Collaborating author: Tracy Abruzzo
Many stakeholders wonder why the CECL model requires an entity to recognize a credit loss for a financial asset that was just purchased at fair value.
These stakeholders argue that:
- When an entity purchases a financial instrument, part of the yield compensates the entity for the credit losses initially expected.
- Buyers would demand a higher yield for instruments with higher expected credit losses at the date of the purchase.
- No economic loss is suffered at initial recognition because those expected credit losses are already embedded in the initial pricing of the instrument, reflecting the fair value of the instrument.
How can we reconcile this perceived double-counting of the credit loss?
FASB guidance clearly states that under the CECL model “the income statement reflects the measurement of credit losses for newly recognized financial assets” measured at amortized cost. CECL requires the recognition of an allowance for expected credit losses over the life of the instrument immediately on Day 1 – even for simple receivables.
However, Day 1 accounting for Purchased Credit-Deteriorated (PCD) assets, a subset of financial assets in scope of CECL where the assets were purchased with more-than-insignificant credit deterioration since origination, would not result in the recognition of an expected credit loss. Rather, the allowance for credit loss and the PCD asset basis are grossed-up by the amount of the expected credit loss.
By requiring the recognition of a Day 1 credit loss on a loan or security just purchased, there is no implication that financial markets are “imperfect or inefficient” or that the fair values of these assets need to be corrected to properly incorporate credit risk. CECL simply requires entities to separately recognize expected credit losses independent of any credit loss expectation reflected in an asset’s fair value measurement.
By concentrating exclusively on the credit loss factor in determining a financial asset’s fair value, we may fail to understand the bigger picture—that there are multiple other factors influencing a financial asset’s valuation including liquidity in the market, general market volatility, industry-specific volatility, changes due to interest rate movements and the extent of the existing or desired relationship with the borrower. The credit risk may be difficult to reliably isolate from other discounts reflected in an asset’s purchase price when it is insignificant. Therefore, when an entity expects to accrete a discount into interest income, the discount should not offset the entity’s expectation of credit losses because the discount is not considered part of the credit loss allowance.
Despite all of the above considerations, stakeholders may still feel that recognizing a day one credit loss is unfair, or even inappropriate. However, the separation of credit risk impact from other factors is imperative. Even though an instrument is acquired at fair value, CECL requires the Day 1 recognition of a lifetime credit loss be separately recognized. To ensure transparency, valuation factors should not offset the initial estimate of an expected credit loss.