- FAR candidates need to know how the new CECL (Current Expected Credit Loss) model applies to investment securities such has held to maturity debt securities.
- Held To Maturity Debt securities are carried at amortized cost at year end but if a held to maturity bond investment was issued by an entity that may have trouble re-paying the bonds, a credit loss expense is booked on the income statement. Credit losses are an exception to accounting treatment for Held to Maturity Debt Securities, just like they were for Available for Sale Debt Securities.
- Held to Maturity Bonds are purchased for $94,000 on July 1 Year 1. The bonds pay interest on July 1 and December 31, Year 1. The stated rate on the bonds is 10% and the market rate is 12%. The original discount was $6,000
- Journal Entry on 7/1
DR Investment in HTM debt $100,000
CR Discount on Bonds 6,000
CR Cash 94,000
Entry on 12/31
DR Accrued interest receivable $5,000 ($100,000 X 10% X 6/12)
DR Discount on bonds 640
CR interest income $5,640 ($94,000 X .12 X 6/12)
Balance Sheet Presentation on December 31:
Investment in Debt Securities-HTM $100,000
Un-amortized Discount ( 5,360)
Investment in Debt Securities 94,640 (amortized cost)
If fair value is $95,000 on 12/31 or $94,000, general rule is bonds would still be reported at amortized cost.
A company purchases $100,000 of held to maturity debt securities at a cost of $103,000. If only $800 of the premium has been amortized by year end, and the fair value at year end is $101,000, how much are the bonds valued on the balance sheet at year end if management feels that the decline in fair value is due to credit deterioration of the investee?
Answer: Generally, held to maturity debt securities are carried on the balance sheet at amortized cost, cost of $103,000 minus the premium amortized of $800, $102,200, not fair value of $101,000. The decline in value of $1,200 would usually be ignored. However, since management estimates that the loss was due to credit deterioration of the investee, a loss needs to be booked:
DR Credit loss expense $1,200 (IS)
CR Allowance for credit loss $1,200 (contra asset) and as a result, the new carrying amount becomes the fair value of $101,000.
Where did management come up with the estimated credit loss? Using historical experience, current conditions, and reasonable forecasts, management determined that the potential credit loss for this investment is $1,000. The net value of the investment in this debt security is $101,200. •This amount represents the net amount that the investor expects to receive from this debt investment.
- At each balance sheet date, management is required to estimate the expected credit loss associated with the issuer’s ability or inability to repay the debt to the investor. This CECL model replaces the old “impairment model” that was based only on actual incurred losses by the issuer.
- The CECL model is going to measure all expected credit losses for a financial asset as of each balance sheet date and its based on historical experience, current conditions, and reasonable and supportable forecasts from data analytics.
An HTM debt investment is written off when it is deemed uncollectible much like an account receivable write-off.
DR Allowance for credit loss
CR Investment in HTM Debt
Note that the write-off of a worthless Held to Maturity Debt Security does NOT impact the income statement (balance sheet only)