Clarification Issued on Financial Instrument Use in CECL

Coming on the heels of stakeholder’s concerns, the Financial Accounting Standards Board (FASB) discussed feedback received from the Credit Losses Transition Group, which proposed making a number of amendments to guidance related to credit losses, derivatives and hedging, and the recognition and measurement of financial assets and liabilities.

As you consider the application of CECL to your loans and investments, consider these factors that are out for public comment until Dec. 19, 2018:

Topic 326 – Financial Instruments – Credit Losses:

• Accrued interest – Currently Topic 326 requires accrued interest to be tied to the instrument it pertains to. However, the proposed amendment to the standard would permit the separation of the accrued interest from the related asset for the following purposes:
  • Measuring the allowance for loan losses
  • Presentation on the balance sheet separate from the instrument
  • Disclosure
  • The accrued interest would be written off separate from the asset by either charging it to interest income or to the allowance for loan losses

• Recoveries – Recoveries would be included when determining loss history for estimating the allowance for credit losses.

• Collateral dependent loans – A loan will not be able to be written up past its loan balance in situations where the collateral value may exceed the loan balance. However, the clarification provides that a recovery can be recognized on a previously written down loan up to the amount of the previous write down in the event of increases in the collateral value.

• Vintage disclosures – Financial institutions will be required to present the amortized cost basis of lines of credit converted to term loans within the credit quality indicators in the year the loan was originated or the latest credit decision-making period (i.e., if a credit decision was made at the time of conversion to a term loan, then the loan would be placed in the year of conversion for the vintage analysis). If no credit decision is made at the time of conversion, then a separate category must be created for these loans based on vintage.

• Contractual extensions and renewals – Financial institutions will be required to consider extensions or renewal options included in the original or modified contract at the reporting date not unconditionally cancellable by the entity.

• Projections of interest rate environment for variable-rate financial instruments – If your financial institution chooses to use the discounted cash-flow method to determine expected credit losses on a variable-rate instrument, you will have some flexibility in forecasting rate movements.

• Consideration of prepayments in determining the effective interest rate – Expected prepayments are required to be considered in estimating expected cash flows. Financial institutions will be permitted to make an accounting policy election to adjust the effective interest rate used to discount expected future cash flows based on expected prepayments on financial assets to isolate the credit risk. However, a financial institution should not adjust the effective interest rate for subsequent changes in expected prepayments if the financial asset is restructured in a troubled-debt restructuring.

• Costs to sell when foreclosure is probable – Costs to sell would be considered when valuing a financial asset when foreclosure is probable.

Topic 815 – Derivatives and Hedging:

• Partial-term fair value hedges of interest-rate risk – One or more separately designated partial-term fair value hedging relationships of a single financial instrument can be outstanding at the same time.

• Amortization of fair value hedge-basis adjustments – Financial institutions may, but are not required to, begin to amortize a fair value hedge basis adjustment before the fair value hedging relationship is discontinued. Additionally, the basis adjustment should be fully amortized on or before the hedged item’s maturity date.
• Hedging transition guidance – Transition adjustments to amend the measurement methodology of a hedged item in a fair value hedge of interest-rate risk will be made as of the date of initial application of Update 2017-12, which could differ from the date of adoption if an entity adopts as of an interim period. Additional hedging options provided include the following:
  • Rebalancing fair value hedging relationships of interest-rate risk when it modifies the measurement methodology used for the hedged item from total contractual coupon cash flows to the benchmark rate component of the contractual coupon cash flows by any combination of increasing or decreasing the designated notional of the hedging instrument or changing the designated portion of the hedged item. However, the addition of new hedged items or instruments is not permitted.
  • Transitioning from a quantitative method to a method comparing the hedging relationships critical terms for effectiveness assessment, if specific guidance is met.
  • Transferring a debt security from held-to-maturity (HTM to available-for-sale (AFS) would not question the assertion to hold the remaining securities in the HTM portfolio to maturity.

Topic 825 – Recognition and Measurement of Financial Assets and Financial Liabilities:

• HTM debt securities fair value disclosures – Fair value disclosures for HTM securities would no longer be required for non-public entities.
• Transfers of loans or debt securities between classifications – When loans or debt securities are transferred between categories, such as AFS to HTM, or loans from portfolio loans to held-for-sale, financial institutions will be required to reverse any allowance for credit losses or valuation allowance on the loan or debt security. The loan or debt security would then be transferred to the new classification and the financial institution would apply the accounting guidance based on the new classification.
• Measurement alternatives for equity securities – Revaluation of an equity security that is being accounted for using a level-three technique is required because no readily determinable fair value is available. When an orderly transaction is identified, a level-one or level-two technique would be used.

If approved, these clarifications would go into effect for non-public business entities on the same dates as the applicable standard.

For more information on how these factors may impact your CECL model and its application, contact Doeren Mayhew’s financial institutions advisors.