CECL: What About Credit Losses on Debt Securities?

6/14/2022 - By Joshua Jackson, CPA

Since the initial roll-out of ASU 2016-13, Financial Instruments—Credit Losses (Topic 326), much of the prevailing focus has been on accounting for expected credit losses in loan portfolios. As the CECL implementation date draws near for nonpublic business entities, we are starting to receive new questions about CECL’s impacts to securities portfolios as well.

Are credit losses for AFS and HTM debt securities accounted for differently under CECL?

Indeed, they are. Securities held to maturity (“HTM securities”) are subject to the CECL methodology in ASC 326-20, while securities available for sale (“AFS securities”) are not. AFS securities are subject to a separate credit loss methodology under ASC 326-30.

The assessment of expected credit losses for HTM securities under CECL must be performed on a collective basis when similar risk characteristics exist, and expected credit losses must be recognized upon initial recognition (i.e., at the time of purchase). CECL requires the consideration of credit losses even when the risk of loss is remote.

In contrast, the assessment of credit loss for AFS securities must be done at the individual security level, as defined in ASC 326-30-35-4, and only when the amortized cost of an AFS security exceeds its fair value. Credit loss recognition is limited to the fair value of the security (referred to as “the fair value floor”). Any additional amount of loss is referred to as noncredit and is recognized through Accumulated Other Comprehensive Income (AOCI), net of applicable taxes.

How should a bank account for the decline in fair value on an AFS debt security?

To determine the appropriate accounting, the bank must first determine if it intends to sell the security or if it is more likely than not that the bank will be required to sell the security before the fair value increases to at least the amortized cost basis. If either of those selling events is expected, the bank must write down the amortized cost basis of the security to its fair value. This is achieved by writing off any previously recorded allowance for credit losses (ACL), if applicable, and recognizing any incremental impairment through earnings.

If the bank does not intend to sell the security, nor believes it will be required to sell the security before the fair value recovers, the bank must then determine whether any of the decline in fair value has resulted from a credit loss or if it is entirely the result of noncredit factors such as changes in prevailing market rates.

Impairment related to a credit loss will be recognized by establishing an ACL through provision for credit losses. Impairment related to noncredit factors will be recognized in AOCI, net of applicable taxes, just as it is today.

What factors indicate that an AFS debt security impairment may be due to a credit loss?

There are numerous factors to be considered when determining if impairment is due to a credit loss. As described in ASC 326-30-55-1, all the following factors should be considered when making that determination (this list is not meant to be all-inclusive):

Extent to which the fair value is less than the amortized cost basis.
Adverse conditions specifically related to the security, an industry, or a geographic area (for example, changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, in the financial condition of the underlying loan obligors).
Payment structure of the debt security (for example, backed by loans with nontraditional terms) and the likelihood of the issuer being able to make payments that increase in the future.
Failure of the issuer of the security to make scheduled interest or principal payments.
Any changes to the rating of the security by a rating agency.

If after considering these factors, along with any other relevant factors, the bank determines some or all of the impairment is due to a credit loss, the bank should calculate the credit loss using a discounted cash flow approach. A bank should not wait until the security has been impaired for a set period of time before considering whether impairment is due to credit.

How should the bank determine the amount to be recognized as a credit loss at the end of the reporting period?

ASC 326-30-35-6 through 35-8 requires the credit loss to be measured using a discounted cash flow approach. The bank should make its best estimate of the cash flows expected to be collected based on past events, current conditions and reasonable and supportable forecasts. The cash flows expected to be collected should be discounted at the effective interest rate (EIR) implicit in the security at the date of acquisition. The bank should make an accounting policy election to use the contractual EIR or an EIR adjusted for prepayment expectations. This accounting policy election would be applied at the major security type level.

The difference between the discounted expected cash flows and the security’s amortized cost is deemed to be the credit loss. The amount of the credit loss recognized is limited, however, to the amount that fair value is less than amortized cost. The bank would not recognize any credit loss that exceeds the difference between fair value and amortized cost. If the credit loss calculated using the discounted cash flow method is less than the difference between the fair value and amortized cost, the remaining unrealized loss represents noncredit impairment to be recognized in AOCI, net of applicable taxes.

Will a bank be expected to record an ACL for HTM debt securities?

The answer is generally, yes. ASC 326-20 applies to HTM debt securities because they are financial assets carried at amortized cost. CECL requires an ACL for expected credit losses, even if the risk of loss is remote. While an individual investment-grade security may not show risk of credit loss, historical data covering pools of investment-grade securities show that credit losses may occur, even within pools of highly-rated investment-grade securities. Because the ACL for HTM debt securities must be determined by collectively evaluating expected credit losses for securities that share similar risk characteristics, this risk of loss must be captured in the bank’s ACL.

It should be noted, however, that ASC 326 does not require an allowance for credit losses on HTM debt securities for which the expectation of nonpayment of the amortized cost basis is zero based on historical credit loss information, adjusted for current conditions and reasonable and supportable forecasts. The following securities could have zero expected credit losses under current conditions and reasonable and supportable forecasts:

U.S. Treasury securities.
Mortgage-backed securities guaranteed by the Government National Mortgage Association (GNMA).
Mortgage-backed securities issued by the Federal Home Loan Mortgage Corporation (FHLMC).
Mortgage-backed securities issued by the Federal National Mortgage Association (FNMA).

This list is not exhaustive and should be used as a tool and not a bright line.

Questions?

It is important that banks have appropriate credit loss evaluation procedures to determine whether any credit losses related to their securities portfolios should be recognized under the CECL framework. If you have questions about the potential impacts of CECL on your debt securities, please do not hesitate to reach out to a member of our Financial Institutions practice.