Defining Issues. FASB Redeliberates Impairment of Debt Securities and Measurement of Credit Losses. August 2014, No

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1 Defining Issues August 2014, No FASB Redeliberates Impairment of Debt Securities and Measurement of Credit Losses At its August 13 meeting, the FASB continued redeliberations on its proposed standard on financial instrument impairment (proposed ASU) and discussed (1) whether the lifetime expected credit loss model would apply to debt securities and (2) the measurement of expected credit losses for financial assets. 1 Contents Impairment of Debt Securities... 2 Measurement of Expected Credit Losses... 3 KPMG Publications on Past Redeliberations... 5 Key Facts Debt securities classified as available-for-sale (AFS) would continue to apply an other-than-temporary impairment (OTTI) model and therefore would be excluded from the scope of the expected credit loss model. Targeted amendments to the current OTTI model would be made to address concerns about the timely recognition of credit losses for debt securities classified as AFS. 2 An entity would not be required to probability-weight multiple outcomes to measure expected credit losses for financial assets. An entity would evaluate expected credit losses for financial assets with similar risk characteristics on a collective (pool) basis. If the financial asset does not share similar risk characteristics with other financial assets of the entity, expected credit losses would be evaluated on an individual basis. Collateral-based practical expedients may be used when measuring expected credit losses for certain financial assets. For periods beyond which an entity is able to make or obtain reasonable or supportable forecasts, an entity may revert to historical loss experience over (a) the financial asset s estimated life on a straight-line basis or (b) a period and in a pattern that reflects the entity s assumptions about expected credit losses. 1 FASB Proposed Accounting Standards Update, Financial Instruments Credit Losses, December 20, 2012, available at 2 FASB ASC Topic 320, Investments Debt and Equity Securities, available at network of independent member firms affiliated with KPMG International Cooperative, All

2 Impairment of Debt Securities Debt securities classified as AFS will continue to apply an OTTI model and therefore would be excluded from the scope of the expected credit loss model. However, the FASB tentatively decided to make the following targeted amendments to the current OTTI model: The impairment amount would be recognized through the use of an allowance account that would allow reversals of previously recognized credit losses. Under current U.S. GAAP, credit losses on debt securities are recognized in earnings through an adjustment to the amortized cost basis, which is not adjusted for subsequent improvements. When evaluating whether a credit loss exists, an entity would not consider the length of time the fair value has been less than amortized cost. Debt securities classified as held-to-maturity (HTM) would apply the expected credit loss model. Background and Observations. The FASB previously decided that a lifetime expected credit loss model would apply to debt securities classified as either HTM or AFS. For debt securities classified as AFS, if the fair value was less than amortized cost, lifetime expected credit losses recognized in net income would have been limited to the difference between fair value and amortized cost. 3 In June, the FASB held informal workshops with preparers, auditors, and regulators to obtain feedback on the operability and cost-benefit of the expected credit loss model, including the tentative decisions on debt securities. Some participants noted that for debt securities classified as AFS, credit losses are only recognized when fair value is less than amortized cost and therefore an entity may be required to recognize lifetime expected credit losses due to fair value declines even if they are solely attributable to changes in the interest rate environment. Additionally, some participants observed that any perceived issues with timely recognition of credit losses on debt securities had been sufficiently addressed through FASB standards. 4 Determining credit impairment using the OTTI model for securities classified as AFS and using the expected credit loss model for securities classified as HTM could result in significant differences in the timing and amounts of credit impairments for similar securities depending on their classification. The targeted amendments to OTTI may result in earlier impairment recognition than the current OTTI model because an entity would not consider the length of time the fair value has been less than the amortized cost basis. 3 March 12, 2014, FASB Board meeting. 4 FASB Staff Position No and FAS 124-2, Recognition and Presentation of Other-Than- Temporary Impairments, available at 2 network of independent member firms affiliated with KPMG International Cooperative, All

3 Measurement of Expected Credit Losses An entity would not be required to reflect probability-weighted multiple outcomes to measure expected credit losses. Instead, an entity would be required to evaluate expected credit losses for financial assets with similar risk characteristics on a collective (pool) basis. An entity would remove a financial asset from a pool if its risk characteristics are no longer similar to the other financial assets in the pool. After the asset is removed from the pool, the expected credit losses for the pool would be evaluated and adjusted, if necessary. If the financial asset does not share similar risk characteristics with other financial assets of the entity, expected credit losses would be evaluated on an individual asset basis. Background and Observations. The proposed ASU did not require an entity to evaluate financial assets with similar risk characteristics on a collective (pool) basis. 5 The FASB decided to require collective assessment for assets with similar risk characteristics in lieu of requiring entities to measure impairment based on probability-weighting multiple outcomes. The expectation is that when assets are assessed collectively, entities would generally factor in multiple outcomes for the assets in the pool. The collective assessment would be expected to produce similar results as probability-weighting multiple outcomes at the individual asset level. An entity would be required to evaluate the expected credit losses on financial assets with similar risk characteristics collectively, even if it manages and evaluates the financial assets individually. This requirement would apply to both loans and HTM debt securities. As a result of eliminating the requirement to measure impairment amounts by probability-weighting multiple outcomes, more instances may occur where no impairment is recognized for individually assessed financial assets. For example, an entity might conclude that no impairment should be recognized for an individual financial asset because its best estimate is that it will collect the contractual cash flows for that specific asset. However, it is also likely that fewer financial assets will be assessed for impairment individually because many financial assets will meet the criteria for collective assessment. Given the potential for different impairment amounts to be recognized according to whether an asset is assessed individually or collectively, entities would need to develop processes and internal controls to ensure that the criteria for collective assessment are applied appropriately. 5 Similar risk characteristics may include internal or external (third-party) credit score or credit ratings, risk ratings or classification, financial asset type, collateral type, size, interest rate, term, geographic location, or industry of the borrower. 3 network of independent member firms affiliated with KPMG International Cooperative, All

4 Collateral-Based Practical Expedient Collateral values may be used as a practical expedient when measuring expected credit losses for collateral-dependent financial assets (such as impaired loans) and financial assets in which the borrower must continually adjust the collateral amount (such as reverse repurchase agreements). When the practical expedient is applied, the allowance for expected credit losses would be measured as the difference between the collateral s fair value (adjusted for selling costs when applicable) and the amortized cost basis of the financial asset. Background and Observations. The FASB decided to clarify when and how an entity would use collateral value as a practical expedient to address questions raised by stakeholders about whether the practical expedient would apply only to certain financial assets or all lending arrangements with a collateral requirement. The FASB decided that use of the practical expedient would be limited to collateral-dependent financial assets and financial assets in which the borrower must continually adjust the collateral amount (such as reverse repurchase agreements). The proposed ASU defines collateral-dependent financial assets as financial assets for which repayment is expected to be made primarily or substantially through the operation (by the lender) or sale of the collateral. Historical Loss Experience For periods beyond which an entity is able to make or obtain reasonable or supportable forecasts, an entity may revert to historical loss experience over (a) the financial asset s estimated life on a straight-line basis or (b) a period and in a pattern that reflects the entity s assumptions about expected credit losses over that period. An entity would be required to disclose the reversion method in the notes to the financial statements. Changes in the reversion method would not represent an accounting policy change. Background and Observations. The FASB previously decided an entity would update historical loss experience for current conditions and reasonable and supportable forecasts. For periods beyond those that could be reasonably forecasted, an entity would revert to unadjusted historical loss experience. 6 To clarify the prior decision, the Board tentatively decided that an entity may revert to historical loss experience over (a) the financial asset s estimated life on a straight-line basis or (b) a period and in a pattern that reflects the entity s assumptions about expected credit losses over that period. The Board indicated if an entity cannot determine a period and pattern that reflects its assumptions about expected credit losses over that period, the entity would revert to historical average loss experience over the asset s remaining estimated life on a straight-line basis. If an entity reverts to historical average loss experience over the asset s remaining estimated life on a straight-line basis, and the entity s estimate of losses at the end of the period that could be reasonably forecasted was either above or below that historical experience, then the estimate of losses for the asset s remaining life would continue to reflect levels either above or below the entity s historical experience. 6 September 17, 2013, FASB Board meeting. 4 network of independent member firms affiliated with KPMG International Cooperative, All

5 KPMG Publications on Past Redeliberations Information about the FASB s previous tentative decisions on the proposed ASU can be found in the following Defining Issues. Financial Instruments: Changes to Financial Asset Impairment, Classification and Measurement (14-28) Financial Instruments: Changes to Financial Asset Impairment, Classification and Measurement (14-14) Redeliberations Continue on Impairment of Financial Instruments (14-12) IFRS Convergence Not Probable on Impairment and Classification and Measurement of Financial Instruments (13-56) Redeliberations Begin on Impairment, Classification and Measurement of Financial Instruments (13-43) Additionally, more detailed information is presented in Issues In-Depth No. 13-1, Applying the FASB Proposed Model on Financial Asset Credit Losses. Contact us: This is a publication of KPMG s Department of Professional Practice Contributing authors: Mark Northan and Danielle Imperiale Earlier editions are available at: Legal The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the proposed standard or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues is a registered trademark of KPMG LLP. 5 network of independent member firms affiliated with KPMG International Cooperative, All