How CECL Impacts Acquisitive Banks


CECL-7-30-19.pngBank buyers preparing to review a potential transaction or close a purchase may encounter unexpected challenges.

For public and private financial institutions, the impending accounting standard called the current expected credit loss or CECL will change how they will account for acquired receivables. It is imperative that buyers use careful planning and consideration to avoid CECL headaches.

Moving to CECL will change the name and definitions for acquired loans. The existing accounting guidance classifies loans into two categories: purchased-credit impaired (PCI) loans and purchased performing loans. Under CECL, the categories will change to purchased credit deteriorated (PCD) loans and non-PCD loans.

PCI loans are loans that have experienced deterioration in credit quality after origination. It is probable that the acquiring institution will be unable to collect all the contractually obligated payments from the borrower for these loans. In comparison, PCD loans are purchased financial assets that have experienced a more-than-insignificant amount of credit deterioration since origination. CECL will give financial institutions broader latitude for considering which of their acquired loans have impairments.

Under existing guidance for PCI loans, management teams must establish what contractual cash flows they expect to receive, as well as the cash flows they do not expect to receive. The yield on these loans can change with expected cash flows assessments following the close of a deal. In contrast, changes in the expected credit losses on PCD loans will impact provisions for loan losses following a deal, similar to changes in expectations on originated loans.

CECL will significantly change how banks treat existing purchased performing loans. Right now, accounting for purchased performing loans is straightforward: banks record loans at fair value, with no allowance recorded on Day One.

Under CECL, acquired assets that have only insignificant credit deterioration (non-PCD loans) will be treated similarly to originated assets. This requires a bank to record an allowance at acquisition, with an offset to the income statement.

The key difference with the CECL standard for these loans is that it is not appropriate for a financial institution to offset the need for an allowance with a purchase discount that is accreted into income. To take it a step further: a bank will need to record an appropriate allowance for all purchased performing loans from past mergers and acquisitions that it has on the balance sheet, even if the remaining purchase discounts resulted in no allowance under today’s standards.

Management teams should understand how CECL impacts accounting for acquired loans as they model potential transactions. The most substantial change relates to how banks account for acquired non-PCD loans. These loans first need to be adjusted to fair value under the requirements of accounting standards codification 805, Business Combinations, and then require a Day One reserve as discussed above. This new accounting could further dilute capital during an acquisition and increase the amount of time it takes a bank to earn back its tangible book value.

Banks should work with their advisors to model the impact of these changes and consider whether they should adjust pricing or deal structure in response. Executives who are considering transactions that will close near their bank’s CECL adoption date not only will need to model the impact on the acquired loans but also the impact on their own loan portfolio. This preparation is imperative, so they can accurately estimate the impact on regulatory capital.

FASB’s New Standards for Financial Instruments: What Banks Need to Know


FASB-2-15-16.pngAt 232 pages, Accounting Standards Update (ASU) No. 2016-01, issued in January of 2016, might be intimidating, but we will boil down the essentials you need to know as a bank accountant, chief financial officer, or member of an audit committee. In 2010, the Financial Accounting Standards Board (FASB) issued a massive proposal with many significant changes including marking the majority of a bank’s balance sheet (securities, loans and deposits) to fair value. The FASB has come a long way since then and completes part one of its financial instruments project with the issuance of this standard. When boiled down, the standard contains eight or nine significant changes of interest to banks. Not every bank will be affected by all of the changes, and whether you view these changes as positive or negative depends upon whether you are a preparer or user.

Two of the changes—both of which the banking industry views as favorable—may be adopted early for financial statements not yet issued:

  • Liabilities using the fair value option: Under current generally accepted accounting principles (GAAP), the change in fair value resulting from instrument-specific credit risk is presented in earnings, which has an interesting result. As a bank’s own credit worthiness declines, income is recorded because the value of the liability declines, usually the bank’s debt. Many found that to be an odd outcome—and the FASB agreed. This ASU corrects that and those changes now will be recorded in other comprehensive income (OCI) instead of earnings, and consistent with regulatory capital treatment.
  • Disclosures of fair value of financial instruments: In an effort to provide relief, the FASB is dropping this requirement, which was born in Financial Accounting Standards (FAS) No. 107, for non-public business entities (non-PBEs). Beware, though: The definition of PBE is very broad and extends far beyond those who file with the SEC. Many banks have been surprised to learn they are considered to be PBEs.

The most significant change is that PBEs will have to calculate fair values using the exit price notion, obtaining a fair value using what a market participant would use. This is a big deal because under current GAAP, there is a provision that permits banks to calculate these fair values using a discounted cash flow approach known as entrance pricing. For example, the fair value of loans commonly is computed by discounting the cash flows using the current rates at which similar loans would be made to borrowers with mirroring credit ratings and remaining maturities. Requiring exit pricing could prove challenging, particularly for loans. A small but positive change for PBEs is the elimination of the requirement to disclose the methods and significant assumptions used.

The next big area of change is for equity investments, with general exceptions for those using the equity method or those that are consolidated. The unpopular change for banks is that, going forward, changes in fair value will run through earnings. Under current GAAP, equity investments can be classified as available for sale (AFS) with fair values changes running through OCI, or trading with fair value changes running through earnings. This change eliminates the AFS option.

There is good news, however, for equity investments without readily determinable fair values. Banks will have the option to measure these at cost minus impairment, if any, plus or minus changes resulting from qualifying observable price changes. This means investments can be written up with proper observable transactions. The FASB also simplified the impairment assessment by using a qualitative assessment.

Two more changes:

  • Deferred tax assets (DTAs) on AFS securities: Currently there is diversity in practice on evaluating such DTAs separately (given management has control because the securities can be sold) or in combination with other DTAs. The FASB chose the latter.
  • Measurement category: Financial assets and liabilities must be presented by measurement category (such as fair value or amortized cost) and form of financial asset (securities, loans or receivables) on the balance sheet or in the footnotes.

When Is This Effective?

For PBEs, the changes take effect for fiscal years beginning after Dec. 15, 2017, including interim periods within (which means first quarter of 2018 for calendar year-end reporting companies).

For non-PBEs, the changes take effect for fiscal years beginning after Dec. 15, 2018, and interim periods beginning after Dec. 15, 2019 (which means Dec. 31, 2019, for calendar year-ends).

The FASB plans to issue part two of its financial instruments project, a final standard on credit losses, in the first part of 2016 and part three, a proposal on hedging, in the second quarter of 2016.

Fair Value and the Allowance for Credit Losses: What Does the Future Hold?


These two topics, near and dear to bankers, are in the process of being addressed by the Financial Accounting Standards Board’s (FASB) financial instruments project. The financial instruments proposal, issued in May 2010, was a monster–fair value, impairment and hedging all rolled into one.

Adding to the complexity, remember that FASB is trying to converge with the International Accounting Standards Board (IASB)–but IASB is using timetables that differ from FASB’s. In this post, I’m setting aside hedging to focus on the two areas that affect everyone: fair value and the allowance for credit losses.

Fair Value

red-pin-finances.jpgFASB’s past proposal to carry most financial instruments (loans, securities and deposits) on the balance sheet at fair value was received with little enthusiasm, for two primary reasons. First, robust market data doesn’t exist for many of those instruments, raising concerns about the reliability of the fair values that would be used. Second, the proposal did not take into account management’s intent–when management does not intend to ever sell most of those instruments, what is the point in recording them at fair value?
 
The good news is that FASB has reconsidered its initial proposal. The board has moved away from broadly requiring fair value for most financial instruments. Instead, the determination of whether an instrument is carried at fair value will depend on (1) the characteristics of the financial asset and (2) the business strategy. The result is three categories:


Fair Value–Net Income: Measured at fair value with all changes in fair value recognized in net income. It includes items held in trading or for sale.

  1. Fair Value–Other Comprehensive Income: Measured at fair value with qualifying changes in fair value recognized in other comprehensive income. It includes financial assets for which the business objective is investing with a focus on managing risk exposures and maximizing total return, typically characteristics of an investment portfolio category.
  2. Amortized Cost: Measured at historical cost and for assets, evaluated for impairment. It includes financial instruments for which the business strategy is managing the instruments through a lending, borrowing or customer financing activity, typically characteristics of a loan portfolio category. This category would also include those liabilities (deposits) that the bank intends to hold.

If you think this overall model looks similar to what we have today, you are correct. However, there is an important shift. Today, the accounting model is driven primarily by the form of the instrument. That is, we follow one model if the asset is deemed to be a loan and another model if the asset is deemed to be a security. The shift is really toward one model, but then drivers are the marketability of the instrument (Is there a readily available market for the asset?) and management’s intent (What is the plan for the asset? Is the intent to hold the asset and collect the cash flows the typical intent for a loan? Or is the intent to manage interest rate risk and liquidity, which is typical for an investment portfolio?).
 
While there are many nuances with this area of the project, the key point is that FASB has moved away from essentially requiring fair value for the majority of the balance sheet. Stay tuned–FASB plans to make its final decisions in the third quarter of 2011.

Allowance for Credit Losses

Near and dear to bankers is the allowance for loan and leases losses (ALLL), an area in which FASB’s financial instruments project seeks to make some changes. For decades, we have struggled with the accounting in this area in large measure because of the confusion about what the allowance does and doesn’t represent. Today, losses cannot be recorded until they are probable and incurred. Those are words of art meaning that a loss has indeed happened and that a future event will likely confirm the loss. In other words, the allowance does not represent all possible or expected losses in the portfolio.

However, these concepts are being reevaluated. In late January, FASB and the IASB published a joint proposal for comment that is focused primarily on loans evaluated on a pool basis. Think about that in the context of loans that are not individually flagged being problematic. The proposal seeks to change the allowance from a probable and incurred loss model to a more forward-looking model–that is, closer to an expected loss model.

However, the two boards differ. FASB favors an approach that looks to the foreseeable future but not one that includes losses over the life of the portfolio. IASB favors an approach that takes expected losses over the portfolio and records those losses over time. The new proposal is really a hybrid of the two approaches. Essentially, bankers would have to determine the outcome of both approaches and record the lesser of the two amounts. So, for pools, the allowance for credit losses would be calculated based on the lower of a time-proportional amount (the IASB model) or losses expected to occur in the foreseeable future, which can’t be less than 12 months (the FASB model).

Unsurprisingly, the comment letters did not yield a consensus of opinion. So, with a goal of reaching a consensus by late June, the boards are back to the drawing board. Depending on the outcome, we may see yet another exposure draft. Stay tuned–more fun to come!

Can You See ThiS????