It has been almost two years now since the Financial Accounting Standards Board issued ASC Topic 326 which changes the accounting for credit impairment. Accounting Standards Update (ASU) No. 2016-13, Financial Instruments – Credit Losses was issued in June 2016 and while the standard is expected to have the largest impact on institutions in the financial services industry, it applies to all entities. As such, all entities should understand the new impairment models established by ASC 326 and the impact they will have.
In this post, we take a peek into the provisions of ASC 326.
ASC 326 establishes accounting for credit impairment for the following:
- Financial assets measured at amortized cost
- Available-for-sale debt securities
- Purchased financial assets with credit deterioration (PCD)
Financial Assets measured at amortized cost
Under current guidance, credit impairment for assets measured at amortized cost is based on an “incurred loss model.” This means that it must be probable that a loss has been incurred at the measurement date before impairment is recognized in the financial statements. The incurred loss model was criticized because it did not permit expected credit losses to be recognized if the loss had not yet been “incurred” and that does not meet the “probable threshold”. The FASB addressed this with ASC 326.
ASC 326 replaces the incurred loss model with an expected credit loss model, referred to as “the Current Expected Credit Loss (CECL) model”. Under CECL, there is no threshold for impairment loss recognition. Rather, impairment should reflect a current estimate of all expected credit losses.
The guidance does not specify a method for measuring expected credit losses. It allows an entity to apply methods that reasonably reflect its expectations of the credit loss estimate. The estimate is forward-looking so should consider forecasts about future economic conditions over the remaining life of the instrument. Generally, this is expected to result in earlier recognition of credit impairment as compared to the accounting under today’s incurred loss model.
Under ASC 326, credit impairment is recognized as an allowance (a contra-asset) and not as a direct write-down of the amortized cost basis of the financial asset. While this is consistent with the current incurred loss model approach for loans and trade receivables, it represents a difference for other financial assets, such as held-to-maturity debt securities.
Available-for-sale debt securities
The current other-than-temporary impairment (OTTI) model for accounting for available-for-sale debt securities is retained by ASC 326 but modifications are introduced, including elimination of the “other-than-temporary” impairment concept.
An entity will continue to determine whether a decline in fair value below its cost is a result of a credit loss, in which case impairment should be recognized, or whether it is a result of other factors. A key change though, is that credit losses will be recognized as an allowance instead of a reduction to the amortized cost of the securities. With the allowance approach, when the estimate of credit losses declines, a reversal of credit losses is recorded whereas under the current OTTI model, reversals are not permitted.
Purchased financial assets with credit deterioration assets
ASC 326 eliminates the current accounting model for purchased credit impaired (PCI) loans and debt securities. Under current guidance in ASC 310-30, the purchase credit impaired loan or security is recorded at fair value at acquisition, so no allowance is recorded, and accounted for based on expected cash flows.
Over time, the accretable yield, which is the amount of expected cash flows that exceed the initial investment in the loan, is recognized as interest income on a level yield basis over the life of the loan. The amount of principal and interest not considered collectible is the nonaccretable difference. Subsequent changes in the estimated cash flows expected to be collected result in changes in the accretable yield and nonaccretable difference. ASC 310-30 accounting for PCI loans is complex and often difficult to apply, but ASC 326 brings some relief.
Under ASC 326, a simplified approach is employed where upon acquisition, the purchased impaired asset will be recorded at a grossed up initial amortized cost equal to the sum of the purchase price and the estimate of credit losses as of the date of acquisition. Subsequent accounting is simplified and follows the other ASC 326 credit impairment models. This change makes the accounting for credit losses for originated and purchased financial assets more comparable.
ASC 326 guidance on purchase impaired assets extends to other purchased financial assets, such as purchased beneficial interest so the concept of “purchase credit impaired (PCI)” is replaced by “purchased financial assets with credit deterioration (PCD)”.
So, that is a brief overview of ASC 326 and some of the changes it brings to the accounting for credit losses. In future blog posts, we will look at further detail into some of the key provisions.
ASC 326 has tiered effective dates:
- For public business entities that are U.S. Securities and Exchange Commission (SEC) filers, ASC 326 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.
- For all other public business entities, it is effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years.
- For all other entities, it is effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021.
The standard does permit early adoption for all entities for annual periods beginning after December 15, 2018 and interim periods therein.
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