Available for sale debt securities and the new credit loss model

Video Feb 28, 2017

Is a discounted cash flow required for available for sale securities under the new financial instruments credit loss standard? Hear PwC’s Edward Lee describe this important question raised by many practitioners during application of the new standard and share his perspectives. He also addresses situations when a company has multiple positions in the same security, but classifies some as held to maturity and some as available for sale.

AFS debt securities and the new credit loss model

Is a DCF required for AFS securities under the new FI credit loss standard? Hear the discussion.

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This video is part of The quarter close publication and video perspectives series.

Transcript

Hi, I’m Edward Lee.

I’m here today to discuss a couple of key areas relating to the application of the new FASB credit loss standard for available-for-sale and held-to-maturity debt securities. The new impairment guidance for AFS debt securities requires an assessment of whether a credit loss exists when fair value is less than amortized cost and, the company does not intend to sell the security or, it isn’t more likely than not that the company will be required to sell the security. One change from today’s guidance is the concept of whether an AFS security is “other-than-temporarily” impaired does not exist in the new standard.

One of the questions we have been receiving is whether a discounted cash flow analysis is always required or are there other approaches that could be applied when assessing if a credit loss exists under the new AFS debt security impairment model. In certain circumstances it may be possible to apply other approaches. Under today’s guidance, companies use either quantitative or qualitative analysis to assess whether a credit loss exists. For example, for certain securities, such as many beneficial interests, many companies use a quantitative approach by leveraging their existing discounted cash flow analyses.

For other securities, for example, US government agency securities, a company might use qualitative factors to determine if a decline in fair value is credit related and other-than-temporary. If these qualitative factors demonstrate that the decline in fair value is credit related and other-than-temporary, then companies will perform a quantitative calculation. Under the new standard, there may be circumstances where a qualitative analysis considering a series of data points and factors may allow a company to reach appropriate conclusions regarding whether an impairment exists without running a full discounted cash flow analysis. This was confirmed by the FASB staff at the September 2016 AICPA banking conference. However, the qualitative factors currently used by companies should be updated to align with the new standard. For example, as mentioned earlier, the new guidance eliminates the concept of other than temporary impairment and entities should not consider the length of time a security has been in an unrealized loss position.

We believe that the process and application of qualitative factors to assess whether a credit loss exists should be designed such that it does not yield a significantly different result than calculating a discounted cash flow and comparing it to the amortized cost. Companies should maintain controls and documentation demonstrating how their process reaches appropriate conclusions regarding impairment. As a reminder, under the new guidance, credit impairments will be recorded as a contra-asset allowance as opposed to a write-off of the amortized cost basis of the security.

Another question we have been receiving relates to whether the allowance would be the same in situations when a company has multiple positions in the same security, but classifies one as held-to-maturity and one as available-for-sale. Under the new standard, held-to-maturity securities apply the current expected credit loss or CECL guidance. On the other hand, as I just discussed, separate impairment guidance exists for available-for-sale debt securities.

The AFS impairment guidance differs from the CECL model in a number of ways, such as:

  • AFS impairment requires an unrealized loss trigger, that is fair value must be below amortized cost for an impairment analysis to be conducted. No such trigger exists under CECL.
  • AFS impairments are measured using discounted cash flows. CECL permits the use of other methods such as loss rates.
  • For AFS the impairment assessment must be performed at an individual security level. CECL requires pooling of similar instruments.
  • For AFS the allowance should not be greater than the difference between the security’s fair value and amortized cost basis, also known as the fair value floor. CECL has no similar floor.

In addition, even if a company applies a discounted cash flow analysis to both the available-for-sale and held-to-maturity securities to estimate the allowance, the allowance amount can be different. This is because the AFS debt security model is a “best estimate” calculation while CECL is not. Under CECL, an entity’s estimate of expected credit losses should include a measure of loss even if that risk is remote. Therefore, except for specific circumstances, we would expect most held-to-maturity securities to have an allowance. For the reasons discussed above, the allowance would likely be different when a company has multiple positions in the same security but classifies one as held-to-maturity and the other as available-for-sale.

For more information on this topic, refer to the Loans and investments guide on CFOdirect.com.

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