Severe economic disruption and a possible recession may result in extreme operational challenges for companies that hold available-for-sale (AFS) debt securities. The economic impact of the COVID-19 crisis comes when companies are implementing the new credit losses accounting standard, which should prompt companies to rethink how to evaluate their AFS debt securities to identify credit impairment.1 Doing so now can help companies ease the burden on operations that may be required due to the stark change in the economic outlook and securities prices.
New rules for identifying credit impairment
Accounting Standard Update (ASU) No. 2016-13—also known as ASC 326 Financial Instruments – Credit Losses, or “ASC 326”— changed the rules for credit loss accounting and reporting for AFS debt securities. AFS debt securities continue to be carried at fair value, with the difference between fair value and amortized cost related to non-credit differences recognized in other comprehensive income. Prior to ASC 326, other-than- temporary impairment from credit losses resulted in a permanent adjustment to the amortized cost of an individual AFS debt security. However, upon the adoption of ASC 326, companies are required to recognize credit losses through a valuation allowance that can be adjusted up or down based on further debt deterioration or improvement in credit quality.
More importantly, in determining which AFS debt securities have experienced credit losses, companies are no longer permitted to consider the length of time the fair value of a security has fallen below amortized cost. Companies also cannot consider changes in fair value after the reporting date or the historical or implied volatility of fair value. The new standard requires entities holding AFS debt securities in a loss position to perform a credit loss analysis in each reporting period during which the entity asserts that it does not intend to sell the security, and that it is more likely than not that the company will not be required to sell the security before recovery of its amortized cost.
ASC 326 continues to allow companies to perform qualitative and/or quantitative assessment “screens” to determine whether credit losses exist when the fair value falls below amortized cost. Companies typically apply screens to identify if the decline in fair value is caused by temporary non-credit related circumstances such as interest or liquidity risk, and thus should be recorded in equity as other comprehensive losses, versus credit losses that would be required to be captured in income. Additionally, and importantly, these screens often ease the operational burden that can result from performing more detailed analyses, including discounted cash flow (DCF) calculations that are required when it cannot be determined that an AFS debt security’s fair value decline is not due to credit changes.
A Call to Action
Prior to the recent market disruption, many companies were planning on targeted changes to their existing AFS credit loss analysis assessments. For example, many companies planned to add a market value to book value ratio analysis against a specific reduction tolerance to determine if a potential credit loss exists. One such test is to consider if fair value has dropped below a given percentage or amortized cost. In this test, as long as the security fair value has not dropped below this threshold of amortized cost and the company can attest that the fair value changes are not credit related, the change can be recoded in equity, and a DCF analysis would not be required.2
However, much has changed since ASC 326 became effective. AFS debt securities that seemed like monetarily safe investments at the beginning of the year are no longer so, due to a dramatic increase in yields. Bond prices have fallen substantially, particularly in directly affected industries such as tourism, airlines, hospitality, commercial real estate, and manufacturing. Credit rating downgrades appear inevitable, absent government assistance. In this environment, in which many securities have fallen below the company’s threshold, using market value reduction compared to amortized cost as a credit screen may no longer be an effective of indicator of temporary non-credit losses. In the absence of other screens, this may result in more burdensome DCF analyses.
We believe it is important for companies to take action immediately to identify the potential operational burden that may come at the end of the first quarter of 2020 (as well as in future downturns) as a result of more AFS debt securities being in a loss position. This means obtaining an understanding of the level of credit risk through a DCF analysis that may be required prior to beginning the quarterly reporting process. This does not necessarily mean abandoning new processes and screens established earlier this year to identify AFS debt securities in a loss position. But it may mean considering if reporting processes and screens could be augmented with additional screening tests to adapt to the current market environment. Ultimately, companies need to act now to determine if using their ASC 326 process to analyze portfolios results in a handful of securities that will require a DCF analysis—or if that number has jumped into the hundreds or thousands as a result of the economic disruption in the first quarter of 2020.
Current Established Screens that May be Affected?
Below are some other industry practices we have seen adopted during implementation of the ASC 326 standard, which would be used to determine whether a credit loss exists. For each, we offer our observations:
- Considering credit rating migration of a security (i.e. has an agency downgraded an investment).
Observation: Credit rating agency downgrades often lag market developments, particularly in turbulent times. This test, therefore, may result in a “false negative” and may be challenged by auditors as not effective in the current environment.
- Including any adverse news about the financial condition of the issuer of the security.
Observation: During turbulent market times, news reports can swiftly change.
- Analyzing cash flows for structured securities to assess whether there’s an expected principal shortfall.
Observation: Government- or regulator-mandated relief programs may complicate efforts to analyze assumptions to apply to generate cash flows.
- Use an industry benchmark yield to compare to the subject security’s implied yield.
Observation: Security yields within industries have changed dramatically across the spectrum. Therefore comparing the implied yield of a subject security to a benchmark may not filter securities as effectively as it would have prior to the market disruption.
Considerations for AFS Credit Loss Processes
The following are some considerations that may be helpful to supplement existing AFS credit-loss processes in this time of economic disruption.
- Start the credit loss identification process for AFS securities now, prior to quarter end.
- Determine the population at the interim analysis date that fails your current screens and consider what other qualitative or quantitative analysis could be utilized to further assess the extent of credit losses.
- For securities where it appears credit losses may exist, determine the volume and assess capability of the current process to further calculate the potential credit losses of debt securities (completing DCF analysis at an individual security level).
- Consider changes to the process and begin to execute in the interim (perform DCF analysis).
- Roll forward the analysis during the quarterly reporting cycle and record credit losses and non-credit losses.
- Begin discussions with auditors about results and any changes in processes.
Another Consideration: Purchases of AFS Debt Securities
ASC 326 also introduced the concept of financial instruments purchased with credit deterioration (PCD). Under ASC 326-30, a purchased debt security classified as AFS shall be considered to be PCD when the indicators of a credit loss exists at the date of purchase. Entities will need to apply new ASC 326 policies regarding identification of PCD debt securities and exercise judgment in determining if additional considerations are necessary in applying these policies as a result of COVID-19. If an AFS security is considered PCD, it is recorded at its purchase price plus a gross-up for an allowance for credit losses. The sum of the purchase price and the allowance for credit losses is the initial amortized cost.
Comparisons with 2008
It may be tempting to draw parallels between current market conditions and the 2008 financial crisis. However, there are important distinctions, such as the nature of the disruption, ability for government intervention, and the relevant accounting standards.
In 2008, the financial crisis began with the deterioration of credit and liquidity in the financial sector, which subsequently spread to other sectors. Today, the price deterioration of debt securities is a result of weakening economic fundamentals across industries, driven by the impact of the the COVID-19 health crisis. This resulting decline in security prices has prompted the Federal Reserve to use a full range of tools to support prices and enhance liquidity of U.S. Treasury and agency securities, high-grade corporate debt, and asset-backed securities.
Second, in 2008, accounting rules did not permit entities to record the non-credit component of AFS debt security impairment through other comprehensive income. Those rules were changed in 2009, and the general principle remains today under the new standard, with the added benefit that future improvement in credit quality will be recognized through reversals of the allowance for credit losses.
The dramatic decline in financial markets since the beginning of the year, and the uncertain magnitude and duration of a possible recession will affect credit loss accounting for AFS debt securities in the first quarter of 2020 and likely beyond. This will have a significant impact on credit loss analysis for companies that established new AFS credit-loss processes without an expectation for such market disruption. This could result in operational disruption for companies during their quarterly reporting process—in addition to strain on companies’ operations and processes from the economic disruption itself. As a result, proactively assessing the AFS credit loss accounting process could ease the potential strain on personnel and operations in areas such as treasury, accounting, and reporting. The above considerations should remain top-of-mind as companies prepare their first quarterly financial statements under ASC 326. Above all else, companies will need to remain flexible and react nimbly to the swiftly changing environment.
Learn more about how KPMG is helping our clients navigate the challenge COVID-19 presents here.