CECL: Where to start

Read this if you are a CFO or controller.

The Governmental Accounting Standards Board (GASB) recently provided much needed guidance for governmental organizations struggling to account for relief provided in the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). In their Technical Bulletin No. 2020-1, Accounting and Financial Reporting Issues Related to the CARES Act and Coronavirus Diseases, GASB addressed a number of pressing recognition and presentation questions that you should be aware of when preparing financial statements. The following is a summary of the guidance:

• Resources received under the Coronavirus Relief Fund (CRF) subject to restrictions should be recognized as voluntary nonexchange transactions, subject to eligibility rather than purpose restrictions. As such, the entity should recognize resources received from the CRF as liabilities until the applicable eligibility requirements are met, including the incurrence of eligible expenditures. When the eligibility requirements have been met, revenue should be recognized for CRF resources received.
• Provisions of the CARES Act that address the entity’s loss of revenue should be considered an eligibility requirement for purposes of revenue recognition. 
• Any possible amendments to the CARES Act issued subsequent to the statement of net position date but before the issuance of financial statements, even when enacted with retroactive provisions, do not represent conditions that existed as of the period-end being reported and should only be reported as a nonrecognized subsequent event.
• With the exception of CARES Act funds provided through the Provider Relief Fund's Uninsured Program (operating revenues), funds received under the CARES Act are subsidies and should be reported as nonoperating revenues and presented as noncapital finance activities in the statement of cash flows.
• Outflows of resources incurred in response to the coronavirus disease due to actions taken to slow the spread of the virus or the implementation of "stay-at-home" orders should not be reported as extraordinary items or special items.
• In addition to the guidance provided with the Technical Bulletin, the GASB also provides a number of additional stakeholder resources that may be useful during this period on its website, including an Emergency Toolbox that provides guidance on donated assets, management’s discussion and analysis (MD&A), asset impairment, and many more. 

Please contact Robert Smalley if you have questions on the latest GASB updates.
 

Recently the Governmental Accounting Standards Board (GASB) finished its Governmental Accounting Research System (GARS), a full codification of governmental accounting standards. The completion of the project allows preparers easy access to accounting guidance from GASB. The overall project, starting from the codification of older pre-1989 Financial Accounting Standards Board (FASB) pronouncements in 2010, was focused on pulling together all authoritative guidance, similar to what FASB had done in 2009.

Here’s what we found interesting.

Poking around the GARS (Basic View is free) I was struck by a paragraph surrounded by a thick-lined box that read “The provisions of this Codification need not be applied to immaterial items.” If you have ever read a GASB or FASB pronouncement, you have seen a similar box. But probably, like me, you didn’t fully consider its potential benefits. Understanding this, GASB published an article on its website aimed at (in my opinion) prompting financial statement preparers to consider reducing disclosure for the many clearly insignificant items often included within governmental financial statements.

After issuing more than 80 pronouncements since its inception in 1984, including 19 in the last five years, GASB accounting requirements continue to grow. Many expect the pace to continue, with issues like leases accounting, potential revision of the financial reporting model, and comprehensive review of revenue and expense recognition accounting currently in process. With these additional accounting standards come more disclosure requirements.

With many still reeling from implementation of the disclosure heavy pension guidance, GASB is already under pressure from stakeholders with respect to information overload. Users of financial statements can be easily overwhelmed by the amount of detailed disclosure, often finding it difficult to identify and focus on the most significant issues for the entity. Balancing the perceived need to meet disclosure requirements with the need to highlight significant information can be a difficult task for preparers. Often preparers lean towards providing too much information in an effort to “make sure everything is in there that should be”. So, what can you do to ease the pain?

While the concept of materiality is not addressed specifically in the GASB standards, by working with your auditors there are a number of ways to reduce the overall length and complexity of the statements. We recommend reviewing your financial statements periodically with your auditor, focusing on the following types of questions:

• On the face of the financial statements, are we breaking out items that are clearly inconsequential in nature and the amount?
• Are there opportunities to combine items where appropriate?
• In the notes to the financial statements are we providing excessive details about insignificant items?
• Do we have an excess amount of historical disclosure from years past?
• In the management’s discussion & analysis, is the analysis completed to an appropriate level? Is there discussion on items that are insignificant?

The spirit behind the box is that GASB was specifically thinking about material amounts and disclosures. It was not their intention to clutter the financials with what their article referred to as “nickel and dime” items. With more disclosure requirements on the way, now might be the time to think INSIDE the box.  

For more guidance on this and other GASB information, please contact Rob Smalley.

Recently, federal banking regulators released an interagency financial institution letter on CECL, in the form of a Q&A. Read it here. While there weren’t a lot of new insights into expectations examiners may have upon adoption, here is what we gleaned, and what you need to know, from the letter.

ALLL Documentation: More is better

Your management will be required to develop reasonable and supportable forecasts to determine an appropriate estimate for their allowance for loan and lease losses (ALLL). Institutions have always worked under the rule that accounting estimates need to be supported by evidence. Everyone knows both examiners and auditors LOVE documentation, but how much is necessary to prove whether the new CECL estimate is reasonable and supportable? The best answer I can give you is “more”.

And regardless of the exact model institutions develop, there will be significantly more decision points required with CECL than with the incurred loss model. At each point, both your management and your auditors will need to ask, “Why this path vs. another?” Defining those decision points and developing a process for documenting the path taken while also exploring alternatives is essential to build a model that estimates losses under both the letter and the spirit of the new rules. This is especially true when developing forecasts. We know you are not fortune tellers. Neither are we.

The challenge will be to document the sources used for forecasts, making the connections between that information and its effect on your loss data as clear as possible, so the model bases the loss estimate on your institution’s historical experience under conditions similar to those you’re forecasting, to the extent possible.

Software may make this easier… or harder.               

The leading allowance software applications allow for virtually instantaneous switching between different models, permitting users to test various assumptions in a painless environment. These applications feature collection points that enable users to document the basis for their decisions that become part of the final ALLL package. Take care to try and ensure that the support collected matches the decisions made and assumptions used.

Whether you use software or not there is a common set of essential controls to help ensure your ALLL calculation is supported. They are:

• Documented review and recalculation of the ALLL estimate by a qualified individual(s) independent of the preparation of the calculation
• Control over reports and spreadsheets that include data that feed into the overall calculation
• Documentation supporting qualitative factors, including reasonableness of the resulting reserve amounts
• Controls over loan ratings if they are a factor in your model
• Controls over the timeliness of charge-offs

In the process of implementing the new CECL guidance it can be easy to focus all of your effort on the details of creating models, collecting data and getting to a reasonable number. Based on the regulators’ new Q&A document, you’ll also want to spend some time making sure the ALLL number is supportable.  

Next time, we’ll look at a lesser known section of the CECL guidance that could have a significantly negative impact on the size of the ALLL and capital as a result: off-balance-sheet credit exposures.

Read this if you are a bank.

Consolidated Appropriations Act
On December 27, 2020, the Consolidated Appropriations Act, 2021 (CAA) was signed into law. For financial institutions, aside from approving an additional $284 billion in Paycheck Protection Program funding, the CAA most notably extended troubled debt restructuring (TDR) relief. Originally provided in Section 4013 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, this relief allows financial institutions to temporarily disregard TDR accounting under US generally accepted accounting principles for certain COVlD-19-related loan modifications. Under the CARES Act, this relief was set to expire on December 31, 2020. The CAA extends such relief to January 1, 2022.

Relief from CECL implementation was also extended from December 31, 2020 to January 1, 2022.

We are here to help
If any questions arise, please contact the financial services team with any questions.

Read this if you are a CFO, CEO, COO, or CLO at a financial institution.

The preparation of financial statements by financial institutions involves a number of accounting estimates, some of which can be quite complex. As these estimates are often a significant focus of audits of those financial statements, financial institution personnel affected by the audit process might benefit from a discussion of the rules auditors need to follow when auditing estimates.

Accounting estimates

Across all industries, there are financial statement items that require a degree of estimation because they cannot be measured precisely. These amounts, called accounting estimates, are determined using a wide array of information available to management. In using such information to arrive at the estimates, a degree of estimation uncertainty exists, which has a direct effect on the risks of material misstatement of the resulting accounting estimates. For financial institutions, common examples of accounting estimates include the allowance for loan losses, valuation of investment securities, allocation of the purchase price in a bank or branch acquisition, and depreciation and amortization of premises and equipment, in addition to intangibles and goodwill. 

For entities other than public companies, the auditing rules are established by the American Institute of Certified Public Accountants’ Auditing Standards Board (ASB). Under these requirements a financial statement auditor has a responsibility to assess the risks of material misstatement for accounting estimates by obtaining an understanding of the following items: 

• The requirements of generally accepted accounting principles (GAAP) relevant to accounting estimates, including related disclosures. 
• How management identifies those transactions, events, and conditions that may give rise to the need for accounting estimates to be recognized or disclosed in the financial statements. In obtaining this understanding, the auditor should make inquiries of management about changes in circumstances that may give rise to new, or the need to revise existing, accounting estimates. 
• How management makes the accounting estimates and the data on which they are based. 

This final item—determining how management has calculated the accounting estimate in question—includes the following specific aspects for the auditor to address:

• the method(s), including, when applicable, the model, used in making the accounting estimate; 
• relevant controls; 
• whether management has used a specialist; 
• the assumptions underlying the accounting estimates; 
• whether there has been or ought to have been a change from the prior period in the method(s) or assumption(s) for making the accounting estimates, and if so, why; and 
• if so, how management has assessed the effects of estimation uncertainty. 

Professional skepticism

When analyzing management’s assessment of the effects of estimation uncertainty, the auditor needs to apply professional skepticism to the accounting estimate by considering whether management considered alternative assumptions, and, if a range of assumptions was reasonable, how they determined the amount chosen was the most appropriate. If estimation uncertainty is determined to be high, this is one indicator to the auditor that estimation uncertainty may pose a significant risk of material misstatement. An identified significant risk requires the auditor to perform a test of controls and/or details during the audit; in other words, analytical procedures and testing performed in previous audits will not suffice. 

CECL considerations

For audits of financial institutions, including those that have implemented the FASB CECL standard as well as those still using the incurred loss method, the allowance for loan losses will likely be deemed a significant risk due to its materiality, estimation uncertainty, complexity, and sensitivity from a user’s perspective.   

Additional factors the auditor needs to consider include whether management performed a sensitivity analysis as part of its consideration of estimation uncertainty as described above, and whether management performed a lookback analysis to evaluate the previous process used. Auditors of accounting estimates are required to do at least a high-level lookback analysis to gain an understanding of any differences between previous estimates and actual results, and to assess the reliability of management’s process. 

Auditing estimate procedures

Procedures for auditing estimates include an evaluation of subsequent events, tests of management’s methodology, tests of controls, and, in some instances, preparation of an independent estimate by the auditor. Tests of management’s method and tests of controls, including auditing the design and implementation of controls, are the most practical and likely procedures to apply to audits of the allowance for loan losses at financial institutions, both under the current guidance and following adoption of the current expected credit loss (CECL) method under Financial Accounting Standards Board (FASB) Accounting Standards Update No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. As FASB has not prescribed a specific model, auditors must be prepared to tailor their procedures to address the facts and circumstances in place at each respective financial institution. 

In addition to auditing management’s estimate, auditors have the responsibility to audit related disclosures, including information about management’s methods and the model used, assumptions used in developing the estimate, and any other disclosures required by GAAP or necessary for a fair presentation of the financial statements. Throughout the audit process, auditors need to continue to exercise professional skepticism to consider what could have gone wrong during management’s process and to assess indicators of management bias, if any. 

For public companies, the Public Company Accounting Oversight Board (PCAOB) specifies auditors must evaluate both evidence that corroborates and evidence that contradicts management’s financial statement assertions in order to avoid confirmation bias. When considering the assessment of risks, as risk increases, the level of evidence obtained by the auditor should increase. As with audits of private companies, the auditor needs to consider whether the data is accurate, complete, and sufficiently precise and detailed to be used as audit evidence.

An added consideration under PCAOB rules is that the auditor is typically opining on the institution’s internal controls as well as its financial statements. This may restrict the results of control testing performed by parties independent of the function being tested from being used as audit evidence from a financial statement audit perspective. For financial institutions, this is often the case with independent loan review, since the loan review is considered part of the institution’s internal control upon which the auditor is opining. 

Supporting evidence

As with the incurred loss method, PCAOB auditing standards will require the auditor consider how much evidence is necessary to support the allowance for loan losses under CECL. All significant components of management’s allowance for loan losses estimate, including qualitative factors, will need to be supported by institution-specific data. If such data is unavailable (for example, because the institution introduces a new type of loan offering), the FASB standard indicates appropriate peer data may be acceptable. In such cases, management and the auditor may need to understand the controls in place at the vendor providing the peer data to determine its reliability. You may provide this information in the form of System and Organization Controls (commonly know as SOC1) reports of the vendor’s system.  

Recently, the International Auditing and Assurance Standards Board revised its auditing rules for estimates, with a goal of enhancing guidance regarding application of the basic audit risk model in the context of auditing estimates. The revised rules require that auditors must separately assess inherent and control risk when obtaining an understanding of controls, identifying and assessing risks, and designing and performing further audit procedures. The ASB seeks convergence of rules both internationally and domestically, and has therefore proposed changes to its requirements for auditing estimates to align with the IAASB revised rules. The ASB’s proposal on these changes indicated they would be effective beginning with audits of fiscal year ending December 31, 2022; the final effective date will be determined in conjunction with its issuance of the final rules.

The best CECL approach 

The best approach to take? Management should discuss planned changes to estimate the process with your auditors to get their perspective on best practices under CECL. Key areas to review in the discussion include documenting the decision-making process, key players involved, and the resulting review and approval process (especially for changes to methods or assumptions). Always retain copies of your final documentation for auditor review. If you would like more information, or have a specific question about your situation, please contact the team. We’re here to help. 

On June 16^th the FASB issued the final standard for credit losses. We’ve analyzed the new standard and pulled together some key items you’ll need to know:

It looks like you should be able to implement CECL without purchasing expensive third-party models, if your institution is able to get adequate historical data from your core system and has the personnel available to crunch the numbers. Following is one approach that should pass muster with regulators (and, hopefully, the PCAOB):

1. Determine loans for which specific reserves are appropriate, much as you are currently doing. The notion of “impaired” loans goes away; a loan should be evaluated specifically if the institution becomes aware of loan-specific information indicating it has an exposure to loss that differs from other loans it would otherwise be pooled with. In practice, we think that’ll be largely the same loans that are currently being identified as impaired.
2. For the rest of the portfolio: Group loans by common characteristics – same as you’re doing now.
   1. For each group, create subgroups for each origination year. It looks like current year and previous four years are the critical ones to focus on; anything older than five years could probably be lumped together.
   2. For each subgroup, establish economic and other relevant conditions for the average term of loans in the subgroup. This includes actual conditions from year of origination to the present, forecasted conditions for the near future, and long-term historical conditions for the remaining average loan term
      • Select an historical loss period that best approximates the conditions established in (b) above.
      • Determine average lifetime chargeoffs for that historical loss period for each loan type
      • Adjust that average for any current or expected conditions that you believe are different from this historical data.  Such adjustments should be based on the institution’s chargeoff experience when similar conditions occurred in the past.  An example might be an actual or expected decline in real estate values that you believe is more pronounced than in the historical loss period chosen.

While not specifically mentioned in the guidance, we believe a modest unallocated allowance is still supportable, especially since imprecision is certainly higher when factoring in expected losses in addition to incurred losses.
 

Other points that caught our eye:

1. The guidance applies to purchased loans with credit deterioration, as well as originated loans. That will create more comparability in terms of the allowance as a % of loans for institutions that have done acquisitions vs. those who haven’t. An interesting twist, though – for acquired loans that have experienced a more-than-insignificant deterioration in credit quality since origination, the allowance established is simply an adjustment to (ultimately) the premium or discount, while for other loans acquired in the transaction, an allowance is established with an offset to loan loss expense at acquisition. 
2. The guidance applies to held-to-maturity debt securities, and there’s specific guidance that affects the accounting for available-for-sale debt securities as well. These will likely only come into play for institutions with private-label mortgage-backed securities and/or corporate bonds. However, some of the CECL disclosure requirements apply to securities as well; in particular, the one that caught our eye was the requirement in ASC 326-20-50-5 to disclose credit quality indicators (e.g., S&P ratings) for securities as well as loans.
3. Surprisingly, you continue to assume no change in future interest rates for purposes of establishing expected credit losses for specific variable rate loans. We think FASB may have missed the boat on this one, as resetting ARMs were one of the factors that led to the 2008 crisis that CECL is intended to be responsive to.
4. There will obviously be much, much more dialogue about these new rules, and we’ll need to begin the process of helping you understand them and prepare for implementation sooner rather than later.

Please call us if you have any questions.

When last we blogged about the Financial Accounting Standards Board’s (FASB) new “current expected credit losses” (CECL) model for estimating an allowance for loan and lease losses (ALLL), we reviewed the process for developing reasonable and supportable forecasts for use in establishing the ALLL. Once you develop those forecasts, how does that information translate into amounts to set aside for loan losses?

A portion of the ALLL will continue to be based on specifically identified loans you’re concerned about. For those loans, you will continue to establish a specific component of the ALLL based on your estimate of the loss ultimately expected on the loans.

The tricky part, of course, is estimating an ALLL for the other 99% of the loan portfolio. This is where the forecasts come in. The new rules do not prescribe a particular methodology, and banking regulators have indicated community banks will likely be able to continue with their current approach, adjusted to use appropriate inputs in a manner that complies with the CECL model. One of the biggest challenges is the expectation in CECL that the ALLL will be estimated using the institution’s historical information, to the extent available and relevant.

Following is just one of many ways  you can approach it. I’ve also included a link at the end of this article to an example illustrating this approach.

Step One: Historical Loss Factors

1. First, for a given subset of the loan portfolio (e.g., the residential loan pool), you might first break down the portfolio by the number of years remaining until expected payoff (via maturity or refinancing). This is important because, on average, a loan with seven years remaining until expected payoff will have a higher level of remaining lifetime losses than a loan with one year remaining. It therefore generally wouldn’t be appropriate to use the same loss factor for both loans.
    
2. Next, decide on a set of drivers that tend to correlate with loan losses over time. FASB has indicated it doesn’t expect highly mathematical correlation models will be necessary, especially for community banks. Instead, select factors in your bank’s experience indicative of future losses. These may include:
   • External factors, such as GDP growth, unemployment rates, and housing prices
   • Internal factors such as delinquency rates, classified asset ratios, and the percentage of loans in the portfolio for which certain policy exceptions (e.g., loan-to-value ratio or minimum credit score) were granted
      
3. Once you select this set of drivers, find an historical loss period — a period of years corresponding to the estimated remaining life of the portfolio in question — where the historical drivers best approximate those you’re expecting in the future, based on your forecasts. For that historical loss period, determine the lifetime remaining loss rates of the loans outstanding at the beginning of that period, broken down by the number of years remaining until payoff. (This may require significant data mining, especially if that historical loss period was quite a few years ago.
    
4. Apply those loss rates to the breakdown derived in (a) above, by years remaining until maturity.

   Step Two: Adjustments to Historical Loss Rates

   The CECL model requires we adjust historical loss factors for conditions that may not be adequately captured by the historical loss period analysis we’ve just described. Let’s say a particular geographical subset of your market area is significantly affected by the economic fortunes of a large employer in that area.  Based on economic trends or recent developments, you might expect that employer to have a particularly bright – or dim – future over the forecast period; accordingly, you forecast loans to borrowers in that area will have losses that differ significantly from the rest of the portfolio.

   The approach for these loans is the same as in the previous step. However:

   These loans would be segregated from the remainder of the portfolio, which would be subject to the general approach in step one. As you think through this approach, there are myriad variations and many decisions to make, such as:

   Our intent in describing this methodology is to help your CECL implementation team start the dialogue in terms of converting theoretical concepts in the CECL model to actual loans and historical experience.

   To facilitate that discussion, we’ve included a very simple example here that illustrates the steps described above. Analyzing an entire loan portfolio under the CECL model is an exponentially more complex process, but the concepts are the same — forecasting future conditions, and establishing an ALLL based on the bank’s (or, when necessary, peers’) lifetime loan loss experience under similar historical conditions.

   Given the amount of number crunching and analysis necessary, and the potentially significant increase in the ALLL that may result from a lifetime-of-loan loss model, it’s safe to say the time to start is now! If you have any questions about CECL implementation, please contact Tracy Harding or Rob Smalley.

   Other resources
   For more information on CECL, check out our other blogs:

   CECL: Where to Start
   CECL: Bank and Branch Acquisitions
   CECL: Reasonable and Supportable

   To sign up to receive notification of our next CECL update, click here.

   • In substep (c), you would focus on forecasted conditions (such as unemployment rate and changes in real estate values) in the geographical area in which the significant employer is located.
   • You would then select an historical loss period that had actual conditions for that area that best correspond to those you’ve just forecasted.
   • In substep (d), you would determine the lifetime remaining loss rates of loans outstanding at the beginning of that period.
   • In substep (e), you would apply those rates to loans in that geographic area.
   • How to break down the portfolio
   • Which conditions to analyze
   • How to analyze the conditions for correlation with historical loss periods
   • Which resulting loss factors to apply to which loans

By now, pretty much everyone in the banking industry has heard plenty of talk about CECL – the forthcoming “Current Expected Credit Loss” model of accounting for an institution’s allowance for loan losses (ALL). While the previous “Incurred Loss” model has been problematic to implement conceptually, and most of us thought CECL would improve ALL accounting and make it more comparable to how banks account for other debt instruments, it’s beginning to feel a bit like the dog who caught the car – now that we have this model, how the heck do we implement it?

The good news: We have a number of years before CECL’s effective date, and thus have some time to better understand the new rules and how to adapt an institution’s ALL model to reflect them. The bad news – the banking regulators recently announced they want banks to get cracking on this, and will expect to see some progress when they visit during upcoming exams – maybe not immediately, but likely at some point during the 2017 exam cycle.

This is the third in a series of articles addressing various aspects of this complex pronouncement. We hope that they provide you with practical advice that can help you get started on the nuts and bolts of CECL implementation.

Our previous article offered pointers on building the CECL team, brainstorming the process, and starting the data gathering conversation. In this article, we look at how to implement CECL when acquiring another bank, one or more branches of another bank, or simply a loan portfolio, such as a group of auto or credit card loans.

First, let’s remember the basics

The basic premise of CECL is that lifetime expected losses are to be booked at origination (or, in the case of an acquisition, at the acquisition date). You’ve likely heard some gnashing of teeth over the fact that this means losses are recorded “on Day One”, which many of us have some degree of conceptual difficulty with: For example, a higher risk loan will likely carry a higher yield at origination, so booking a higher level of expected losses on Day One (through the ALL) and the offsetting higher yield over the loan term (through interest income) feels like a mismatch between income and expense.

The Financial Accounting Standards Board (FASB) was sympathetic to this point, and spent a lot of time pondering it. Its international equivalent, the International Accounting Standards Board (IASB), which establishes – you guessed it – international accounting standards, actually tackled this issue by precluding Day One losses, unless they were expected to materialize within one year of origination (Day 365 losses?).

This approach, however, has led to a fairly convoluted – and challenging – model, which is already drawing a fair amount of criticism in the international community. In the end, although they had hoped to have a “converged” standard that would result in the same approach for U.S. and international institutions, FASB and the IASB decided to part company and use different models.

The short answer? We have to accept the notion of Day One losses as the price to pay for a less convoluted (but still complex to implement) model. This becomes important to remember as we look at accounting for acquisitions.

Accounting for acquisitions

Whether you’re acquiring a pool of loans, a branch, or an entire institution, the basic accounting under CECL is the same, and it’s the same (with a twist) as the accounting for originated loans: an ALL should be established for the purchase price allocated to the loans, and that ALL should reflect management’s estimate of the lifetime losses in the acquired portfolio.

Before we get into the details of how to do this, let’s take a moment to celebrate. Prior to CECL, it was not permissible to establish an initial ALL for acquired loans. Many bankers – and investors – complained that this made it difficult to compare one bank to another on metrics such as ALL coverage ratios. If one bank had a strategy that included acquisitions, and another didn’t, their ALLs would likely be quite different even if their loan portfolios and estimated incurred losses were similar. Now, with the CECL model, these two banks’ financial statements are much easier to compare.

As noted above, an ALL should be established for these loans under CECL, using the same methodology you would use for originated loans. The twist relates to what to do with the other side of the entry. The solution:

• For loans with a more-than-insignificant amount of credit deterioration since origination, the offset is to add this amount to the amount originally recorded for the purchase price allocated to the loans.

• For the rest of the acquired portfolio, the offset is to loan loss expense. That’s right, your provision is increased by the amount of ALL recorded in the transaction, except as noted in the previous bullet.

Why is this so? FASB is apparently assuming that:

• Buyers adjust the purchase price for the first item above. These loans, which we used to call “purchased – credit impaired (PCI)”, and now will call “purchased – credit deteriorated (PCD)” under CECL, are the loans with hair on them. They probably got some extra scrutiny during due diligence, thus theoretically depressing the purchase price a bit. Therefore, the amount of the purchase price allocated to loans is a lower number, and offsetting the establishment of the ALL by adding that amount to the purchase price assigned to the loans properly “grosses up” the recorded loan balance.

• Buyers don’t adjust the purchase price for other loans. This is probably true, as the lifetime losses on loans that aren’t PCD are just the cost of doing business for financial institutions. Therefore, as it is with originated loans, a big Day One provision is booked at closing.

It should be noted that the extent to which the definition of PCD loans differs from the previous definition of PCI loans depends on your interpretation of the old PCI definition. It appears clear that the new definition of PCD loans refers to loans that have specific indicators of significant credit deterioration since origination.

Let’s look at an example:

A bank buys three branches from another bank, which have total loans with a principal balance of $20 million and a fair value of $20,100,000. The portfolio includes loans with a principal balance of $1 million, and a fair value of $910,000, that are PCD.

The buyer bank determines the ALL under CECL would be $100,000 for the PCD loans and $475,000 for the rest of the acquired portfolio. Thus, the buyer bank records an ALL of $575,000. What’s the offset? As noted above:

• For the PCD loans, the offsetting $100,000 will be added to the $910,000 of purchase price allocated to those loans. As a result, these loans will have a gross amount allocated of $910,000 plus $100,000, or $1,010,000, which will then be reduced by an ALL of $100,000 on the balance sheet, for a net reported amount of $910,000 (their fair value). The difference between the gross amount assigned ($1,010,000) and the principal balance ($1 million), or $10,000, represents an implied adjustment to reflect current market interest rates, and is therefore amortized over the expected loan term through interest income.

• For the rest, the offsetting $475,000 will be an increase to the provision for loan losses, and will thus reduce income.

The last number could be a big one for institutions that do large or frequent acquisitions; thus, their balance sheets may be more comparable to other banks, but their income statements in the year of acquisition won’t be! The good news – like other acquisition costs such as legal fees and conversion expenses, this amount will be separately disclosed, so a reader can adjust for it if they believe it’s appropriate to do so.

Next time, we’ll look at the nuts and bolts of CECL’s concept of “reasonable and supportable” by considering proper documentation and controls over the ALL.

On June 16th the FASB issued the final standard for credit losses. We’ve analyzed the new standard and pulled together some key items you’ll need to know:

It looks like you should be able to implement CECL without purchasing expensive third-party models, if your institution is able to get adequate historical data from your core system and has the personnel available to crunch the numbers. Following is one approach that should pass muster with regulators (and, hopefully, the Public Company Accounting Oversight Board (PCAOB)):

1. Determine loans for which specific reserves are appropriate, much as you are currently doing. The notion of “impaired” loans goes away; a loan should be evaluated specifically if the institution becomes aware of loan-specific information indicating it has an exposure to loss that differs from other loans it would otherwise be pooled with. In practice, we think that’ll be largely the same loans that are currently being identified as impaired.
2. For the rest of the portfolio:
   Group loans by common characteristics – same as you’re doing now.
    

   a.	For each group, create subgroups for each origination year. It looks like current year and previous four years are the critical ones to focus on; anything older than five years could probably be lumped together.
   b.	For each subgroup, establish economic and other relevant conditions for the average term of loans in the subgroup. This includes actual conditions from year of origination to the present, forecasted conditions for the near future, and long-term historical conditions for the remaining average loan term.
   	•	Select an historical loss period that best approximates the conditions established in (b) above.
   	•	Determine average lifetime chargeoffs for that historical loss period for each loan type.
   	•	Adjust that average for any current or expected conditions that you believe are different from this historical data.  Such adjustments should be based on the institution’s chargeoff experience when similar conditions occurred in the past.  An example might be an actual or expected decline in real estate values that you believe is more pronounced than in the historical loss period chosen.

While not specifically mentioned in the guidance, we believe a modest unallocated allowance is still supportable, especially since imprecision is certainly higher when factoring in expected losses in addition to incurred losses.

Other points that caught our eye:

1. The guidance applies to purchased loans with credit deterioration, as well as originated loans. That will create more comparability in terms of the allowance as a % of loans for institutions that have done acquisitions vs. those who haven’t. An interesting twist, though – for acquired loans that have experienced a more-than-insignificant deterioration in credit quality since origination, the allowance established is simply an adjustment to (ultimately) the premium or discount, while for other loans acquired in the transaction, an allowance is established with an offset to loan loss expense at acquisition.
2. The guidance applies to held-to-maturity debt securities, and there’s specific guidance that affects the accounting for available-for-sale debt securities as well. These will likely only come into play for institutions with private-label mortgage-backed securities and/or corporate bonds. However, some of the CECL disclosure requirements apply to securities as well; in particular, the one that caught our eye was the requirement in ASC 326-20-50-5 to disclose credit quality indicators (e.g., S&P ratings) for securities as well as loans.
3. Surprisingly, you continue to assume no change in future interest rates for purposes of establishing expected credit losses for specific variable rate loans. We think FASB may have missed the boat on this one, as resetting ARMs were one of the factors that led to the 2008 crisis that CECL is intended to be responsive to.

There will obviously be much, much more dialogue about these new rules, and we’ll need to begin the process of helping you understand them and prepare for implementation sooner rather than later.

Please call us if you have any questions.