For debt securities classified as available-for-sale and held-to-maturity, the current expected credit loss (CECL) model will be applicable. Under the CECL model, a company will assess all available relevant information when estimating an expected credit loss over the life of the debt security. This includes historical events, current conditions, and future expectations.

This method is more conservative as companies are no longer delaying the recognition of credit losses. Instead, credit losses are being reported when it becomes clear that the debt security is impaired. Credit losses are recorded directly to the income statement as they are deemed to be permanent and not temporary. Any unrealized losses not attributable to credit losses are reported in other comprehensive income (along with unrealized gains).

This is a very complex topic that is tested on the CPA exam. We have developed a 4-step approach that can be used to tackle questions on how to recognize expected credit losses in a company’s financial statements.

Step 1) The first step is to calculate the present value of future expected cash flows which is based on the remaining interest payments and principal to be repaid upon maturity.

Step 2) The next step is to determine the expected credit loss. To do this, we take the present value of future cash flows (from step #1) and subtract the amortized cost. If the result is negative, that represents the expected credit loss, but we have to move to step #3 as the credit loss reported in the income statement is limited to the difference between the amortized cost and fair value of the debt security for AFS debt securities. If HTM, the expected credit loss is reported to the income statement, and you would skip steps #3 and #4.  

Step 3) For an AFS debt security, we need to determine what amount is recorded to the income statement (permanent impairment loss) and what amount is recorded to OCI (temporary loss). To do this, we take the fair value and subtract the amortized cost. If the result is positive, then we have a gain, and the gain is reported in OCI (step #4). If we have a negative number, that represents the max credit loss that can be reported (if less than expected credit loss).

Step 4) This is where we record the impact to OCI. If we had a gain resulting from step #3, then we would credit OCI for the gain. If the expected credit loss from step #2 is still higher than the credit loss from step #3, the excess loss is recorded to OCI.

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Step 1) We would start by calculating the present value of future cash flows, but the question tells us that equates to $650,000. Big Wave is expecting to receive $650,000 of present value adjusted interest income and principal repayment on the investment from now through when the debt security matures.

Step 2) Now we take the PV of future cash flows of $650,000 and subtract the amortized cost of $700,000, which results in expected credit losses of $50,000.

Step 3) When we take the fair value of $625,000 and subtract the amortized cost of $700,000, that results in a loss of $75,000. However, our expected credit losses were only $50,000, so the remaining loss will be recorded to OCI.

Step 4) $50,000 of the decline relates to credit losses (can’t exceed amount in step #2) while the remaining $25,000 relates to a temporary decline in fair value, so that is recorded as an unrealized loss in OCI. Therefore, our credit loss that is reported in the income statement is $50,000.

Journal entry: Big Wave would debit credit loss for $50,000 and credit allowance for credit losses for $50,000. The remaining $25,000 loss would go to OCI, which would be recorded through a debit to unrealized loss – AFS for $25,000 and credit to valuation allowance (AFS) for $25,000.

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Step 1) We would start by calculating the present value of future cash flows, but the question tells us that equates to $650,000. Big Wave is expecting to receive $650,000 of present value adjusted interest income and principal repayment on the investment from now through when the debt security matures.

Step 2) Now, we take the PV of future cash flows of $650,000 and subtract the amortized cost of $700,000, which results in expected credit losses of $50,000.

Step 3) Since the debt security is classified as HTM, we do not perform step #3 since the debt security is reported at the amortized cost and not the fair value.  

Step 4) The full $50,000 expected credit loss becomes the credit loss and is recorded to the income statement since the debt security is classified as held-to-maturity.

Journal entry: Big Wave would debit credit loss for $50,000 and credit allowance for credit losses for $50,000. There is not any impact to OCI.