ever be zero?"
Impairment of AFS Debt Securities under ASC 326
ASC 326’s new CECL model does not apply to AFS debt securities; rather, there is a separate impairment model for AFS debt securities.
ASC 326 Credit Losses Changes the Accounting for Credit Impairment
ASC 326’s new CECL model and other key provisions are expected to result in earlier recognition of credit losses.
Resources From the FASB and IASB:
- ASC 326 Financial Instruments – Credit Losses – This link will take you to the authoritative guidance (professional subscription required)
- FASB Technical Agenda – There are often FASB projects related to financial instruments. Use this link to see what is on the horizon.
- IFRS 9 Financial Instruments – This link will take you to the landing page for IFRS 9. A professional subscription is required to access the full standard with all applicable appendices.
- International Accounting Standards Work Plan – There are often IASB projects related to financial instruments. Use this link to see what is on the horizon.
Resources From Accounting Firms:
The Big 4 accounting firms have informative, in-depth guides on accounting for impairment of financial assets. To save you time and effort in your research, we have linked to them below.
- PwC’s Accounting Guide: Loans and Investments
- KPMG’s Handbook: Credit Impairment
- EY’s Financial Reporting Developments: Credit Impairment Under ASC 326
- Deloitte’s A Roadmap to Accounting for Current Expected Credit Losses