According to Mike Gullette, vice president of Accounting Policy and Financial Management for the American Bankers Association, "CECL represents the biggest change to bank accounting ever. [...] FASB writes high-level principles with no prescribed measurement methods."
What's happening
FASB (Financial Accounting Standards Board) has issued ASU Topic 326, which introduces the Current Expected Credit Loss (CECL) method of recording estimated or foreseeable losses. This pronouncement was largely initiated to help the U.S. try to mitigate the risk of recurrence of an event like the 2008 financial crisis. Just as the 2001 recession resulted in additional purchase accounting rules under ASC 805 (formerly FASB 141r) and ASC 350 (formerly FASB 142), FASB is increasing the level of measurement and scrutiny to monitor and try to help mitigate potential losses incurred.
Purchase accounting for non-bank and bank acquisitions has evolved. We can expect CECL’s effect on the financial sector to be felt when the standard becomes effective in 2020 for publicly traded banks and 2021 for all other banks.
The American Bankers Association published a FAQ for Bankers on the CECL update which included the question, "Does CECL change purchase accounting?". Here’s the ABA’s response:
FASB is repairing the accounting for purchased credit-impaired (PCI) assets, using a “gross up” method that effectively creates an ALLL upon purchase. After purchase, no longer will there be an explicit forecast of specific future cash flows or ongoing changes to the effective yield, as are currently required. This will greatly simplify the ALLL process and help investors who like to analyze allowance coverage ratios and net interest margins.
While there still remain similar issues for those non-impaired purchased loans (as those loans will continue to be initially recorded at fair value with no ALLL), FASB has included further guidance that indicates the number of loans that will qualify for this “gross up” method will greatly expand (in contrast to the current PCI term used today, CECL refers to assets purchased with credit deterioration – PCD), thus significantly alleviating the problem.
When applying purchase accounting once CECL becomes effective, both the accounting for credit-impaired loans and non-credit-impaired loans will be affected.
Current method
To illustrate this change, this chart shows the current method of accounting for credit-impaired assets.
|
DR |
CR |
| Credit-impaired loan balance |
$825,000 |
|
| ALLL |
|
$ 0 |
| Yield/discount on purchase |
|
$ 75,000 |
| Purchase consideration |
|
$750,000 |
New method
The next table demonstrates the new method of accounting for credit-impaired assets under CECL.
|
DR |
CR |
| Credit-impaired loan balance |
$1,000,000 |
|
| ALLL |
|
$175,000 |
| Yield/discount on purchase |
|
$ 75,000 |
| Purchase consideration |
|
$750,000 |
Source: Frequently Asked Questions on the New Accounting Standard on Financial Instruments – Credit Losses, Question 14: How should institutions account for PCD financial assets under CECL?, December 19, 2016, Office of the Comptroller of the Currency.
Observations:
- Loans will be recorded at their contractual amount, so there is no need for shadow loan accounting.
- The allowance, or credit-risk portion of credit-impaired loans, comes over into the acquiring bank’s allowance account.
Non-Purchased-Credit-Deteriorated (PCD) assets
For non-purchased-credit-deteriorated (PCD) assets (i.e., performing loans), the purchase accounting applied is as follows:
|
DR |
CR |
| Non-impaired loan balance (FMV) |
$1,000,000 |
|
| Yield/discount on purchase |
|
$110,000 |
| Purchase consideration |
|
$890,000 |
Non-PCD assets
Under CECL, the accounting for non-PCD assets would be accounted for as follows:
|
DR |
CR |
| Non-impaired loan balance |
$1,000,000 |
|
| Provision for loan loss |
$ 60,000 |
|
| ALLL |
|
$ 60,000 |
| Yield/discount on purchase |
|
$ 50,000 |
| Purchase consideration |
|
$950,000 |
Observations:
- Day 1 accounting under CECL will require the recognition of a loss for the estimated credit risk of non-PCD assets.
- The prior definition for purchased credit-impaired loans was fairly restrictive; the new term used in CECL is purchased credit deteriorated (PCD). It is believed that more loans / pools will qualify to be recorded as PCD assets, which allows the allowance to come over upon acquisition, as opposed to recognizing a loss for the allowance as shown under CECL guidance for non-PCD assets. Recognizing this loss will not likely be attractive to most who are making acquisitions.
In addition to the treatment for non-PCD assets, the following issues present certain challenges for both the acquirer and acquisition target.
- Depending on the acquisition target’s size and market demographics, gathering sufficient information could be a significant challenge. This could lengthen the time it takes for deals to close. Additionally, some deals may never materialize, which is not uncommon, but it is another wrench added to the due diligence process.
- Different banks will be allowed some latitude in developing a model to track CECL. Based on this, there could be integration issues in the regulatory process. See the different methods here.
- The audit review process for the purchase will likely lengthen as a result of any new standard that has not been widely used.
- Using a forward-looking model will require subjective inputs, and substantiation of those inputs will be integral to getting through the audit and regulatory process. Examples of such inputs would be:
- Prepayment speed assumptions
- Interest rate curve on variable loans
- Local, regional, and national unemployment rates, possibly even under-employment rates, which are not often tracked
- Industry concentrations in loan protfolios, requiring additional due diligence
- Unfortunately, the accretive model used for Day 2 accounting for the combined entities will continue for credit-impaired loans.
- According to Gullette, vice president of the ABA, FASB’s roll-out of CECL is high-level at best and any life-of-loan model for forecasting the credit losses has not been sufficiently defined. As with other FASB pronouncements, the AICPA and other financial governing entities may provide practice aids at a later date.
Steps to take
We recommend the following to ensure that the bank transaction process goes smoothly.
- Acquiring bank management should communicate with the target bank’s management to understand how the target bank is preparing for and implementing CECL before it becomes effective.
- Work collaboratively within different departments and put the necessary rules in place so that risk is managed effectively.
- Learn from other banks that may have gone through the process. Reviewing what went well, what could have been improved, and lessons learned could save you and your team time and money.
- Understand the inputs and assumptions the acquiring bank uses in its life-of-loan model and compare to the target bank’s assumptions to identify any variances early in the process.
Following the acquisition and during the integration process, we recommend the following actions, especially to mitigate impairment losses for the combined entities in the future.
- Begin tracking credit scores of borrowers in databases regularly.
- Develop a system to communicate with management promptly regarding credit risk issues.
- Track risk ratings in your bank’s database and consider an outside review of those ratings for a certain group of loans on an ongoing basis.
- A range of tech-based products entering the marketplace are vying to help you track your loss assumptions; these need to be vetted significantly before making any major investment of time or money.
Additional resources
Here are additional resources related to new developments in the banking industry.