Rhead Hatch, CPA
Product Owner, Accounting
Rhead ensures that Clearwater’s investment accounting module is up-to-date with current compliance requirements and maintains accounting basis guidelines. Rhead helps implement new accounting functions into the Clearwater system and assists developers with outlining new product enhancements.
Rhead has been a part of the Clearwater team since 2006 and has worked directly with many Fortune 500 companies to integrate Clearwater’s accounting product into their processes.
Rhead has a master’s in accounting with a specialty in tax and a bachelor’s in accounting from Boise State University.
The adoption of ASU 2016-13 caused major changes in the investment accounting industry, particularly in the treatment of bank loans. Investment accountants are preparing for several adjustments to their reporting regarding held-to-maturity (HTM) and available-for-sale (AFS) securities.
Our investment accounting experts have received a host of questions regarding how ASU 2016-13 will impact accounting. The following summary can help readers prepare for upcoming CECL changes.
How will treatment of HTM and AFS securities change under the CECL model?
Bank loans and companies that hold loans and receivables are the main investments impacted by impairment changes. The past model relied on an incurred credit loss, which required an event to occur to recognize impairment. This model was not always effective, since the model of using past economic behavior to predict future behavior was not adaptable to changing market conditions. Since banks were already using their own models to predict future cash flows and better prepare for potential impairment losses, the FASB made updates to GAAP accounting.
Updates to GAAP dictate that the expected credit loss model only applies to HTM securities, as opposed to the IFRS 9 model that applies to all AFS or HTM securities. Substantial changes only impact companies that hold HTM securities, such as life insurance companies, as opposed to health or property and casualty.
ASU 2016-13: HELD TO MATURITY SECURITIES
With the adoption of ASU 2016-13, investors must review any credit losses expected over the life of HTM securities, including loans and receivables on banks. Investors must forecast what they expect the credit losses to be for the entire life of the instrument based on historical experience, current conditions, changes to economic conditions expected in the future, and potential influences that may impact the credits. This forecast must be supported by “reasonable and supportable” models that use a forward-looking approach to better inform credit loss estimates.
“Reasonable and Supportable”
The term “reasonable and supportable” provides organizations with flexibility to support their forecasts and continue to use the business models already created before the implementation of ASU 2016-13. Historical loss rates can be difficult to leverage when predicting future economic conditions, but some economic condition predictions may only apply up to seven years. Historical loss rates may be used to supplement periods beyond which a company can make “reasonable and supportable” forecasts. Transitioning between using predictive data sets and historical data sets may be challenging for some investors, and the methodology for doing so has not been clearly establish under this new guidance.
Previously, if a security had a low probability of defaulting, it did not have to be reported. With the adoption of ASU 2016-13, any risk of impairment is recognized to provide more transparency into what losses companies predict. Impairment for HTM securities is now accounted for as an allowance, which means the book value of a security is not changing. The allowance is adjusted, which offsets the asset. If the predicted economic condition becomes more optimistic, the predicted impairment losses recognized in the past can be reversed. This new system is more flexible with changing market conditions and does not affect interest income and amortization accretion since the security’s impairment is based on allowance.
ASU 2016-13: AVAILABLE FOR SALE SECURITIES
AFS securities will continue to use the discounted cash flow model for their credit allowance assessment, testing to determine whether fair value is less than book value. If an AFS security is held to an unrealized gain, no impairment loss is necessary. If the security is held at an unrealized loss, it is evaluated to determine whether the intent is to sell and recorded to current fair value. The ASU reorganized impairment guidance and eliminated the other-than-temporary impairment concept. “Intent to Sell” and “More Likely Than Not will be Required to Sell” are still triggers for impairment recognition and indicate a direct write-down of amortized cost.
If security is AFS and the future expected cash flows are currently less than market value, the FASB recognizes that if the security is sold for more than the estimated future cash flows, market value will at least be recovered. The impairment is limited to unrealized loss, so allowance does not need to be greater than unrealized loss. With an allowance approach, impairment loss can be reversed if the discount of future cash flows become closer to book value.
Purchase Credit Deterioration Assets
This guidance has also changed how purchase credit deterioration (PCD) assets are accounted for. Since PCD assets are purchased with an inherent expectation of credit loss on initial recognition, they have had their own separate set of guidance in the past. This has been cumbersome for reporting. According to the new guidance, book value will be calculated based on predicted return for better representation of the asset, and adjustment is based on the pre-allowance amount. The goal of this forward-thinking approach is simply to treat PCD assets similarly to other securities instead of as an outlier.