CECL & Acquisitions: Considering the Impact of Tomorrow’s Standard on Today’s Acquisitions
Among the many changes to accompany the impending Current Expected Credit Loss (CECL) accounting standard is how assets purchased through an acquisition are evaluated for credit loss and the accompanying allowance. Even current acquisitions, with loans and associated losses accounted for under the incurred loss standard, should be considered for how they will be treated under CECL. Among key considerations: the need to retain data on acquired loans, how CECL’s “purchased with credit deterioration” loans differ from today’s “purchased credit impaired” loans, and how acquired loan losses might impact capital and subsequently dividends.
According to Mike Lundberg, CPA, a partner at RSM US, an acquiring lender will need to treat acquired loan data differently, or at least more cautiously. “Currently, in most cases, after acquisition and system conversion, the old data is simply not retained. CECL modeling and the related disclosures will require a longer look-back on loans, to origination. The acquirer will need to have that data available.”
Most critical to evaluating loans for purchase is the difference in how CECL defines and treats loans with declines in credit quality as compared to today’s accounting model. Under the new standard, purchase credit deteriorated (PCD) loans are loosely defined, but can be characterized by at least one of three factors: delinquency as of the acquisition date, a risk rating that has been downgraded since origination, or nonaccrual status or identified as criticized or classified loans for regulatory purposes. According to the FASB guidance, PCD loans are defined by “a significant difference between the contractual cash flows and expected cash flows.” That, according to Lundberg, is a much broader definition than applied to purchase credit impaired (PCI) loans under incurred loss accounting.
“More loans will qualify as PCD than PCI,” he said. “Under the new standard the significance of credit deterioration will be measured from origination of the asset. As well, the acquirer will need to determine how to define ‘significant’ for the institution and how to operationalize it. Is it a fifty-point drop in FICO score or a hundred? Is it a change in collateral value or debt service ratio or both? There is an accounting policy component that should be consistently applied.”
The PCD allowance is an important consideration in planning and modeling the acquisition transaction, Lundberg pointed out. Expected losses on acquired PCD loans will be recorded directly to the allowance for loan losses, with the offset recorded to loans, with no income statement impact. For the acquired, non-PCD loans, the expected losses will also be recorded in the allowance for loan losses, but the offset recorded to credit loss expense.
On a large acquisition, the recording of expected credit losses could result in a meaningful net loss for the year, Lundberg explained. That could result in reductions in capital and restrictions on dividend payments.
“The losses incurred with the acquisition reduce the funds you have for dividend distributions. In the case of a large acquisition by an S corporation, where earnings and losses flow through to the shareholders, it could leave the shareholders with substantial taxable earnings and no dividend distributions to offset the related tax burden – an unfortunate surprise if it’s unanticipated.”
Accounting shouldn’t drive the economics of an acquisition, Lundberg asserted. Still, banks need to be well informed of accounting implications to avoid surprises
“There’s no strategy for mitigating the impact of CECL on acquisitions. Lenders simply need to understand the implications of the accounting issues on the assets they are acquiring.”
About Mike Lundberg, CPA
Mike Lundberg is the National Director of Financial Institution Services for RSM US LLP (formerly McGladrey LLP). In this role, Mike has responsibility for audit, accounting and risk containment matters across the firm’s financial institution practice, which includes community banks, credit unions, finance and leasing companies, and other specialty lenders. He has worked with a variety of financial institutions, with a primary focus on large community banks.
Many thanks to Mike for sharing his expertise in this article.