CECL Current technical developments Part II

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1 CECL Current technical developments Part II Current Developments in FASB s Current Expected Credit Loss Model December 11, 2018 We will be starting soon Please disable pop-up blocking software before viewing this webcast

2 Presenters Rachel Binder Senior Manager NPSG Dallas, TX Rahul Gupta Partner Accounting Principles Chicago, IL Graham Dyer Partner Accounting Principles Chicago, IL

3 Learning objectives Identify how to incorporate recent technical developments into a CECL implementation plan Describe issues raised by FASB, SEC and AICPA 3

4 Agenda AFS debt securities Purchased Credit Deteriorated (PCD) Assets Considerations for accrued and capitalized interest Life of a credit card receivable Subsequent events Other topics Part I The Basic Model Scope of CECL Measurement principle Estimating CECL: 5 components HTM securities Disclosures Archived on GrantThornton.com 4

5 Scope CECL applies to financial assets held at amortized cost In scope Financing receivables Held to maturity debt securities Trade receivables Reinsurance receivables Lessor's net investment in leases Off-balance sheet credit exposures Out of scope Financial assets measured at fair value Available-for-sale debt securities (revised model) Loans and receivables between entities under common control Pledge receivable of not for profits Operating lease receivables Policy loan receivables of insurance company 5

6 AFS debt securities Impairment: Current GAAP Other-than-temporary impairment (OTTI) model in ASC 320 OTTI not expected to be recovered, or is related to credit, is written off against the cost basis through earnings Subsequent recoveries of cost basis are recognized in OCI until realized Post-ASU : ASC Allowance approach used for recognizing credit losses Non-credit losses recognized in OCI Fair value floor Allowance assessed on an individual security basis Matter ASC (CECL) ASC (AFS OTTI) Trigger for recognizing credit losses None FV < Amortized Cost Method for estimating credit losses Not prescribed Discounted Cash Flow (DCF) Only Amount of credit loss recognized Full lifetime losses Credit losses recognized subject to fair value floor Unit of estimation Pool Individual AFS security 6

7 Debt Securities: AFS FV of AFS < amortized cost? Yes (1) Intends to sell or (2) More likely than not required to sell No No Yes No impairment to assess Recognize full impairment against amortized cost basis Elect to perform qualitative assessment? Yes Qualitative assessment indicate credit loss? No Recognize change in FV in OCI No Yes Determine PV of expected cash flows PV of expected cash flows < amortized cost = ACL, subject to FV floor Remaining change in FV, if any, in OCI 7

8 AFS debt securities Factors to consider in determining whether a credit loss exists Extent of impairment Adverse conditions specific to the security (including its industry or geographic area) Payment structure of the debt security Failure of the issuer to make contractually required payments of principal or interest Changes in the security's credit rating Influence of non-free-standing credit enhancements Factors that shall not be considered Duration of impairment Historical and implied volatility of fair value of the security If investor determines that a security has experienced a credit loss Measured initially and subsequently based on investor's best estimate of future expected cash flows If investor intends to sell, or more likely than not will be required to sell, before recovery of amortized cost, write AFS security down to FV 8

9 AFS debt securities Background Amortized cost of AFS security: $100 Fair value of AFS security: $90 Effective interest rate (EIR): 10% Qualitative credit loss factors Extent of impairment: 10% Adverse conditions: declining industry Payment structure of debt security: N/A Failure to make contractually required payments: N/A Changes in security's credit rating: downgraded Influence of credit enhancements: N/A Future Expected Cash Flows PV $ 85 $ 10 $ 10 $ 7 $ 5 $ 95 Credit Loss 10 Allowance for Credit Loss 10 9

10 Transfers out of AFS / HFS TRG Discussion June 2017 Issue #10 Background AFS debt securities: FV(OCI) with allowance for credit losses (FV floor) HFS loans: Lower of Cost or Market (LOCOM) HTM debt securities / HFI loans: amortized cost and CECL Question If an debt security classified as AFS is transferred to HTM or loan classified as HFS is transferred to HFI, how should any previously recognized credit losses impact the initial accounting upon transfer? TRG Views AFS: Existing allowance can be reclassified to ACL HFS: Reverse LOCOM adjustment through earnings, then recognize ACL through earnings as a credit loss NOTE: Subsequent FASB discussions have suggested a "gross" approach to transfers that is, any credit allowance on AFS securities or LOCOM adjustment on HFS loans would be reversed through the income statement, and an ACL established also through the income statement on a gross basis. 10

11 Transfers out of AFS / HFS TRG Discussion June 2017 Issue #10 Examples An investor has an AFS debt security with an amortized cost basis of $100 and a fair value of $80. The investor estimates that out of the $20 of impairment, $15 is related to credit. An investor has an HFS loan with an amortized cost of $100 and a fair value of $80. The investor estimates that out of the $20 impairment, $15 is related to credit. AFS Debt Security Reverse AFS credit allowance Dr: Allowance $15 Cr: Credit loss on AFS $15 Recognize ACL on HTM security DR: Credit loss expense $15 Cr: Allowance for credit loss $15 HFS Loan Reverse LOCOM adjustment Dr: LOCOM allowance $20 Cr: LOCOM expense $20 Recognize ACL on HTM security DR: Credit loss expense $15 Cr: Allowance for credit loss $15 Note: Remaining $5 of AFS unrealized loss is accreted to the amortized cost basis as an adjustment to interest income, similar to a purchase premium 11

12 FX-Denominated AFS Securities TRG Discussion November 2018 Background Prior to the amendments in ASU , a change in foreign exchange (FX) rates could trigger recognition of an other-thantemporary impairment (OTTI) ASU amended that guidance such that (a) impairment related to credit losses are recognized via an ACL, and (b) all other changes are recognized in OCI Question Entities inquired of the FASB staff whether changes in FX on a foreign-currency-denominated AFS security should be recognized in earnings (either via ASC or ASC 450) or whether they should be recognized as a component of OCI TRG Views The FASB staff reaffirmed the guidance in ASU that all non-credit-related impairment would be recognized in OCI The TRG generally agreed with the staff's analysis NOTE: The TRG clarified that an entity would apply the following steps when estimating the ACL on an foreign-currency-denominated AFS security: 1. Calculate the ACL in the foreign currency pursuant to ASC Translate the ACL to the reporting currency via ASC 830, and report all other changes in fair value in OCI 12

13 FX-Denominated AFS securities TRG discussion November 2018 Examples Investor purchases a 1,000,000 Euro-denominated debt security at par, and classifies that security as available-for-sale, on 1/1/X1 Investor's reporting currency is USD At the acquisition date, the FX-rate of USD:Euro is 1:1 At 12/31/X1, the exchange rate of USD:Euro is now 1.05:1 and the fair value of the security is 900,000 Euros and 945,000 USD Investor, via a DCF analysis, determines that the credit impairment is 50,000 Euros Step 1 Step 2 Euro FX Rate USD Amortized Cost 1,000,000 $ 1,000,000 Fair Value 900,000 $ 945,000 Total Impairment 75,000 $ 55,000 Expected Loss 50, $ 52,500 OCI 50,000 $ 2,500 Journal Entry at 12/31/X1 Credit Loss Expense $ 52,500 OCI $ 2,500 ACL $ 52,500 AFS Security $ 2,500 13

14 AFS debt securities Disclosures Objective: Enable users to understand: Credit risk in AFS Securities Management's estimate of credit losses Management's initial and updated estimates of expected credit losses Disclosures: AFS securities in unrealized loss positions without an allowance for credit losses Allowance for credit losses Roll-forward of the allowance for credit losses Purchased AFS securities with credit deterioration 14

15 PCD assets Purchased Credit Deteriorated (PCD) Assets Removes Subtopic Definition of PCD: "assets with more-than-insignificant credit deterioration since origination" Beneficial interests also in scope if: "contractual cash flows are significantly different from expected cash flows at purchase date" 15

16 PCD assets - scope TRG discussion June 2017 Issue #2 Background BI's are PCD if there is either: more than insignificant credit deterioration since origination significant difference between expected and contractual cash flows Question When is there a significant difference between expected and contractual cash flows for BI, specifically when contractual cash flows may not be specified (ex: I/O strip or residual interests) TRG views When cash flows are not specified, look through to underlying assets Significant difference between expected and contractual should not be due to prepayments NOTE: Day 1 gross-up of PCD BI's would only include effect of credit risk (and not prepayments). However, all subsequent changes in cash flows, including due to prepayments would be recognized through ACL until ACL is zero, and then through an adjustment to yield. 16

17 PCD assets - scope Example Asset-Backed Security Pool of prepayable loans with 10 year terms. Total payments contractually due of $1,000 each year. 3 tranches (A, B, and residual C). First $500 allocated to A, next $400 to B, and residual to C. All loans that do not default are expected to prepay after year 7. Expected credit losses on the underlying loans of $100 in year 5, $200 in year 6 and $300 in year 7 Tranche C has a FV at acquisition of $275 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 Expected 1,000 1,000 1,000 1, Tranche A Shortfalls Shortfalls due Tranche B due to credit to losses prepayments Tranche C

18 PCD assets SEC speech (2017 AICPA SEC & PCAOB Conference) Background ASC (PCI accounting) will be replaced by the PCD model in ASC 326 PCI accounting has been applied by analogy in many circumstances today Question Should entities expect that transactions to which PCI accounting was applied, but are outside its scope, will be able to apply PCD accounting by analogy? SEC staff views Scenario 1: Originate loans secured by defaulted loans could not apply PCI by analogy b/c originated Scenario 2: Originate loans secured by sub-prime loans could not apply PCD by analogy b/c originated Scenario 3: Purchase sub-prime loans at origination could not apply PCD by analogy b/c no deterioration NOTE: Entities that have applied PCI by analogy should consider carefully whether such transactions are within the scope of the PCD guidance and not assume that they will receive similar treatment under CECL 18

19 PCD assets Purchased Credit Deteriorated (PCD) assets Removes Subtopic Definition of PCD: "assets with more-than-insignificant credit deterioration since origination" Beneficial interests also in scope if: "contractual cash flows are significantly different from expected cash flows at purchase date" Accounting Estimate ECL at acquisition Gross-up asset and ACL by that amount Include acquired assets in extant poolings go-forward Non-credit discount component of yield 19

20 PCD assets Discounted cash flow method Y N Expected credit losses will be discounted at the rate that equates the present value of the estimate of future cash flows to purchase price Expected credit losses will be measured on unpaid principal balance (face amount) Impact of time value of money on ACL may be recognized in interest income or credit loss expense 20

21 PCD assets Expected credit loss / noncredit discount or premium determined on a pool of assets Allocate to individual assets 21

22 PCD assets Initial measurement Facts: Purchase Price: $ 1,918,559 Face amount: $ 5,000,000 Coupon: 6 percent Unpaid principal balance (UPB): $ 2,176,204 Estimated loss-rate: 10 percent Estimated credit losses: $ 217,620 Non-credit related discount: $ 40,025 Original (remaining) contractual term: 5 (2) years UPB ($2,176,204) x Loss Rate (10%) = $217,620 Purchase Discount ($257,645) ACL ($217,620) = $40,025 Journal entry: Loan (Unpaid principal bal) DR $2,176,204 Loan (Non-credit discount) CR $ 40,025 Allowance for credit losses CR $ 217,620 Cash CR $ 1,918,559 22

23 PCD assets Transition from PCI TRG discussion June 2017 Issue #3 Background Transition guidance states that PCI assets (310-30) are in scope of PCD guidance in 326 Further, an entity may maintain PCI pools at adoption of 326 Question Is ability to maintain PCI pools at adoption of 326 limited only to period of adoption, or may that entity maintain those pools until the pool is repaid? TRG views Entities may maintain PCI pools indefinitely NOTE: Certain aspects of will be referenced in the transition guidance as continuing to be applicable for PCI pools maintained (even though is eliminated by new guidance) 23

24 Life of a credit card TRG discussion June 2017 Issue #5 Background Credit card receivables do not have contractual life Application of payments against a card balance is complex No ACL may be estimated for unilaterally cancellable undrawn amounts Question Should (and, if so, how) an entity consider future expected draws on a credit card when estimating expected losses on extant card balance at measurement date? TRG Views View A: apply all expected future principal payments to current balance via CARD Act View B: apply expected future principal payments to current balance and to future expected draws via CARD Act NOTE: FASB staff noted that View B may be more appropriate for populations of credit card borrowers that demonstrate link between monthly draws and payments. However, may choose either method that faithfully estimates expected credit losses. 24

25 Life of a credit card TRG discussion June 2017 Issue #5 Applying View A Estimate future principal payments based solely on measurement date balances, based on historical experience, adjusted for current conditions and reasonable and supportable forecasts of future conditions Apply principal payments to measurement date balances according to CARD Act Applying View B Estimate future draws and the related future total payments based on historical experience, adjusted for current conditions and reasonable and supportable forecasts of future conditions Reduce future payments by expected interest and fees Apply remaining principal payments to measurement date balances according to CARD Act CARD Act requires allocating payments to the highest interest balances first 25

26 Life of a credit card TRG discussion June 2017 Issue #5 Transactors Credit card receivables Revolvers Minimum segmentation expectation of banking regulators (2018 AICPA Banking Conference) ACL expected to be minimal: Pay off balance each period No ACL on undrawn amounts Consider further criteria for segmentation, including whether future draw activity is predictive of future expected payments, amongst others. 26

27 Life of a credit card TRG discussion June 2017 Issue #5 Example view B Entity A determines that its expected future cash payments on credit card receivables are correlated to expected future draws and estimates the life of their credit card receivables using View B Their credit card receivables have 3 types of balances Balance transfers that have a 0% APR Promotional purchases that have a 5% APR Normal purchases that have a15% APR Borrower facts Borrower has balances related to each of the 3 balance types ($200, $500 and $500, respectively) Entity A expects Borrower to have draws of $200 and $400 in T1 and T2 27

28 Life of a credit card TRG discussion June 2017 Issue #5 28

29 Subsequent events Background ASU modified certain subsequent event guidance, making it unclear whether an entity should consider any information received after the balance sheet date when estimating its ACL The SEC staff communicated views on 3 fact patterns Servicer report Scenario: Entity receives a servicer report in January that relates to December loan activity. The report has a material effect on the loan balances. SEC staff view: object to not considering Appraisal Scenario: Entity orders an appraisal on collateral for certain impaired loans as of December 31. Entity receives appraisal in January, and it indicates a material change in the fair value of collateral. SEC staff view: object to not considering Updated unemployment data Scenario: Entity considers unemployment to be a key metric for estimating ECLs. Entity uses unemployment data through November to make its reasonable and supportable forecast. In January, Entity receives December unemployment data. SEC staff view: would not object to considering or not considering 29

30 Capitalized interest TRG discussion June 2017 Issue #8 Background An estimate of the ACL using a non-dcf approach must meet two criteria: The ACL should reflect expected credit losses of the amortized cost basis as of the reporting date A discount expected to be accreted into income should not offset the entity's expected credit losses Question Must an entity estimate the timing of expected credit losses to determine the amount of the discount expected to be accreted into income? May the amount of the ACL change over time as the amortized cost changes? TRG Views Estimating timing of losses for non-dcf approaches is not required ACL may change as amortized cost changes There is a difference between an unamortized discount and unearned interest that is expected to be earned and capitalized 30

31 Capitalized interest TRG discussion June 2017 Issue #8 Example Lender advances $60 to borrower Borrower agrees to repay lender $100 in 3 years Lender estimates it will receive only $90 at the end of 3 years Day one estimate of ACL via non-dcf method Inappropriate to conclude that there is zero credit loss b/c $90 expected is > $60 amortized cost says a discount should not offset the ACL if an entity expects to accrete the discount into income Example of appropriate loss rate method (other non-dcf methods may also be used) Loss rate of 10% ($10 loss out of $100 amortized cost basis at end of 3 years) Multiply amortized cost basis at each reporting date by loss rate Initial ACL: $6 ($60 x 10%) will grow to $10 over remaining 3 years as amortized cost basis increases for capitalized interest 31

32 Accrued interest TRG discussion June 2017 Issue #9 Background The definition of amortized cost in ASC 326 includes accrued interest Today there is mixed practice regarding treatment of accrued interest, particularly between entities that do/do not apply nonaccrual policies Question Must the ACL include an estimate of uncollectible accrued interest, or may entities that apply nonaccrual policies that reverse uncollectible accrued interest through interest income continue to follow those policies? TRG Views Agreed with FASB staff recommendation for a practical expedient to separately present accrued interest and have a separate ACL ACL/reversal against interest should be parallel NOTE: FASB will consider whether amendments are necessary, including providing the discussed "practical expedient" 32

33 Applying CECL to Trading BI's TRG discussion November 2018 Background Certain beneficial interests (BI's) are in the scope of ASC may be classified as trading That subtopic does not provide detailed guidance on the subsequent measurement of accretable yield for BI's classified as trading and measured at fair value through net income Question Stakeholders questioned whether entities should measure an ACL on BI's classified as trading TRG Views The TRG generally agreed with the FASB staff that entities do not need to measure an ACL on BI's classified as trading The TRG also acknowledged that entities may recognize different amounts of accretable yield in a given period based purely on how the BI is classified under ASC 320 (held-to-maturity, available-for-sale, or trading) NOTE: The FASB acknowledged that GAAP does not provide detailed guidance on the recognition of interest income on financial instruments measured at fair value through net income. However, questions on that topic are beyond the remit of the TRG. 33

34 Partial Discounting TRG Discussion November 2018 Background Some entities indicated that they utilize methods that discount certain inputs, but not all inputs, when estimating losses These methods are commonly imposed by regulators for financial institutions for purposes assessing capital adequacy Question Are such methods consistent with CECL? TRG Views The FASB staff indicated that if an entity wanted to incorporate discounting into its estimate of the ACL, then it should discount all inputs in its estimate. The TRG generally agreed with the FASB staff NOTE: While loss estimation methods imposed by regulators to in the context of stress-testing or capital adequacy assessments (such as DFAST or CCAR) may be a starting point for building a CECL estimation method, banking regulators have stated that there are important differences between CECL and DFAST/CCAR and they expect CECL models to be compliant with ASC

35 Disposition of leased assets FASB TI Background Lessor's net investment in leases is in-scope of CECL (ASC 842) Upon return of a leased asset, lessor may have gain/loss on disposition of the previously leased asset. Question Should ACL estimate include gains/losses on subsequent disposition? TRG views Yes lessor should include future expected gains/losses on disposition when estimating ACL NOTE: Entity must support with sound documentation 35

36 Any final questions? 36

37 Presenters Rachel Binder Senior Manager NPSG Dallas, TX Rahul Gupta Partner Accounting Principles Chicago, IL Graham Dyer Partner Accounting Principles Chicago, IL

38 Disclaimer This Grant Thornton LLP presentation is not a comprehensive analysis of the subject matters covered and may include proposed guidance that is subject to change before it is issued in final form. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this presentation. The views and interpretations expressed in the presentation are those of the presenters and the presentation is not intended to provide accounting or other advice or guidance with respect to the matters covered. For additional information on matters covered in this presentation, contact your Grant Thornton LLP adviser.

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