How CECL affects financial institutions acquisition accounting
With acquisition activity gaining traction in the banking industry, it is important for institutions that plan to grow via acquisition to consider how adoption of the current expected credit loss (CECL) model, or Accounting Standards Codification (ASC) 326, will affect accounting for loans, securities and other affected instruments at the target institution. Acquirers will need a solid understanding of the target’s CECL modeling decisions (which may be different from your own), as well as an understanding of the impact on the provision for loan losses resulting from the acquisition of performing loans required under CECL, which will likely affect capital requirements following the acquisition and the internal rate of return from the deal. Keep in mind that deals often take several months to complete, so information gathered at the start of the process will likely change before closing. Additionally, the new CECL accounting guidance changes purchase accounting in a business combination for financial assets with credit deterioration. Other purchase accounting rules are still applicable.
First, here are a few reminders regarding timing and the basic concepts of CECL.
The following are the effective dates for CECL:
- For Securities and Exchange Commission (SEC) filers, fiscal years beginning after Dec. 15, 2019, including interim periods (2020 for calendar year-end)
- For public business entities that are not SEC filers, fiscal years beginning after Dec. 15, 2020, including interim periods (2021 for calendar year-end)
- For all others, fiscal periods beginning after Dec. 15, 2020, interim periods beginning after Dec. 15, 2021 (2022 for calendar year-end)
- Early adoption is permitted for fiscal years beginning after Dec. 15, 2018 (2019 for calendar year-end)
CECL requires financial institutions to recognize expected credit losses over the life of an asset on day one through an allowance for recognized financial assets, which has been expanded to include held-to-maturity (HTM) debt securities or through a liability for any off balance sheet exposure. This is in contrast to the current incurred loss requirement applied to the loan portfolio. Allowance disclosures and roll forwards as well as disclosure of past-due and nonaccrual assets will continue to be required and now also apply to HTM securities.
Treatment of acquired loans under purchase accounting
Currently, under purchase accounting rules, the acquired loans are marked to fair value by the acquiring institution. The fair value marks consist of yield and credit components. As these loans are marked to fair value there is no allowance for loan and lease losses (ALLL) carried over on day one for the acquired loans. The majority of acquisitions in recent years have involved primarily non-impaired loans. For these loans, the acquiring bank accretes the total fair value discount from day one into earnings over the life of the acquired loans, and an increase in the ALLL needs to be considered. (The accounting is different for purchased credit impaired loans as essentially only the yield mark can be accreted).
Under CECL, for loans considered non-purchase credit deteriorated (non-PCD), the acquiring bank will still mark the loans to fair value, taking into consideration both credit and yield at acquisition. However, the acquiring bank will also have to include in the combined banks’ ALLL the expected credit loss on the acquired loans, affecting the income statement in the quarter of acquisition. The acquiring bank will still accrete the fair value mark discount, both credit and yield, into earnings. Due to these changes, a buyer needs to take into consideration capital on day one and the return on an acquiring institution’s investment as they will both likely be negatively affected. See the examples below.
Purchase credit deteriorated (PCD) assets is a new concept introduced with CECL. PCD refers to financial assets with credit deterioration at purchase. During the transaction, the acquirer is likely to acquire loans or other assets that have suffered credit deterioration since their origination; therefore, it is imperative for financial institutions to understand how to account for PCDs.
Which loans of the target should be classified as PCDs?
- A loan that is delinquent as of the acquisition date
- A loan that has experienced downgrades to the risk rating since origination
- A loan that is in nonaccrual status or that has been identified as a criticized or classified loan for regulatory purposes
The key change with the implementation of the concept of PCD loans is that when they are acquired in a transaction the only fair value mark component considered is related to yield, not credit. This differs from non-PCD loans, the fair value mark for which, as stated above, has both a credit and yield component. Similar to non-PCD loans, an adjustment is made to the ALLL for the expected loss, however in the case of PCD loans, the acquisition date allowance does not impact the income statement. The following examples illustrate the differences in pre-tax treatment between PCD and non-PCD loans at acquisition.
Assume a financial institution acquires a loan that is a non-PCD loan with a current outstanding amount of $1 million, for which the acquirer pays $950,000. At the date of acquisition, the allowance for credit losses on the unpaid principal balance is estimated at $40,000. The acquisition date journal entry would be as follows:
Now assume a PCD loan, also with an outstanding amount of $1 million, was acquired for $750,000 with an expected allowance for credit loss of $175,000, the acquisition date journal entry would appear as follows:
CECL—Differences between acquirer and target
As an acquirer, there are additional matters to keep in mind during due diligence, including how the acquirer is modeling the combined institution on a pro forma basis:
- Which loans of the target will be treated as PCD and non-PCD? What is the corresponding impact on capital and projected earnings?
- What methods has the target used to account for their loans under CECL? If those methods differ from the method used by the acquirer, what impact will this have on the ALLL and what issues could this cause from an implementation standpoint?
- What assumptions are being used by the target, and are they reasonable and supportable? Will adjustments be made to these assumptions post-acquisition?
- How adequate and accurate is the historical performance information compiled by the target?
- What impact will the above matters have on the combined institution? Will additional capital be needed? How are the expected return on investment and payback periods affected?
- As institutions complete acquisitions, what impact will the acquired loans versus legacy loans have on the ALLL post-CECL?
- Is adequate information available to meet full disclosure requirements following the acquisition?
While an institution still has time before the implementation of CECL, as you plan your acquisition strategy it is important to keep these questions in mind. Also, in the near term it is key for acquisition institutions to be aware of how targets have started preparing for CECL and what information they have started to gather. If an institution is planning to sell, taking a proactive approach in CECL readiness and information gathering can lead to a more efficient and beneficial sales process.
CECL will be a significant accounting change for financial institutions. Understanding the new CECL purchase accounting changes and their impact on any transaction, from both a seller and buyer standpoint, is important for effective implementation.