AFS Investment Portfolio Considerations as Your Bank Prepares for CECL

With the upcoming adoption of the Financial Accounting Standards Board's (FASB) credit impairment standard (ASU 2016-13 or Topic 326) dealing with current expected credit losses (CECL), there has been significant discussion about the allowance for the loan portfolio. For many financial institutions, this is where they will see the most significant impact; however, Topic 326 is not only a standard to estimate an allowance for loans.

Subtopic 326-30 provides a credit loss model for available-for-sale (AFS) debt securities in a bank's investment portfolio, replacing the legacy U.S. GAAP other than temporary impairment (OTTI) model. The new model retains the requirement to evaluate impairment of AFS securities at an individual asset level. The differences under 326-30 include but are not limited to:

• Credit losses recognized in net income through an allowance account, permitting reversals of previously recognized losses (also through the income statement);
• Concept of a fair value floor, which limits credit losses to the difference between the asset's cost basis and fair value; and,
• Modifications to the evaluation factors to determine whether a credit loss exists (e.g., there will no longer be consideration of the length of time the security's fair value was less than the amortized cost).

ASC 326-30-35-1&2 state that "an investment is impaired if the fair value of the investment is less than its amortized cost. For individual debt securities classified as available-for-sale securities, an entity shall determine whether a decline in fair value below the amortized cost basis has resulted from a credit loss or other factors. An entity shall record impairment relating to credit losses through an allowance for credit losses. However, the allowance shall be limited by the amount that the fair value is less than the amortized cost basis. Impairment that has not been recorded through an allowance for credit losses shall be recorded through other comprehensive income, net of applicable taxes."

ASC 326-30-35-6 is specific to state that when assessing whether a credit loss exists (as opposed to an impairment loss due to other factors such as interest rates), an entity should compare the present value of cash flows (PVCF) expected to be collected from the security with the amortized cost basis of the security. If the expected PVCF to be collected is less than the amortized cost basis, a credit loss exists. Determining whether a credit loss exists includes multiple factors, among those being the extent to which the fair value is less than the amortized cost basis, adverse conditions related to the security such as the industry or geographic area, failure of the issuer of the security to make scheduled interest or principal payments and changes to the rating of the security (ASC 326-30-55-1).

An example follows for XYZ Bancorp with an AFS debt security as of Dec. 31, 20X7. XYZ Bancorp does not intend to sell the security, and it is not more likely than not that it will be required to sell the security before recovering the cost basis.

Based on this example excluding the impact on income taxes for simplicity, Bancorp is recording the impact as of Dec. 31, 20X7.

The security is impaired because the fair value is less than the amortized cost. XYZ Bancorp has evaluated the factors under Topic 326 and concluded that a credit loss exists, and the estimate of future expected cash flows through the maturity date using the discounted cash flow method is $265,000. XYZ Bancorp records the following journal entries.

Alternatively, if the facts remain consistent with the example above, except that the fair value of the debt security as of Dec. 31, 20X7, is $275,000 (versus $250,000), the amount of credit loss recorded is limited by the fair value floor.

In subsequent reporting periods, it could be determined that it is more likely than not that the security will be sold before the cost basis is recovered. Such a conclusion results in the previously recognized allowance for AFS credit loss to be reversed (written-off), and the amortized cost basis is then reduced to the debt security's fair value with any additional impairment to be recorded in the income statement.

In terms of assessing impairment at the individual security level, ASC 326-30-35-4 states that the "individual security level means the level and method of aggregation used by the reporting entity to measure realized and unrealized gains and losses on its debt securities. (For example, debt securities bearing the same Committee on Uniform Security Identification Procedures (CUSIP) number that were purchased in separate trade lots may be aggregated by a reporting entity on an average cost basis if that corresponds to the basis used to measure realized and unrealized gains and losses for the debt securities.) Providing a general allowance for an unidentified impairment in a portfolio of debt securities is not appropriate."

While not discussed within this article, it is important to consider that with the adoption of Topic 326 are new presentation requirements and expanded disclosures for AFS securities and changes to the evaluation of purchased credit deteriorated AFS securities.

As financial institutions prepare for CECL adoption, be sure to address not only the impacts to the loan portfolio but also to the AFS investment portfolio and held to maturity investment portfolios (not discussed within) to avoid surprises.

About DHG Financial Services

DHG Financial Services professionals provide in-depth industry knowledge and a wide range of advisory, assurance and tax services to address issues facing your industry in today's challenging environment. For more information, visit dhg.com/financial-services.