Bank mergers and acquisitions are not easy: balancing the standard process of due diligence to verify financial and credit information, adapting processing methods and measuring fair value assets and liabilities. The ongoing pandemic coinciding with the implementation of the current expected credit loss model, or CECL, by larger financial institutions has made bank mergers even more complex. As your financial institution weighs the benefits of a merger or acquisition, here are two important accounting impacts to consider.
Fair Value Accounting During a Pandemic
When two banks merge, the acquiring bank will categorize the loans as performing or purchase credit impaired/deteriorated and mark the assets and liabilities of the target bank to fair value.
This categorization of loans is difficult — the performance of these loans is currently masked due to the large number of loan modifications made in the second quarter. With many customers requesting loan modifications to defer payments for several months until the economy improves, it is difficult for the acquiring bank to accurately evaluate the current financial position of the target bank’s customers. Many of these customers could be struggling in the current environment; without additional information, it may be very difficult to determine how to classify them on the day of the merger.
One of the more complex areas to assess for fair value is the loan portfolio, due to limited availability of market data for seasoned loans. As a result, banks are forced to calculate the fair value of assets while relying on subjective inputs, such as assumptions about credit quality. Pandemic-response government programs and significant bank-sponsored modification programs make it difficult to fully estimate the true impact of Covid-19 on the loan portfolio. Modifications have obscured the credit performance data that management teams will base their assumptions, complicating the process even further.
U.S. Generally Accepted Accounting Principles (GAAP) allows for true-up adjustments to Day 1 valuations for facts that were not available at the time of the valuation to correct the fair value accounting. These adjustments are typically for a few isolated items. However, the lagging indicators of Covid-19 have added more complexity to this process. There may be more-pervasive adjustments in the coming year related to current acquisitions as facts and circumstances become available. It is critical for management teams to differentiate between the facts that existed the day the merger closed versus events that occurred subsequent to the merger, which should generally be accounted for in current operations.
For large banks that implemented CECL in the first quarter of 2020, a significant change in the accounting for acquired loans can create a new hurdle. Under the incurred loss model, no allowance is recorded on acquired loans, as it is incorporated in the fair value of the loans. Under the new CECL accounting standard, the acquirer is required to record an allowance on the day of acquisition — in addition to the fair value accounting adjustments. While this allowance for purchase deteriorated credits is a grossing-up of the balance sheet, the performing loan portfolio allowance is recorded through the provision for loan losses in the income statement.
This so-called “double-dip” of accounting for credit risk on acquired performing loans is significant. It may also be an unexpected change for many users of the financial statements. Although CECL guidance has been available for years, this particular accounting treatment for acquired performing loans was often overlooked and may surprise investors and board members. The immediate impact on earnings can be significant, and the time period for recapturing merger costs may lengthen. As a result, bank management teams are spending more time on investor calls and expanding financial statement disclosures to educate users on the new accounting standards and its impact on their transactions.
The two-fold accounting challenges of implementing CECL during a global pandemic can feel insurmountable. While the CECL standard was announced prior to Covid-19, management teams should take a fresh look at their financial statements as they prepare for earnings announcements. Similarly, if your bank is preparing to close an acquisition, plan on additional time and effort to determine the fair value accounting. By maintaining strong and effective communication, financial institutions will emerge stronger and prepared for future growth opportunities.