One of the most pressing topics for investment accounting is the implementation of ASU 2016-13, Financial Instruments — Credit Losses. This update, one of the biggest changes to accounting for financial assets in decades, revises how organizations identify and report on credit losses.
Large financial institutions have spent years preparing and implementing solutions to these changes because the update affects their primary business models. Other organizations are just starting the process of understanding the changes in guidance, how this may impact them, and what their organization will need to be compliant.
This article is intended to help organizations perform that assessment and understand how their investment accounting processes via Clearwater might change under the revised guidance. For details on the guidance changes, please see our upcoming Preparing for CECL eGuide.
The first step is to understand when your organization will be required to adopt ASU 2016-13. At issue and as revised in ASU 2018-19, there were three different tiers of adoption:
Guidance Effective for Fiscal Years Beginning After:
Public Business Entities that are SEC filers
12/15/2019 (i.e. 2020 for calendar year companies)
Public Business Entities that are not SEC filers
12/15/2020 (i.e. 2021 for calendar year companies)
Nonpublic Business Entities
12/15/2021 (i.e. 2022 for calendar year companies)
At the time of this writing, FASB voted in favor of adjusting the adoption dates for some companies. The revised effective dates fall into only two tiers of adoption:
Guidance Effective for Fiscal Years Beginning After:
Public Business Entities that are SEC filers and do not qualify as a Smaller Reporting Company
12/15/2019 (i.e. 2020 for calendar year companies)
All other companies
12/15/2022 (i.e. 2023 for calendar year companies)
The types of assets your organization holds will determine how much of an impact this guidance update may have.
Available for Sale Holdings
For many Clearwater clients, the only relevant assets that are impacted by ASU 2016-13 are holdings in debt securities, and many clients consider their entire investment portfolio to be available-for-sale (AFS). For organizations that have mostly or all AFS assets, there are minimal guidance changes.
For AFS assets, organizations will likely be able to continue a very similar initial analysis to what they have been doing.
- The impairment assessment is still limited to securities at an unrealized loss
- The processes of identifying securities where there is either an intent to sell, or it is more-likely-than-not that the security will need to be sold, can continue
- The impairment process for the above situations does not change
Further qualitative assessment can continue for lots that are at an unrealized loss and do not need either of the above impairments to be recognized. Many organizations refer to this qualitative assessment as an impairment policy. While this process remains, the updated guidance no longer allows the length of an unrealized loss to be a limiting consideration. For example, if an organization’s policy dictated that they would not perform further assessment of a credit loss on lots that have been at an unrealized loss position consecutively for less than 6 months, this feature of the qualitative assessment would no longer be allowed.
In preparation for adoption, organizations should determine what impact the elimination of the length of impairment as a relevant criterion will have to their analysis. If the impact is significant, they should consider what modifications they might need to limit the calculations to lots that reasonably could have potential credit losses. For most organizations, that might involve revising the impairment policy to scope out issuers they can assert have no potential for a credit loss, such as securities backed by the US government. For organizations whose investment policies limit them to securities that carry little risk of credit losses, they should identify what types of criteria best support a reasonable assertion that a credit loss does not exist.
As organizations review and revise their policies, they should work closely with their auditors to ensure both parties are comfortable with the new processes and policies.
For securities that require an assessment for credit loss, organizations can again maintain a similar calculation for that credit loss; namely, it is the difference between amortized cost and the present value of future expected cash flows. As an organization reviews their process for credit loss assessment, it might be an opportune time to validate that the cash flows used for the present value calculation are reflective of the organization’s best estimate of future cash flows based on expectations of future economic conditions.
After an organization has validated that they have a process to identify credit losses, one new consideration is the limitation of the allowance to the difference between amortized cost and the fair value of the security, sometimes referred to as the fair value floor.
Assets Held at Amortized Cost
Assets held at amortized cost, including held-to-maturity (HTM) securities, have a different set of credit loss guidelines, often referred to as the Current Expected Credit Loss (CECL) model.
If an organization holds some AFS securities and HTM securities, it is important to note that while these required the same impairment process in the past, these two categories will follow slightly different guidelines once the new guidance in implemented.
One of the first important practical implications of the CECL model is that there is no threshold for credit loss evaluation. If an organization has assets they believe should never be assessed for a credit loss, it will be critical to discuss those assertions with their auditors to make sure they agree.
Another consideration is whether they have assets that share similar risk characteristics. Unlike previous guidance for HTM securities, the CECL model requires pooling of assets that share similar risk characteristics.
The consideration that is appropriately getting the most attention is identifying how organizations will calculate the allowance value that is now needed. Organizations should keep the following in mind as they consider how the allowance will be calculated, or determine where they will source the calculation.
What model to use: The CECL approach allows management to use whatever model they believe enables them to arrive at an allowance amount that best matches their expectations of future economic conditions. If an organization has future expected cash flows available that reflect their reasonable and supportable forecasts of the future, they can use those in a similar way to the process for AFS securities. If an organization has another model that better fits their needs and capabilities, they should be able to use it as long as it provides that reasonable and supportable forecast.
Considerations for an external source: Many organizations may find they lack the expertise and data required for the credit loss allowance calculation, and therefore may look for third parties who have historically had the data and modeling experience to leverage into the new allowance calculation. Some things to consider as they evaluate the potential solutions:
- Does the solution support the types of assumptions you expect to make about future economic conditions?
- Does the solution provide support for deeper inquiries into how your assumptions affected the models and resulting calculated values?
- Does the service provider cover all the types of investments you hold or for which you may need the allowance calculated?
Data Flow Process: While working with third parties, it is important to understand the underlying data flow they use.
- What data does your allowance source need you to provide?
- How will that data be delivered to the source?
- What type of data does the source output?
- What is the formatting of the output?
- How will the allowance data flow back into your investment accounting engine?
Purchased Credit Deteriorated Assets
If your investment strategy includes purchasing securities with known credit deterioration (PCD assets), identifying updates to processes regarding these securities will also be relevant.
The first process to consider is the identification of which PCD assets have been acquired. With the overlap with securities purchased with credit impairment (PCI), there may already be processes in place which can be adjusted to meet the new requirements. An organization that has the potential of buying these types of assets should make sure they have a solid process for identify them going forward.
Once PCD assets have been identified, the guidance updates will now require identification of the amount of credit loss allowance to use on the initial recognition of the asset. If these types of assets are purchased, it will also be important to have a process for quickly assessing the amount of the allowance. This process, as well as the identification, may be something an organization can leverage the external investment manager acquiring these assets to help them with.
The final consideration for PCD assets would be connecting these pieces of information to their accounting and reporting processes. For clients of Clearwater, we anticipate receiving these data points from our clients, but we are interested in your thoughts and expectations on how best to pass this information back to us.
Changes to General Ledger Chart of Accounts
After identifying your organization’s potential accounting changes, you should determine how these entries should fit into your existing chart of accounts or if new ledger accounts might be needed. This evaluation should consider how details in the ledger might be utilized for various reporting functions versus subledger reporting function.
If your current chart of accounts splits the unrealized gain/loss from the historic-based asset value, you may want to consider whether the allowance for losses should have its own ledger account or if it should be wrapped into one of the existing asset balances.
A similar consideration should be made for the loss/expense side of the new credit loss entry. You may find it acceptable to use an existing loss or expense balance to record these entries, or you may determine that a new ledger account might better suit your needs.
If new ledger accounts are needed, the process of having these created should be started soon enough to have them available by the beginning of the fiscal year if there are any entries needed at adoption.
In addition to (potentially) creating new ledger accounts, attention should be given to any reconciliation processes that may need to be adjusted. This could involve validating how accounting data will be represented in the subledger and how that will correlate to the chart of accounts you have decided upon.
In addition to updates in process for the accounting changes, it is also important to identify how to change the disclosures to be consistent with the guidance update. Clearwater will soon release new reports to help automate these disclosures for our clients.
Tabular Disclosure of Securities at an Unrealized Loss
A modified version of the current tabular disclosure of securities at an unrealized loss will still be required. This disclosure is now specific to AFS securities, whereas historically it applied to all securities. Additionally, it should only include debt securities at an unrealized loss for which an allowance has not been recognized.
Credit Loss Roll Forward
New disclosures are required to help financial statement users reconcile the change in allowance for credit losses over the course of the reporting period. This should involve reporting the beginning allowance amount, a set of the types of changes that could occur throughout the period, and the ending balance. This type of disclosure is required for both AFS assets and assets held at amortized cost, with slightly different types of changes.
There are also new disclosures to show the reconciliation of the acquired value of PCD assets, the initial allowance recognized on the acquisition, and the resulting non-credit discounts. These should also be disclosed for both AFS assets and assets held at amortized cost.
For more information about CECL and how Clearwater has prepared, see Clearwater’s upcoming Preparing for CECL eGuide.