FAR · Select balance sheet accounts · 11 practice questions
AFS Debt Credit Losses: Allowance, OCI, or Write-Down
AFS debt credit losses go to earnings through an allowance, while noncredit losses go to OCI unless a sale trigger applies. Below, change one fact in the same bond scenario to see when the accounting flips.
Try one first
Hint
First compute the total unrealized loss, then determine the credit-related portion by comparing amortized cost to the present value of cash flows expected to be collected; the residual is the noncredit portion that remains in OCI.
Answer C. Under current U.S. GAAP for AFS debt securities held with no intent and not more likely than not required to be sold, the credit-related portion of an impairment is recognized in earnings as an allowance for credit losses (measured as amortized cost less present value of expected cash flows), limited to the total unrealized loss; any remaining unrealized loss is recognized in OCI. Here total unrealized loss = $1,000 − $956 = $44; credit-related portion = $1,000 − $972 = $28; the residual $16 is recorded in OCI.
Why not A: Appealing because AFS unrealized losses typically go to OCI, but when part of the decline is credit-related the credit portion must be recognized in earnings (measured as amortized cost less PV of expected cash flows).
Why not B: This is tempting if one assumes the entire fair value decline is credit-related, but guidance requires recognizing only the credit-related portion in earnings; the remainder of an AFS unrealized loss is reported in OCI.
Why not D: This correctly splits earnings and OCI but swaps the amounts; the credit-related portion is $28 (amortized cost less PV of expected cash flows), not $16.
Same scenario, one fact changes
Base case
At year-end, Alder Co. holds an AFS bond with amortized cost of $1,000,000 and fair value of $920,000. The present value of expected cash flows at the original effective interest rate is $950,000. Alder does not intend to sell and is not more likely than not required to sell before recovery. No allowance exists. Ignore income taxes.
Answer: Record a $50,000 allowance with a $50,000 loss in earnings and a $30,000 loss in OCI.
Total decline is $80,000 ($1,000,000 - $920,000). Credit shortfall is $50,000 ($1,000,000 - $950,000), below the cap. The $30,000 remainder goes to OCI.
Before you open each one, predict the answer.
Change 1Expected cash-flow present value rises from $950,000 to $1,000,000.
Answer: Recognize the $80,000 decline in OCI. Record no credit-loss allowance.
Expected cash flows cover amortized cost, so there is no credit loss. With no sale trigger, the entire decline stays in OCI.
Change 2Alder now intends to sell the bond.
Answer: Recognize an $80,000 loss in earnings by writing the bond down to $920,000. No allowance or related AOCI remains.
Intent to sell overrides the split. The full $80,000 decline enters earnings, and $920,000 becomes the new cost basis.
Change 3Alder is now more likely than not required to sell before recovering amortized cost.
Answer: Recognize an $80,000 loss in earnings by writing the bond down to $920,000. No allowance or related AOCI remains.
Being more likely than not required to sell before recovery overrides the split, even without intent to sell.
Change 4Expected cash-flow present value falls from $950,000 to $900,000.
Answer: Record an $80,000 allowance and loss in earnings. Recognize no loss in OCI; leave amortized cost unchanged.
The cash-flow shortfall is $100,000, but the fair-value decline is only $80,000. Cap the allowance at $80,000; do not record the excess.
Key points
- Remember: A sale trigger means full loss in earnings; otherwise, cap the credit allowance and put the rest in OCI.
- Discount expected cash flows at the security's original effective interest rate, not a current market rate.
- AFS debt is reported at fair value, not amortized cost minus the credit-loss allowance.
- Use amortized cost, not purchase price, when measuring the fair-value decline and cash-flow shortfall.
How the exam traps you
- Putting the whole decline in OCI because the bond is AFS. With no sale trigger, recognize the credit portion in earnings through an allowance.
- Charging the whole decline to earnings whenever any credit loss exists. Unless a sale trigger applies, separate credit from noncredit and cap the allowance at the fair-value decline.
- Writing down amortized cost for a credit loss without a sale trigger. Use an allowance instead. A sale trigger requires a direct write-down to fair value.
Now the same facts as questions
Each question changes one fact from the one before. Watch which change flips the answer.
Question 1
Answer C. Right. The $50,000 shortfall is below the $80,000 cap; the remaining $30,000 goes to OCI.
Why not A: Wrong. The $50,000 cash-flow shortfall is a credit loss that belongs in earnings.
Why not B: Wrong. The $80,000 decline includes $30,000 of noncredit loss, which belongs in OCI.
Why not D: Wrong. Without a sale trigger, credit losses use an allowance, not a direct write-down.
Question 2
Answer A. Right. There is no credit shortfall, so the entire $80,000 decline goes to OCI.
Why not B: Wrong. Expected cash flows cover amortized cost, so no credit-loss allowance is needed.
Why not C: Wrong. The $50,000 credit shortfall disappears when expected cash-flow present value equals amortized cost.
Why not D: Wrong. AFS fair-value losses still enter OCI when no credit loss or sale trigger exists.
Question 3
Answer D. Right. Recognize the full $80,000 loss in earnings and reset the cost basis to $920,000.
Why not A: Wrong. Intent to sell overrides the credit/noncredit split.
Why not B: Wrong. Intent to sell requires the full decline in earnings, not OCI.
Why not C: Wrong. The amount is $80,000, but a sale trigger requires a direct write-down, not an allowance.
Question 4
Answer A. Right. The required-sale test triggers a full write-down through earnings, even without intent to sell.
Why not B: Wrong. The required-sale trigger overrides the credit/noncredit split.
Why not C: Wrong. A sale trigger requires a direct write-down rather than an allowance.
Why not D: Wrong. The full decline belongs in earnings because the required-sale test is met.
Question 5
Answer B. Right. Cap the $100,000 shortfall at $80,000. No noncredit loss remains for OCI.
Why not A: Wrong. The allowance cannot exceed the $80,000 fair-value decline; no offsetting OCI gain is recorded.
Why not C: Wrong. Neither sale trigger exists, so use an allowance and leave amortized cost unchanged.
Why not D: Wrong. This uses the original cash-flow estimate instead of the changed $900,000 present value.
Question 2
Hint
Separate measurement basis (AFS = fair value; HTM = amortized cost) from how expected credit losses are recognized.
Answer B. AFS debt securities are measured at fair value. Under current U.S. GAAP (ASC 320 and ASC 326), the expected credit-loss portion of an AFS decline is recognized in earnings through an allowance (limited to the excess of amortized cost over fair value), with any remaining unrealized loss presented in OCI. HTM debt securities are measured at amortized cost, and expected credit losses are reflected through an allowance rather than by remeasuring the security to fair value.
Why not A: This is tempting because AFS credit declines are allocated between earnings and OCI, but it incorrectly applies fair-value measurement to HTM securities. HTM securities remain at amortized cost and reflect expected credit losses through an allowance rather than by carrying the security at fair value.
Why not C: Management's intent affects disclosures and the assessment of sales likelihood, but it does not change the AFS measurement basis, AFS securities are still reported at fair value. Also, HTM securities do not use a lower-of-cost-or-market or automatic fair-value write-down model; expected credit losses for HTM are recognized through an allowance.
Why not D: Although both securities involve expected credit-loss considerations, this answer ignores the measurement-basis distinction: AFS securities are presented at fair value (with the credit portion of any decline recognized in earnings and the noncredit portion in OCI), while HTM securities remain at amortized cost with an allowance.
Question 3
Hint
Separate the total decline into the expected-credit-loss component and the noncredit fair-value component, and recall how available-for-sale debt securities are presented.
Answer D. Under ASC 320 (as amended by ASC 326), available-for-sale debt securities are presented at fair value. Expected credit losses are recognized in earnings through an allowance; the remaining noncredit portion of the fair-value decline is reported in OCI. Here the total decline is $60,000: $25,000 is the expected-credit-loss component (recognized in earnings) and $35,000 is the noncredit unrealized loss (OCI), so the security is reported at its fair value of $940,000.
Why not A: This distractor appeals to those who treat the allowance as the only immediate effect on carrying amount and who defer noncredit unrealized losses, but under current GAAP the noncredit portion of an AFS debt security's fair-value decline is recognized in OCI now rather than deferred until sale.
Why not B: This is tempting because credit losses are recognized in earnings, but for AFS debt securities only the expected-credit-loss component is recognized in earnings; the noncredit unrealized portion is presented in OCI.
Why not C: This option may appeal to candidates who think the allowance should simply reduce carrying amount while OCI records the remainder; however, AFS debt securities are presented at fair value, so carrying the security at amortized cost net of an allowance while simultaneously recognizing the unrealized loss in OCI is not consistent with the measurement model.
Question 4
Hint
Separate the security's classification from the reason for the decline. For an available-for-sale debt security, ask what part of the loss is credit-related and whether the company expects to sell before recovery.
Answer B. For an available-for-sale debt security that the entity does not intend, and is not more likely than not required, to sell before recovery, GAAP separates the fair value decline into credit and noncredit components. The credit-related portion is recognized in earnings (typically as an allowance for credit losses), while the noncredit portion is recognized in OCI. Thus $20,000 is charged to earnings and the remaining $40,000 is reported as an unrealized loss in OCI.
Why not A: This overgeneralizes the rule that AFS unrealized gains and losses go to OCI. When part of the decline is due to credit loss, the credit component is recognized in earnings rather than entirely in OCI.
Why not C: This incorrectly treats any credit concern as converting the entire decline to income. GAAP requires separating credit and noncredit components for AFS debt securities; only the credit portion affects earnings.
Why not D: The noncredit portion is not deferred until sale; it is recognized currently in OCI. Deferring the $40,000 would contradict the treatment for unrealized noncredit losses on AFS debt securities.
Question 5
Hint
First decide whether Maple's intent or the likelihood of forced sale would require full earnings recognition. If not, split the $40,000 decline into credit and noncredit components and recognize only the credit component in earnings via an allowance; record the remainder in OCI.
Answer D. Under ASC 320 in conjunction with ASC 326, for an available-for-sale debt security when the entity does not intend to sell and is not more likely than not to be required to sell before recovery, the credit-related portion of an unrealized decline is recognized in earnings as an allowance for credit losses while the noncredit portion is reported in OCI. Maple has identified $15,000 of the $40,000 decline as expected credit losses and $25,000 as market-rate related, so $15,000 is established as an allowance (charge to earnings) and $25,000 is recorded as an unrealized loss in OCI. Assume no prior allowance exists, so the allowance is established at year end for the credit portion.
Why not A: This assumes the entire decline is credit-related. The facts explicitly allocate $25,000 of the decline to market interest-rate effects, which should be reported in OCI rather than as credit losses in earnings.
Why not B: This is tempting because AFS unrealized gains and losses typically flow to OCI; however ASC 326 requires that the credit-related portion of an AFS debt security's decline be recognized in earnings via an allowance even when the entity does not intend to sell.
Why not C: This treats the decline as entirely recognized in earnings (similar to trading or a fully credit-related decline). For AFS debt securities not expected to be sold before recovery, only the credit portion is recognized in earnings; the remaining noncredit portion stays in OCI.
Question 6
Hint
First compute the total decline from amortized cost to fair value. Then identify how much of that decline is credit-related, paying close attention to the stated condition about whether the company plans or may be forced to sell.
Answer B. For an available-for-sale debt security where the entity does not intend to sell and is not more likely than not required to sell before recovery, recognize in earnings only the credit-related portion of the decline. The credit loss equals amortized cost minus the present value of expected cash flows: $980,000 - $960,000 = $20,000. The remainder of the total decline to fair value ($50,000 total decline less $20,000 credit loss = $30,000) is noncredit and reported in OCI.
Why not A: This is tempting because $50,000 is the full drop from amortized cost to fair value; that full amount would be recognized in earnings only if Pruitt intended to sell or was likely required to sell before recovery. The stem rules that out, so only the credit portion belongs in earnings.
Why not C: This splits the loss between earnings and OCI but reverses the amounts. The credit loss is the gap between amortized cost and the present value of expected cash flows ($980,000 - $960,000 = $20,000), not the gap between present value and fair value.
Why not D: Although AFS debt securities generally record unrealized gains and losses in OCI, when a credit loss exists the credit-related portion must be recognized in earnings even if the security remains classified as available-for-sale.
Common questions
Do AFS debt credit losses go to OCI or earnings?
Credit losses go to earnings through an allowance. When neither sale trigger exists, the remaining noncredit decline goes to OCI.
What is the credit-loss allowance limit for AFS debt securities?
The allowance cannot exceed amortized cost minus fair value. A larger expected cash-flow shortfall does not increase the allowance beyond that cap.
When do you write down an AFS debt security instead of using an allowance?
Write down to fair value through earnings when you intend to sell or are more likely than not required to sell before recovery. Remove related AOCI; the new cost basis is fair value.
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