FASB ASC 310-30 for Purchased Credit-Impaired Loans
ASC 310-30 provides a unique accounting lifecycle for purchased credit-impaired loans, from initial valuation based on cash flow estimates to ongoing income recognition.
The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) 326, Financial Instruments—Credit Losses, provides guidance for a specific class of assets: purchased loans and debt instruments showing signs of credit deterioration. This standard, which introduced the Current Expected Credit Losses (CECL) model, dictates how to measure these assets upon acquisition and recognize income over their lifespan. This accounting differs significantly from that for healthy, originated loans.
Scope and Identification of Applicable Assets
The guidance in ASC 326 applies to loans and debt securities acquired through a transfer. An asset falls under this scope if it shows evidence of credit deterioration since origination, making it probable the purchaser will not collect all contractually required payments. This judgment is made at the time of purchase, and assets meeting these criteria are known as purchased with credit deterioration (PCD) assets.
Indicators of credit quality deterioration include a borrower’s history of significant payment delinquency, the loan having been on nonaccrual status, or a downgrade in the borrower’s credit score since origination. Other factors, such as updated loan-to-value ratios or adverse changes in the borrower’s financial condition, are also considered.
For operational efficiency, an entity can assemble individual loans with similar risk characteristics acquired in the same quarter into a pool, which is then treated as a single asset. This approach is used for homogenous loans like residential mortgages or consumer auto loans, while larger commercial loans are accounted for individually.
Initial Measurement and Recognition
The initial accounting for a PCD asset uses a “gross-up” approach. At acquisition, an entity establishes an initial allowance for credit losses (ACL). The initial amortized cost basis is the purchase price plus this initial ACL, which ensures a loss is not recognized on the income statement at purchase.
For example, an investor pays $70,000 for a loan with a $100,000 contractual balance. The investor estimates $15,000 of this amount is uncollectible, establishing this as the initial allowance for credit losses (ACL). Following the gross-up approach, the initial amortized cost basis is the $70,000 purchase price plus the $15,000 ACL, for a total of $85,000.
The $15,000 difference between the loan’s contractual balance ($100,000) and its amortized cost basis ($85,000) is a non-credit discount. This discount is not related to credit risk and is recognized as interest income over the life of the loan.
Subsequent Accounting and Interest Income Recognition
After acquisition, interest income is recognized over the life of the loan based on its amortized cost basis. An effective interest rate, determined at acquisition, is applied to the amortized cost basis each period to calculate interest income. This rate equates the present value of expected future cash flows with the asset’s purchase price.
When the borrower makes payments, the cash received is allocated to accrued interest and the loan’s principal. This reduces the loan’s amortized cost basis over time until the loan is paid off, sold, or otherwise resolved.
Accounting for Changes in Cash Flow Estimates
An investor’s estimates of a PCD asset’s future cash flows may change over its life based on new information. Under ASC 326, subsequent changes in expected cash flows, both increases and decreases, are recorded immediately on the income statement.
If an investor revises the estimate of future cash flows downward due to further credit deterioration, a provision for credit losses is recognized as an expense. This entry increases the allowance for credit losses on the balance sheet.
Conversely, if an investor determines that expected future cash flows will be higher than previously estimated, the entity records a reversal of the provision for credit losses. This results in a gain on the income statement and reduces the allowance for credit losses. The effective interest rate calculated at acquisition is not adjusted for these subsequent changes in cash flow estimates.
Financial Statement Disclosure Requirements
ASC 326 mandates several specific disclosures to provide transparency into an entity’s portfolio of PCD assets and the related accounting judgments.
A required disclosure is a reconciliation of the allowance for credit losses. This schedule must show the beginning balance, additions for current-period credit loss provisions, write-offs of uncollectible amounts, and the ending balance. For PCD assets, the reconciliation must also show the initial allowance recognized on assets purchased during the period.
Entities are required to describe the accounting policies and methodologies used to estimate their allowance for credit losses. This includes discussing the assumptions and data used in projection models, such as default rates, loss severities, and prepayment speeds. For loans accounted for in pools, information about the composition and risk characteristics of those pools is also necessary.