2013 Financial Institutions Conference Loan Acquisition Accounting

Size: px

Start display at page:

Download "2013 Financial Institutions Conference Loan Acquisition Accounting"

Loreen Baldwin
6 years ago
Views:

1 2013 Financial Institutions Conference Loan Acquisition Accounting

2 Today s Objectives Understand main drivers/inputs in initial valuation (Day 1) Understand how impact of those drivers/inputs impact go-forward performance/reporting (Day 2) Understand impact of purchase accounting marks on financial statements Briefly discuss operational risks 2013 Crowe Horwath LLP 2

3 Fair Value of Loans On date of acquisition ( Day 1 ), allowance for target entity goes away Prior to FAS 141R, Business Combinations, codified as ASC 805, credit risk was generally believed to be captured in allowance carried over from seller s books On Day 1, all acquired loans will be re-measured at fair value which considers: Interest rate risk Credit risk Liquidity risk Currency risk Other risks 2013 Crowe Horwath LLP 3

4 Fair Value of Loans Cash flows are influenced by: Interest rate risk Risk due to variability of interest rates Longer term loans carry higher rates Credit risk Risk of loss arising from a borrower who defaults Liquidity risk is market dynamic grounded in supply and demand and does not factor into cash flows generated by asset Fair value can be decomposed into two components: Market price for expected cash flow performance Market price to compensate for liquidity and other risks Expected cash flows are related to unique risk factors of asset Valuation is typically based on discounted cash flows, but market and collateral approaches may be used to estimate fair value of loans 2013 Crowe Horwath LLP 4

5 Fair Value of Loans Market Approach Market Approach FDIC loan transactions Broker quotes Note sales with third parties Considerations for Determining Fair Value Location, collateral value, FICO, type, vintage, remaining terms, coupon rate May include significant illiquidity discounts Liquidation value vs. fair value Inefficient market 2013 Crowe Horwath LLP 5

6 Fair Value of Loans Income Approach Assumptions Prepayment Rates Credit Risks Default probabilities Loan to value ratio (LTV), FICO score, cure rate, past dues, delinquencies, etc. Should be based on comparable vintage data (i.e. default probabilities for 2007 vintage, 2008 vintage, etc.) Timing of default Severity or loss given default (LGD) Collateral values, guarantees, insurance (i.e., PMI), selling, administrative, maintenance expenses, etc. Liquidity risks Illiquidity discount can be embedded in discount rate or collateral value 2013 Crowe Horwath LLP 6

7 Good versus Bad Assets On Day 1 and thereafter acquired portfolio will be segregated Bad loans Loans that qualify as purchased credit impaired (PCI) loans ASC , Loans and Securities Acquired with Deteriorated Credit Quality (fka SOP 03-3) Good loans All other loans considered Good loans ASC , Accounting for Nonrefundable Fees and Costs, (fka FAS 91) No non-accretable differences associated with these loans Different Day 2 Income Recognition PCI assets are accounted for based on future cash flow projections with accretion recognized over expected cash flow period (independent of contractual period) Discount on non-pci assets are accreted/amortized over contractual maturity of assets 2013 Crowe Horwath LLP 7

8 PCI Accounting: Background and Scope Conceptual need for model Purchased loans (and debt securities) result in new basis of accounting Inappropriate to recognize full amount of contractual cash flows as income when do not expect to collect all contractual cash flows This is significantly different model than originated loan accounting Basic premise is to recognize income based on expected, rather than contractual, cash flows Generally requires education of users 2013 Crowe Horwath LLP 8

Illustration: Separating The Cash Flows (CFs) for PCI Difference between contractual and expected total CFs is considered nonaccretable Day 1 Fair Value $7,000 (Contractual Payments^) $6,000

9 Illustration: Separating The Cash Flows (CFs) for PCI Difference between contractual and expected total CFs is considered nonaccretable Day 1 Fair Value $7,000 (Contractual Payments^) $6,000 (Expected CFs) $4,500 (Discounted CFs) Difference between expected total CFs and Day 1 FV is future yield (accretable yield) ^Contractual payments include all contractual interest and principal payments 2013 Crowe Horwath LLP 9

10 PCI Accounting: What is in? What is out? Three criteria must be met (and all three must be met) Evidence of credit deterioration - something had to have happened Red Flags: delinquent loan, non-accrual status, classified credit, TDR Completed transfer in accordance with ASC 860, Transfers and Servicing Does not apply to originated loans Buyer doesn t expect to collect all contractual cash flows Need to consider materiality 2013 Crowe Horwath LLP 10

11 PCI Accounting: Scope Excludes: Originated loans Leases HFS mortgages Revolving credits with credit privileges Retained interests Investments where FV option has been elected Includes: Business combinations Non mortgage loans HFS Revolving credits suspended Debt Securities If asset is not in PCI accounting, how is purchased discount handled? ASC , Accounting for Nonrefundable Fees and Costs (formerly FAS 91) which requires entire discount be accreted to income over life of asset 2013 Crowe Horwath LLP 11

12 PCI Accounting: Importance of Day 1 Cash Flows Decisions made on Day 1 are critical to Day 2 events Open discussion of known and potential problem credits Important to provide best estimate of expected cash flows Determination of complete population Lack of appropriate identification typically results in Day 2 provision volatility Cash flows used in Day 1 valuation are cash flows that will be utilized to measure actual performance on Day 2 Negative changes in Day 2 cash flows results in impairment recorded via provision for loan losses Lenders/credit team need to understand cash flows used in Day 1 valuations on PCI loans 2013 Crowe Horwath LLP 12

13 PCI Accounting: Application to Pools SEC does not object to application of ASC to pools acquired with discount attributable, at least in part, to credit quality For assembling pools, management must follow established pooling criteria under ASC The aggregation shall be based on common risk characteristics that include similar credit risk or risk ratings, and one or more predominant risk characteristics. Loans with similar credit risk (for example, evidenced by similar FICO scores) or risk ratings, and one or more predominant risk characteristics, such as financial asset type, collateral type, size, interest rate, date of origination, term, and geographic location. Collateral type Regulators expect pooling to start at granularity required by Call Report Schedule RC-C For certain collateral types, especially commercial loans, greater granularity may be required to identify common risk characteristics Regulators mentioned large non-homogeneous credits may not be good for pooling Regulators will have more questions on pools of commercial loans 2013 Crowe Horwath LLP 13

14 Non-PCI Loan Valuation Discounted Cash Flow Model based on: Market participant views on discount rates Expectations for credit losses either as separate cash flow projection (e.g., ratings agencies) or built into discount rate (akin to corporate bond credit spread) Other adjustments for liquidity or specific loan pool issues Typical discounts on non-pci loans ranged up to 10% in past, but trend has been changing with low rate environment and improving credit quality 2013 Crowe Horwath LLP 14

15 Example: PCI Accounting A look at debits and credits for PCI accounting 2013 Crowe Horwath LLP 15

16 Example Purchase of a loan with credit problems Purchased at discount, due to credit problems Accrue income from discount based on expected (not contractual) cash flows Facts: Contractual amount of loan is $7,000 Expected cash payments is $6,000 Cash paid is $4, Crowe Horwath LLP 16

17 G/L Accounts and Balance Sheet Day 1 General Ledger accounts: Contractual Payments Receivable $ 7,000 Nonaccretable Difference (1,000) Accretable Yield (1,500) Net Loans Receivable $ 4,500 Balance Sheet presentation: Loans Receivable $ 4,500 ALLL 0 Net Loans Receivable $ 4, Crowe Horwath LLP 17

18 Entries Loan (Total Cash Flows) $7,000 Nonaccretable difference $1,000 Accretable yield $1,500 Cash $4,500 To record purchase. Accretable yield $ 25 Income $ 25 To accrue income. Credit balance stays frozen Accrue $1,500 of income over life of loan 2013 Crowe Horwath LLP 18

19 Example Loan Improves Lender determines it will collect $6,500 in payments instead of $6,000 Nonaccretable difference $500 Accretable yield $500 To record increase in expected cash flows. Balance sheet reclassification; no impact to income Increase is recognized prospectively through increased yield Accretable yield $33 Income $33 To accrue income (increases yield over remaining expected life) 2013 Crowe Horwath LLP 19

20 Example Loan Goes South Lender determines it will collect $5,000 in payments instead of $6,000 Bad Debt Expense $750 ALLL $750 Accretable yield $250 Nonaccretable difference $250 To record decrease in expected cash flows Note interaction with ALLL Accretable yield $21 Income $21 To accrue income (decreases yield over remaining life of loan) 2013 Crowe Horwath LLP 20

21 Example Loan Pays-off in Full, Above Expectations Lender collects $6,050 in unexpected contractual payoff Cash $6,050 Non-accretable difference $1,000 Accretable yield $1,500 Loan (original total cash flows) $7,000 Income $1,550 To recognize income associated with collection of total contractual cash flows Note: If occurs in business combination shortly after acquisition, one might question valuation estimate initially recorded if within 1-year measurement period 2013 Crowe Horwath LLP 21

22 Day 2 Considerations PCI (Bad) Loans Individual analysis versus pooled analysis Pools Pros: Less I/S volatility Cons: I/S volatility is short-term in nature and unwinding can be troublesome, difficult to explain to users, hard to track for tax purposes Determination of system flags Typically easier to place PCI loans as non-accrual on core system (but can t place PCI loans on nonaccrual to avoid income recognition model) Prevents double counting of accretion income and contractual interest income Should be coordinated with any loan accounting system put into place 2013 Crowe Horwath LLP 22

23 Day 2 Considerations Non-PCI (Good) Loans Purchased premiums/discounts are amortized/accreted over contractual life using constant effective yield Easier to put on system and set it and forget it Difficult to calculate constant effective yield manually Typically use valuation to then apply on loan-by-loan basis Allocation of discount Refinancing rules If new loan (change in DCF > 10%) then immediately recognize remaining premium/discount If non-tdr loan modification (change in DCF < 10%) remaining premium/discount will be carried forward to modified loan 2013 Crowe Horwath LLP 23

24 Financial Reporting Accrual status - How are acquired loans seller had on non-accrual handled? ASC does not prohibit placing (or keeping) loans on non-accrual, if conditions in Subtopic 35-3 are met Must be able to reasonably estimate timing and amount of future cash flows For example, if the timing of either a sale of the loan into the secondary market or a sale of loan collateral in essentially the same condition as received upon foreclosure is indeterminate, the investor likely does not have the information necessary to reasonably estimate cash flows expected to be collected to compute its yield and shall cease recognizing income on the loan. However, the ability to place a loan on nonaccrual shall not be used to circumvent the loss recognition guidance. Acquired TDRs are no longer classified as TDRs Still might be PCI loan Acquired non-accrual loans will be on accrual status to extent timing and amount of future cash flows can be reasonably estimated Will continue to report past due status based on contractual agreements 2013 Crowe Horwath LLP 24

25 Financial Reporting Various financial metrics/disclosures are no longer comparable Allowance for loan losses/loans Non-performing and impaired credit metrics (PCI loans performing as expected?) Fair value disclosures Metrics shouldn t be viewed in absolute values, but need to examine in relation to original amounts and/or expectations Allocations for non-pci and PCI loans Public companies should have: MD&A discussion on impact on credit metrics, trends (including comparability to prior periods and other banks) Disclosures of policies on how PCI loans are considered for non-accrual/impairment One year measurement period SEC encourages disclosure of what is still open and what is final Should generally be used on an exception basis Restate Day 1 prospectively, if changes are not material 2013 Crowe Horwath LLP 25

26 Regulatory Considerations Regulators expect management to take responsibility for pooling decisions and recommend having dialogue with external auditors in advance of establishing pools Regulatory reporting Call reports and instructions now include consideration of PCI loans Determine delinquency status in accordance with contractual repayment terms Determine nonaccrual status in accordance with existing nonaccrual guidance Under ASC (SOP 03-3), PCI loans may be placed in nonaccrual status in absence of reasonable expectation about amount and timing of cash flows to be collected 2013 Crowe Horwath LLP 26

27 Tax Considerations Day 1 tax basis assigned to acquired loans may differ from book value assigned Day 2 recognition of interest income and credit losses may be timed very differently for tax than for book Traditional loan accounting systems may not be able to provide data necessary to identify and track book-to-tax differences Problem is only timing in nature but risks understating taxable income in early years, leading to potential additional tax, interest and penalties upon tax authority audit 2013 Crowe Horwath LLP 27

28 Operational Support Typically following departments are utilized for Day 2 accounting purposes Lenders/Credit Team Typical Responsibility: Estimating future cash flows Should understand prior CF expectations, changes in expectations, and financial statement impact Information Technology Typical Responsibility: Flagging SOP loans on system, generating relevant reports Finance/Accounting Typical Responsibility: Aggregating CFs, financial reporting Need to ensure SOP processes and controls are properly developed and executed to prevent surprises Always balance/proof to $0. Need to establish point people for above functions 2013 Crowe Horwath LLP 28

29 Conclusion: Today s Objectives Understand main drivers/inputs in initial valuation (Day 1) Projected cash flows Understand how impact of those drivers/inputs impact go forward performance/reporting (Day 2) Change in cash flows will either result in additional accretion income or provision for loan losses Understand impact of purchase accounting marks on financial statements If cash flows can be reasonably estimated, non-accrual loans will be considered accrual loans Begin dialogue for potential operational matters Establish point persons 2013 Crowe Horwath LLP 29

30 References ASC , Loans and Debt Securities Acquired with Deteriorated Credit Quality (formerly known as SOP 03-3), issued Dec AICPA Technical Practice Aid (TPA), issued Dec Section 2130: Receivables, Questions 9-27 ( ) Depository Institutions Expert Panel confirming letter to Chief Accountant of SEC Issued December ments/confirmation-letter-on-day-2.pdf FDIC Supervisory Insights article (Summer 2004) ng_news.html Practice Bulletin 6, Amortization of Discounts on Certain Acquired Loans, issued August 1989 Superseded by SOP Crowe Horwath LLP 30

31 Crowe Horwath LLP is an independent member of Crowe Horwath International, a Swiss verein. Each member firm of Crowe Horwath International is a separate and independent legal entity. Crowe Horwath LLP and its affiliates are not responsible or liable for any acts or omissions of Crowe Horwath International or any other member of Crowe Horwath International and specifically disclaim any and all responsibility or liability for acts or omissions of Crowe Horwath International or any other Crowe Horwath International member. Accountancy services in Kansas and North Carolina are rendered by Crowe Chizek LLP, which is not a member of Crowe Horwath International Crowe Horwath LLP 2013 Crowe Horwath LLP 31

Audit Tax Advisory Risk Performance Crowe Horwath LLP 1

Audit Tax Advisory Risk Performance Crowe Horwath LLP 1 PACB Annual Convention FASB s Current Expected Credit Loss (CECL) Model: Navigating the Changes September 28, 2015 Matthew Schell, Partner Crowe Horwath LLP Washington, DC 2015 Crowe Horwath LLP 1 Agenda