In a past blog post, we covered an overview of the new impairment guidance and highlighted the changes that ASC 326, Credit Losses, introduces to the accounting for impairment of financial assets.
You may recall that 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
In my last blog post, we took a closer look at the ASC 326 Available-for-sale (AFS) debt securities impairment model. To continue on with the series, today, we will focus on the impact of ASC 326 on purchased financial assets with credit deterioration.
Purchased financial assets with credit deterioration, referred to as “PCD” assets, is a new term introduced by ASC 326 and is defined as follows:
Acquired individual financial assets (or acquired groups of financial assets with similar risk characteristics) that, as of the date of acquisition, have experienced a more-than-insignificant deterioration in credit quality since origination, as determined by an acquirer’s assessment.
Under ASC 326, if a financial asset is purchased and it has experienced more than an insignificant deterioration in credit quality since origination, it should be accounted for in the following manner:
- At acquisition, an initial allowance for credit losses should be estimated and recorded. This initial allowance is added to the purchase price rather than being reported as a credit loss expense.
- Subsequent changes (both favorable and unfavorable) in the allowance for credit losses are recorded as a credit loss expense.
- Interest income for PCD assets should be recognized based on the effective interest rate, excluding the discount embedded in the purchase price that is attributable to the acquirer’s assessment of credit losses at acquisition.
As you may recall, under pre-ASC 326 guidance provided in ASC 310-30, there is a separate model for accounting for loans and debt securities acquired with deteriorated credit quality (referred to as “PCI” assets). This separate model for accounting for PCI assets has been criticized as being complex and difficult to apply.
Under ASC 310-30, “carrying over” or recording an allowance for loan losses when initially accounting for the purchase of an impaired loan or debt security is prohibited. The purchase credit impaired loan or security is initially recorded at fair value at acquisition and accounted for based on expected cash flows.
The difference between the PCI loan or security purchase price and the gross expected cash flows is accreted to income over the life of the asset using the effective interest rate (accretable yield amount). The amount of principal and interest not considered collectible is the nonaccretable difference. The accounting can become complex as there are subsequent changes in the estimated cash flows expected to be collected.
If there is a probable decrease in the cash flows the purchaser reasonably expected to collect when the PCI loan or security was acquired, then an impairment is recognized via an allowance for loan losses. If there is a probable significant increase in the cash flows compared with those that previously were reasonably expected to be collected (or if actual cash flows are significantly greater), then adjustments must be made to the accretable yield which should be recognized prospectively as an adjustment of the yield over the remaining life of the asset.
So, the good news is that ASC 326 brings favorable changes to the accounting for purchased financial assets with credit deterioration. The changes introduced by ASC 326 makes the allowance for credit losses more comparable between originated assets and purchased financial assets, as well as reduces the complexity with the accounting for interest income.
Take a look at our post on Credit Impaired Differences Between U.S. GAAP and IFRS on the blog, our Impairment of Financial Instruments topic page for more resources. For more on CECL, check out our self-study eLearning course.
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