We’ve all heard the talk about the big 3 new standards in U.S. GAAP:
- ASC 606, Revenue from contracts with customers
- ASC 842, Leases; and
- ASC 326: Financial instruments – credit losses
Not surprisingly, everyone’s attention has been on Revenue Recognition, which is now effective for public business entities and will be effective in 2019 for non-public business entities. And we here at GAAP Dynamics are no different. We’ve posted plenty on the subject! Leases has gotten its fair share of attention too, as its effective date is 2019 for public business entities and 2020 for all others.
But what about CECL? But what about CECL? With an effective date of 2020 for public entities and 2022 for non-public entities, it’s not as high on most accountant’s radars, yet. But, as with the other standards, the implementation of this standard will involve a fundamental shift in the accounting process, controls, data gathering and more, so it’s never too early to start thinking about some of the issues associated with implementing this standard! So, let’s take a look at once such issue now: zero expected credit losses.
As we discussed in this post, ASU 2016-13, which introduces ASC Topic 326, Financial Instruments – Credit Losses, 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)
ASC 326 replaces the incurred loss model with an expected credit loss model, referred to as “the Current Expected Credit Loss (CECL) model”. Under this model, 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.
Under CECL, there is no threshold for impairment loss recognition. Rather, impairment should reflect a current estimate of all expected credit losses.
But could there ever be a time when a company could recognize zero expected credit losses? Generally, the answer is no! However, the standard states that no measure of expected credit losses is required for a financial asset or group of financial assets if historical credit loss information, adjusted for current conditions and reasonable and supportable forecasts, results in an expectation of nonpayment of the amortized cost basis of zero.
This is a very high hurdle to meet! Said another way, the historical information supports the fact that there is zero credit loss, the current conditions support the fact that there are zero credit losses, and the forecasts of the foreseeable future support the fact that there are zero credit losses. Past, present, and future…it takes all three!
So, what types of financial instruments could possibly meet the requirements for an entity to recognize zero expected credit losses?
Recently, the AICPA’s Financial Reporting Executive Committee, or FinREC, issued a working draft on how accountants can help apply the guidance to determine whether an instrument might recognize zero expected credit losses. In the working draft, the FinREC provides three examples to illustrate how management could approach an analysis to evaluate whether the expectation of nonpayment is zero:
- A U.S. Treasury security
- A Ginnie Mae (GNMA) mortgage-backed security
- An agency mortgage-backed security
The working draft goes on to provide indicators that the security would have zero loss. Those might include:
- High credit ratings by rating agencies
- Long histories with no credit losses (adjusted for current conditions and reasonable and supportable forecasts)
- Guaranteed (either by a sovereign entity of high credit quality, the “issuing” agency, or an agency of the U.S. government)
- Rates of return (on instruments that are not U.S. Treasuries) are priced above the risk-free rate
- The ultimate “guarantor” (the U.S. government) can print its own currency
But it also includes factors that would indicate that the instrument might have a loss greater than zero. Those include:
- The treasury securities experiencing a downgrade
- The market not pricing the mortgage-backed securities the same as risk free
- Government agencies are subject to government appropriations
- Issues of mortgage-backed securities are not guaranteed that they would be bailed out should there be another event like the financial crisis of 2008
So, although this is a high hurdle to overcome, as you can see, it can be overcome. However, it must be well documented by management and consistently reevaluated. But, assuming the criteria like those listed above are met, there just might be circumstances where management could expect zero credit losses on an instrument.
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