The new standard (ASU 2016-13) impacts both held-to-maturity debt securities and available-for-sale (AFS) debt securities. Here’s how to implement the new standard when you have AFS debt securities which is addressed in accounting standards codification topic ASC 326-30.
- The new standard impacts more than just financial institutions. Here are four steps organizations can take to implement CECL.
Step 1: Identify Potentially Impacted Assets
Does your organization have any of the following that are classified as available-for-sale?
- Preferred stock
- Certain collateralized mortgage obligations
- U.S. treasury securities
- U.S. government securities
- U.S. government agency securities
- Municipal securities
- Corporate bonds
- Convertible debt
- Commercial paper
- All securitized debt instruments
- Interest only and principal-only strips
Step 2: Determine the Fair Value of the Security
Is the fair value of the AFS debt security less than the amortized cost? If yes, move on to step three to determine if the entity intends or will be required to sell the security.
If the fair value of the AFS debt security is not less than the amortized cost, then there is no impairment. The unrealized gain is recognized in other comprehensive income.
Step 3: Determine if the Entity Intends or Will be Required to Sell the Security
Does the entity intend to sell the security or is it more likely than not the investor will be required to sell before recovery?
If yes, write down the security to fair value and recognize the difference between amortized cost and fair value as a loss in the income statement.
If the answer is no, then you’ll need to determine if any portion of the unrealized loss is due to credit loss.
Step 4: Determine if Any Portion of the Unrealized Loss is Due to Credit Loss
The entity should determine if there is any portion of decline in the fair value due to credit loss (an expectation that the full amount of the security will not be collected). The remaining difference is likely due to an increase in the current interest rate.
Is any portion of the unrealized loss due to a credit loss?
If yes, recognize:
- An allowance and a corresponding credit loss in the income statement for the portion of unrealized loss related to credit
- Unrealized loss in other comprehensive income for the remaining portion. This portion is likely due to an increase in interest rates or other factors.
If no, recognize the unrealized loss in other comprehensive income (no allowance on credit loss is recorded).
- Limit the allowance for credit losses to the difference between the fair value and the amortized cost basis. The security should not be recorded for less than the fair value, even if the amount expected to be collected is less than the fair value.
Here are two examples of AFS debt securities to consider:
Example 1 – AFS Debt Securities with unrealized loss due to credit loss and other factors:
XYZ Corporation purchased corporate bonds on 3/31/2021 and the amortized cost basis at 12/31/2023 is $305,000. The bonds’ maturity date is 12/31/2024 and the reporting date is 12/31/2023. The fair value of the bonds at 12/31/2023 is $250,000. XYZ expects future expected cash flows from the security to be $265,000.
The entry at 12/31/23 is as follows:
| 12/31/23 Entry | |
|---|---|
| Debit: Available-for-sale credit loss expense | $40,000 |
| Credit: Allowance for available-for-sale credit loss | $40,000 |
| (to record impairment related to credit: $305,000 - $265,000) | |
| 12/31/23 Entry | |
|---|---|
| Debit: Unrealized loss on available-for-sale debt security (equity adjustment) | $15,000 |
| Credit: Available-for-sale security | $15,000 |
| (to record impairment not related to credit: $265,000 - $250,000) | |
Example 2 – AFS Debt Securities with unrealized loss due to credit loss only:
Alternatively, consider the facts are the same as example 1 above, however, instead the fair value of the debt security at 12/31/23 is $275,000.
The entry at 12/31/23 is as follows:
| 12/31/23 Entry | |
|---|---|
| Debit: Available-for-sale credit loss expense | $30,000 |
| Credit: Allowance for available-for-sale credit loss | $30,000 |
| (to record impairment related to credit: $305,000 - $275,000) | |
Step 5: Evaluate Impact on Financial Statements
In accordance with ASC 326-30 entities must present available-for-sale debt securities at fair value on the balance sheet, and in parentheses the amortized cost along with any credit loss allowance.
The estimated credit losses must be recorded based on the present value of the security’s expected cash flow. Holding gains and losses not related to credit loss or credit deterioration are reported through other comprehensive income after tax.
Impairments must be determined at the individual security level (which is the same method used to determined unrealized or realized gains and losses), however, if the entity has debt securities with the same CUSIP, it can aggregate those values using an average cost basis to determine any allowance.
One key change in balance presentation includes:
- AFS debt securities will continue to be presented at fair value, however, the balance sheet presentation must also include in parenthesis the amortized cost and any credit loss allowance.
Key changes in footnote disclosures include:
- ASC 326 requires expanded disclosures which should include the methodology, security type, and significant inputs that are factored when measuring credit losses. In addition, entities are required to include a roll-forward of the allowance for credit losses that includes:
- Beginning balance of credit loss allowances for debt securities
- Any additions to credit loss allowance that weren’t previously recorded
- Any additions to credit loss allowances related to the purchase of AFS debt securities that are accounted for as purchased financial assets with credit deterioration (PCD assets)
- Any reductions related to securities sold during the reporting period
- Any reductions in credit loss allowances related to securities that are either intended to be sold or are more likely than not to be sold before recovery
- Increases or decreases to credit loss allowance if an entity doesn’t plan on selling the security or it is not more likely than not the security will have to be sold prior to cost recovery
- Any write-offs charged against the allowance
- Any recovery of previously written off amounts
- Ending balances of the credit loss allowances on debt securities
Below is an example of the balance sheet presentation for an AFS debt security with credit losses:
Example 3 – Presentation of AFS debt securities on the balance sheet:
CECL’s impact on AFS debt securities
CECL continues to have far-reaching impacts beyond just financial institutions. Knowing how to use CECL for AFS debt securities is one of the many items organizations need to consider when implementing the new standard.
- View an AFS Debt Securities Impairment Decision Tree here.
