Accounting Standard Updates

ASU 2016-13 – Accounting for the Impairment of Available-for-Sale Debt Securities

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Available-for-sale (AFS) debt securities are not within the scope of the current expected credit loss (CECL) model. However, ASU 2016-13 also introduced a modified impairment model for AFS debt securities. It differs from the previous other-than-temporary impairment (OTTI) model by disregarding the duration in which the fair value remains below its amortized cost basis when assessing potential credit losses. OTTI is now irrelevant under Topic 326. While the NAIC rejected ASU 2016-13, publicly traded insurance companies, holding companies, and agencies that prepare GAAP financial statements must understand the implementation of the revised impairment model if they have AFS debt securities.

This article discusses the application of the AFS debt securities impairment model and includes sample financial statement disclosures.

Measurement. Unlike the CECL model, credit impairment for AFS debt securities must be performed at the individual security level, prohibiting pooling. However, the impairment concept remains consistent: if fair value is below amortized cost, the asset could be impaired. Topic 326 differentiates between credit-related and non-credit impairments to allow earlier recognition of credit impairment through an allowance account (contra-asset) and corresponding charge to earnings. This allowance (contra-account) may fluctuate over time like the CECL model. Non-credit impairments are recorded through other comprehensive income (OCI).

If an entity plans to sell, or if it is probable that it will need to sell the AFS debt securities before recovering the amortized cost basis, any impairment is recognized in earnings for the difference between fair value and amortized cost. In cases of non-credit-related impairment, the entity will recognize the fluctuation, as usual, through OCI.

Application. To determine credit and non-credit related impairments on AFS debt securities, the present value of the expected cash flows should be compared to the amortized cost basis. Suppose the present value of the expected cash flow is less than the amortized cost. In that case, a credit-related impairment exists, and the difference should be recorded as an allowance for credit losses through earnings, limited to the difference between the fair value and amortized costs. If the present value of expected cash flow is greater than the amortized cost, a non-credit-related impairment exists, and the decline in fair value would be recorded in OCI.

Discounted Cash Flow Method. Topic 326 requires the use of a discounted cash flow method to measure credit impairments. The financial asset’s effective interest rate at the date of acquisition should be used to discount expected cash flows.

The flow chart below illustrates the impairment model.

JLKR Insight

Insurance entities tend to invest in high credit quality securities, typically those backed by the US government or its agencies, along with loans or securities that are sufficiently collateralized. For these reasons, most insurance entities will proclaim that the possibility of experiencing credit losses is remote.

Insurance entities also employ investment managers, who often hold the authority to make decisions regarding the sale of securities. A discussion with the investment manager about the intent or likelihood of selling securities in unrealized loss positions will be crucial if investment credit quality is in question. Given that pooling of assets are not allowed and impairment assessment must be conducted at the individual security level, it will also be imperative to discuss with the investment management team regarding their capabilities of calculating credit-related impairments. This calculation will not be a simple undertaking and may require technology to facilitate the process of estimating and discounting expected cash flows.

Accrued Interest. Accrued interest income on AFS debt securities is subject to CECL in accordance with ASU 2016-13. However, entities are allowed to make an accounting policy election to exclude accrued interest receivable from the measurement of the allowance for credit losses, provided that the uncollectible accrued interest balance is written off in a timely manner. If the election to exclude is made, accrued interest must be presented as a separate line item on the balance sheet and the policy disclosed in the notes.

Transition. The update should be applied using a modified retrospective transition approach that would require a cumulative effect adjustment to the opening retained earnings as of the date of adoption.

Disclosures. The standard required entities to provide disclosures enabling financial statement users to understand how management monitors the credit of its financial assets. These disclosures should also assess the quantitative and qualitative risks arising from the credit quality of the financial assets.

The following disclosures assume there were no credit-related losses as the entity holds highly-rated securities. This will likely be the case for most insurance holding companies or agencies.

Related topics:

ASU 2016-13 – Financial Instruments-Credit Losses: An Overview
ASU 2016-13 – Financial Instruments-Credit Losses: Accounting for Premium Receivable
ASU 2016-13 – Financial Instruments-Credit Losses: Accounting for Reinsurance Recoverable