Accounting Standards Update (ASU) No. 2016-13, Financial Instruments – Credit Losses, issued in June 2016 changes the accounting for impairment for financial assets and certain other instruments. For an overview of the new impairment guidance, which is codified in ASC Topic 326 (ASC 326), take a look at our previous blog post, ASC 326 Credit Losses Changes the Accounting for Credit Impairment.
Once ASC 326 is adopted or becomes effective, an entity will need to apply different impairment models for impairment of held-to-maturity (HTM) debt securities and available-for-sale (AFS) debt securities. HTM debt securities will fall under the Current Expected Credit Loss (CECL) model while AFS debt securities is carved out from the CECL model and has its own impairment model.
According to the FASB, the reason behind two separate models is as follows:
…the same credit loss model cannot apply because there are different measurement attributes. The measurement attribute for available-for-sale debt securities necessitates a separate credit loss model because an entity may realize the total value of the securities either through the collection of contractual cash flows or through sales of the securities. Furthermore, the unit of account for these assets is defined as an individual security, which means collective evaluation is not an acceptable approach for determining credit losses. Lastly, the amount of credit losses that will be realized for these assets is limited to the amount that fair value is less than amortized cost because an entity can sell its investment at fair value to avoid the realization of credit losses.
-Excerpt form ASU 2016-13 para. BC81
In this post, we take a closer look at the impairment model for AFS debt securities under ASC 326.
Impairment of AFS Debt Securities under ASC 326
Under ASC 326, AFS debt securities are required to be assessed at the individual debt security level. A security is impaired when its fair value declines below its amortized cost basis. However, just because impairment is present, doesn’t necessarily result in recognition of a credit loss.
The unrealized loss needs further evaluation to determine whether impairment loss recognition is needed and if so, whether it is recorded as a direct write-down of the AFS debt security’s amortized cost basis or recorded as an allowance for credit losses.
An impairment loss is recognized in earnings through a direct write down of the AFS debt security to its fair value if the entity intends to sell the security or if it is more likely than not that they will be required to sell the debt security before recovery of the amortized cost basis.
An impairment is recognized in earnings through an allowance for credit losses, a contra asset account, for any portion of the unrealized loss that is a result of a credit loss. Any portion of the unrealized loss that relates to other factors (i.e. other than credit) is recognized in other comprehensive income.
Here is a basic illustration of the model:
As we can see, key aspects of the previous OTTI model under ASC 320 are retained under the ASC 326 model with targeted amendments made. Some additional differences to note are as follows:
- Under ASC 326, for credit impairment on AFS debt securities that is recognized as an allowance, any subsequent improvements in credit losses are recognized as a reduction in the allowance and credit loss expense (in other words, this initial write-down can be reversed!). This represents a key difference from impairment recognition of AFS debt securities under the current other-than-temporary impairment (OTTI) model in ASC 320. Under the OTTI model, credit losses were recognized as a reduction to the cost basis of the investment with recovery of an impairment loss recognized prospectively over time as interest income (no immediate reversals of impairment allowed!).
- The “other-than-temporary” concept has been eliminated. Use of the length of time a security has been in an unrealized loss position as a factor in determining whether a credit loss exists or not is no longer permissible. Therefore, any declines in fair value below cost may be subject to impairment recognition, even if the decline is a recent trend and expected to be temporary.
- Credit losses are limited to the difference between a security’s amortized cost basis and fair value. This establishes a floor with regards to the ultimate write-down as a result of impairment, irrespective of the extent of credit losses identified.
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