Since its issuance in June 2016, Accounting Standards Codification (ASC) 326, Financial Instruments—Credit Losses, added by Accounting Standards Update (ASU) 2016-13, has been a hot topic in the financial services industry. The amendments within ASC 326 address the measurement for credit losses for financial instruments measured at amortized cost and credit losses on available-for-sale (AFS) debt securities—subtopics ASC 326-20 and ASC 326-30, respectively.
A major focus among practitioners, regulators and auditors within the financial services industry has been on ASC 326-20, since the guidance will affect how practitioners at financial institutions estimate their allowance for loan and lease losses. However, less attention has been given to the effect ASC 326 will have on financial institutions that hold held-to-maturity (HTM) debt securities—which are within the scope of ASC 326-20, since these instruments are accounted for at amortized cost—or AFS debt securities, which are covered by ASC 326-30.
HTM Debt Securities
First, let’s focus on HTM debt securities. The glossary in paragraph 326-10-15-1 defines a debt security as “any security representing a creditor relationship with an entity” and provides examples of instruments included under and excluded from the definition of a debt security. Financial institutions should first review the guidance in paragraph 326-10-15-1 to determine if they’re holding any such instruments and, if so, have classified them as HTM. Once it’s been determined what instruments meet the definition of a debt security and have been classified as HTM, institutions will need to determine an allowance for credit losses as of the ASC 326 adoption date and continue to recognize those allowances going forward. This allowance for credit losses will need to be determined under the current expected credit loss (CECL) model and will be similar to the method used to calculate the allowance for loan losses under CECL guidance.
Institutions will need to segment HTM debt securities based on similar risk characteristics and calculate the allowance on a collective pool basis. Institutions may consider risk factors such as bond ratings, concentrations of municipal bonds issued from a certain state or geographic region, concentrations of corporate debt issued to a certain industry or term. ASC 326-20-55-5 provides a list—albeit not all-inclusive—of risk factors that may be considered on a standalone basis or in combination with other factors to determine segmentation of the HTM portfolio.
Once institutions have determined segmentation of the HTM portfolio, they’ll then need to determine historical loss rate by segment, apply an adjustment factor for current conditions, i.e., qualitative factor adjustment, and apply a forecast adjustment for expected losses over the estimated term of the security pool. There’s no specific required approach to the methodology used to calculate the expected credit losses on each HTM pool with the Topic 326 guidance.
It’s important to note that under the new guidance, it’s expected institutions will have an allowance for credit losses recorded on HTM debt securities even if fair value exceeds amortized cost basis. However, what if the institution hasn’t experienced losses in its HTM debt securities, as a majority of its portfolio might be held in U.S. Treasury securities or securities issued by government-sponsored enterprises (GSE), such as mortgage-backed securities issued by Ginnie Mae, Freddie Mac or Fannie Mae?
ASC 326-20-30-10 states, “An entity’s estimate of the expected credit losses shall include a measure of the expected risk of credit loss even if that risk is remote, regardless of the method applied to estimate credit losses. However, an entity is not required to measure expected credit losses on a financial asset (or group of financial assets) in which historical credit loss information adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the amortized cost basis is zero.”
The guidance offers an example where it specifically addresses how an institution could support not recording an expected credit loss on Treasury securities (see Example 8, paragraphs 326-20-55-48 through 326-20-55-50). The qualitative factors used by the entity in the example to support not recording credit losses include, but aren’t limited to:
- Treasury securities typically are the most highly rated securities among rating agencies.
- Treasury securities have a long history of no credit losses.
- Treasury securities are guaranteed by a sovereign entity (U.S. government) that can print its own money and whose currency (U.S. dollar) is the reserve currency.
The example in the guidance reflected above specifically addresses Treasury securities. Paragraph 326-20-55-48 states, “This example is not intended to be only applicable to U.S. treasury securities.” This leaves some room for interpretation when determining expected credit losses on debt securities issued by GSEs, e.g., Ginnie Mae, Freddie Mac and Fannie Mae mortgage-backed securities. There’s the potential that institutions may determine the risk of credit losses on GSE securities is zero after analyzing qualitative factors, including, but not limited to:
- No credit losses to investors over the past 40 years
- Payments explicitly guaranteed by the United States
- Underlying mortgage loans insured by the Federal Housing Administration or guaranteed by the U.S. Department of Veterans Affairs
- U.S. government can print currency to retire Ginnie Mae obligations
Freddie Mac and Fannie Mae
- Long history of no credit losses to investors
- Principal and interest payments guaranteed by the issuing agency
- Explicit guarantee by the U.S. subject to a cap per the Purchase Agreement made in 2008 when the agencies were taken into conservatorship
However, institutions will need to make sure the determination of zero or minimal expected credit losses on Treasury and GSE HTM debt securities is well-documented and supportable.
AFS Debt Securities
Now let’s look at ASC 326-30, which covers credit losses on AFS debt securities. As previously mentioned, AFS debt securities are addressed in a separate subtopic and excluded from CECL because they’re not carried at amortized cost. Instead, they’ll continue to be carried at fair value with noncredit-related unrealized holding gains and losses reported in other comprehensive income until realized under ASC 320-10-35-1.
ASC 326-30 changes the way institutions will account for identified credit losses of AFS debt securities. Under current guidance (ASC 320-10-35-34), impairment losses determined to be other-than-temporary impairment (OTTI) are recognized in earnings at an amount equal to the entire difference between the investment’s cost and its fair value. This fair value becomes the new amortized cost basis and cannot be adjusted for subsequent recoveries in fair value.
In contrast, under ASC 326-30, the term OTTI has been removed and the recording of the identified credit loss of an AFS debt security moves from a direct write-down approach to an allowance approach that will allow for immediate full or partial reversals of previously recognized credit losses. Before this allowance can be calculated, institutions must first review their AFS debt securities portfolio at each reporting date, i.e., quarterly for public companies or financial institutions filing call reports, and determine if a credit loss exists in the portfolio. This can be a complex process, and institutions should review the considerations provided in the guidance in paragraphs 326-30-55-1 through 326-30-55-4 to help determine whether a credit loss exists. The review should be done on a security-by-security basis, and—contrary to current guidance—paragraph 326-30-55-1 specifies the “length of time a security has been in an unrealized loss position should not be a factor, by itself or in combination with others, that an entity would use to conclude a credit loss does not exist.”
Once a credit loss has been determined to exist for a particular security, institutions should then perform a discounted cash flow analysis to determine the present value of expected cash flows received for the security and compare the calculated amount to the amortized cost basis. This difference is the amount of the credit loss for the security, and any additional unrealized loss between the security’s fair value and amortized cost is considered the noncredit loss and recorded through other comprehensive income. The entries are best illustrated by the following example.
Example to Record Identified Credit Loss on AFS Debt Security
As of its quarterly reporting date, December 31, 201X, Bank A holds an AFS debt security with an amortized cost basis of $1 million and a fair value of $850,000. As such, total unrealized loss as of the reporting date is $150,000.
Bank A has determined the total unrealized loss includes a portion that’s credit-related and performs a discounted cash flow of the estimated future cash flows. This amount is calculated to be $950,000. The journal entry under the new guidance in ASC 326-30 (before the tax effect) would be:
In concluding our discussion of ASC 326-30, it’s important to note the allowance that can be recorded on a credit loss for an AFS debt security is limited to the amount that fair value is less than amortized cost basis (paragraph 326-30-35-3). It also is important to note a present value of expected cash flows method must be used under ASC 326-30 when determining the allowance for credit losses of AFS debt securities (paragraph 326-30-35-6). This contrasts with how credit losses are determined for HTM debt securities under the CECL guidance in ASC 326-20, as the Financial Accounting Standards Board doesn’t require any particular methodology to be used when calculating estimated credit losses.
Adoption of ASC 326 is effective for public business entities for fiscal years beginning after December 15, 2019, and for all other entities for fiscal years beginning after December 15, 2020. It’s important for institutions to not only begin determining the new standard’s effect on calculating the allowance for loan losses, but also to review their HTM and AFS debt security portfolios, as these instruments also will be affected. As HTM debt securities are within the CECL scope, the expectation is that institutions will need to calculate and record a credit loss allowance for expected credit losses over the expected lives of their portfolios, even if securities have fair values in excess of amortized cost—a practice that will be vastly different from current practice.
In contrast, AFS debt securities will continue to be recorded at fair value and any determined credit losses only will have to be recorded through a credit loss allowance if both of these conditions are met:
- The fair value is less than amortized cost.
- The discounted cash flow analysis of expected cash flows is less than contractual cash flows.
We recommend institutions continue to monitor debt securities held in their AFS portfolios for any specific investments with exposure to credit losses that will need to have an allowance recorded upon the standard’s adoption.
Contact your trusted BKD advisor for more information.