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Navigating the impact of ASU 2016-13 on the impairment of AFS debt securities

When the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13, Financial Instruments – Credit Losses, in June of 2016, most of the headlines regarding the ASU focused on its introduction of Subtopic 326-20, commonly referred to as the Current Expected Credit Losses (or, “CECL”) framework.  The CECL framework requires entities to measure lifetime expected credit losses on all financial instruments measured at amortized cost – financial assets like loans receivable and held-to-maturity debt securities.  The focus on the CECL framework was understandable – it represents a sea change in the accounting for a significant class of assets for many entities, particularly lending institutions.

However, ASU 2016-13 affected the accounting for credit losses on other financial instruments as well, such as debt securities held as available-for-sale (or “AFS”).  Below, we will discuss how ASU 2016-13 changed the accounting for credit losses on AFS debt securities.

AFS Framework prior to adopting ASU 2016-13:  OTTI

Prior to an entity’s adoption of ASU 2016-13, the guidance concerning impairment of AFS debt securities is found in Subtopic 320-10, particularly in paragraphs 320-10-35-18 through 35-34, and is known as the Other-Than-Temporary Impairment (or “OTTI”) framework.

Generally, AFS debt securities are carried on the balance sheet at fair value, and changes in the fair value of AFS debt securities are recognized outside of earnings as a component of Other Comprehensive Income (OCI). However, if an AFS debt security’s fair value is less than its amortized cost – that is, the AFS debt security is impaired – the entity must evaluate whether the impairment is an OTTI.

An entity should recognize an OTTI on an impaired security when one of three conditions exists:

1. The entity intends to sell the security
2. It is more likely than not the entity will be required to sell the security prior to recovery of the amortized cost basis of the security
3. The entity does not expect to recover the amortized cost basis of the security

If condition (1) or (2) exists, then the entity will reduce the amortized cost basis of the AFS debt security to its current fair value.  Any subsequent increases in the fair value of the AFS debt security would be recognized outside of earnings as a component of OCI until the gains are realized via cash collection or sale.

If neither condition (1) nor (2) exists, then the entity must evaluate whether it does not expect to recover the amortized cost basis of the security.  The entity may perform a qualitative analysis, considering factors such as the magnitude of the impairment, the duration of the impairment, factors relevant to the issuer of the security, factors relevant to the industry in which the issuer of the security operates, and any other relevant information.  Alternatively, an entity may perform a quantitative analysis by comparing the net present value (NPV) of expected cash flows of the AFS debt security to its amortized cost basis, as described below.

If the entity does not expect to recover the amortized cost basis of the security, an OTTI exists and the security should be written down to its fair value.  The entity must then separate the total impairment (the amount by which the AFS debt security’s amortized cost exceeds its fair value) between the amount of impairment related to (a) credit losses and (b) all other factors.  To make this distinction, the entity compares the NPV of the expected future cash flows on the debt security, discounted at the security’s effective interest rate (or “EIR”), to the amortized cost basis of the security.   The amount by which the amortized cost of the AFS debt security exceeds its NPV is recognized in earnings as a credit loss, while any remaining impairment is recognized outside of earnings as a component of OCI.

AFS Framework upon adopting ASU 2016-13

ASU 2016-13 largely keeps the OTTI framework from Subtopic 320-10 intact.  If either (1) an entity intends to sell, or (2) it is more likely than not that it will be required to sell an AFS debt security whose amortized cost exceeds its fair value, the entity shall write that AFS debt security’s amortized cost basis down to its fair value through earnings.  For AFS debt securities that are impaired, but for which neither (1) the entity intends to sell, nor (2) it is more likely than not that it will be required to sell an AFS debt security whose amortized cost exceeds its fair value, the entity will still need to assess whether it expects to recover the amortized cost basis of the impaired AFS debt security either via a qualitative analysis or via the same quantitative framework in Subtopic 320-10 today (as described above).

However, ASU 2016-13 makes a few important changes.  The most significant changes include:

• Entities may no longer consider the duration of an impairment when qualitatively assessing whether the entity does not expect to recover the amortized cost basis of an impaired AFS debt security.
• If an entity recognizes a credit loss on an AFS debt security, the entity will establish an allowance for credit loss (or “ACL”) rather than perform a direct write-down of the amortized cost basis of the AFS debt security. Accordingly, subsequent reductions in the estimated ACL will be recognized in earnings as they occur.
• The amount of credit losses to be recognized is limited by a “fair value floor” – that is, total credit losses cannot exceed the total amount by which the amortized cost of the AFS debt security exceeds its fair value.

The following flow chart illustrates the how an entity would evaluate an AFS debt security for impairment upon adoption of ASU 2016-13:

Example

Background

• Entity A has an investment in an AFS debt security issued by Company X with an amortized cost of $100
• At 12/31/X1, the fair value of the AFS debt security is $90
• The of the AFS debt security is 10% (as determined in accordance with ASC 310-20)

Entity A does not intend to sell the AFS debt security, nor is it more likely than not that Entity A will be required to sell the AFS debt security prior to recovery of the amortized cost basis.  Entity A elects to perform a qualitative analysis to determine whether the AFS debt security has experienced a credit loss.  In performing that qualitative assessment, Entity A consider the following:

• Extent of impairment: 10%
• Adverse conditions: Company X is in an industry that is in decline
• Company X’s credit rating was recently downgraded

Accordingly, Entity A determines that a credit loss has occurred.  Next, Entity A makes its best estimate of expected future cash flows, and discounts those cash flows to their NPV at the AFS debt security’s EIR of 10% as follows:

In this case, the NPV is $85, which would indicate a $15 ACL.  However, the fair value of the AFS debt security is $90, so the ACL is limited to $10 due to the “fair value floor”.  Accordingly, Entity A would recognize a credit loss expense of $10 and create an ACL, also for $10.

In subsequent periods, Entity A would continue to determine the NPV of future expected cash flows and adjust the ACL up or down as those changes occur, subject to the fair value floor.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column][vc_empty_space][startapp_block_title animation=”” title=”About the Author”][/vc_column][/vc_row][vc_row][vc_column width=”1/6″][vc_single_image image=”2439″][/vc_column][vc_column width=”5/6″][vc_column_text]Graham Dyer, CPA Grant Thornton​

Graham is a partner in Grant Thornton, LLP’s national office where he provides technical accounting guidance to clients across the globe.  Graham has a particular focus on financial institutions, including matters such as the ALLL, consolidations, Purchased Credit Impaired loan income recognition, complex financial instruments, business combinations, and SOX/FDICIA matters. ​

Graham also serves on a number of industry technical committees, including the IASB’s IFRS 9 Impairment Transition Group and the FASB’s CECL Transition Resource Group.  Graham was previously a professional accounting fellow at the OCC.