Eye on the Prize: Accounting s Impact on the Bottom Line Gina Anderson and Sara Dopkin. financial services

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1 Eye on the Prize: Accounting s Impact on the Bottom Line Gina Anderson and Sara Dopkin 1

2 Presenters: Gina Anderson and Sara Dopkin Gina has more than 18 years of experience specializing in audit and accounting services to financial institutions and publicly traded companies, including reviewing filings with the SEC. Sara has 13 years of experience in public accounting and attestation services, and 16 years of experience in working with both publicly traded and privately held companies including SEC and regulatory reporting. Gina Anderson, Director Sara Dopkin, Senior Manager 2

3 Agenda Accounting Estimates ALLL & CECL Financial Instruments New Fair Value Notion Revenue Recognition Leases 3

4 CECL 4

5 Brief Refresher on New Standard What to do Now Control Considerations 5

6 The New Standard Implementation Dates SEC Filers Years and interim periods beginning after 12/15/2019 PBEs that are not SEC Filers Years and interim periods beginning after 12/15/2020 Non-PBEs Years beginning after 12/15/2020 6

7 The New Standard Background: Record lifetime expected credit losses at origination or acquisition of financial assets recorded at cost (primarily receivables, HTM securities and loans) Lifetime means contractual maturity no assumption of renewals or extensions unless there will be a TDR Removes threshold that are present in current GAAP (probable and measureable) 7

8 The New Standard Will incorporate information about past events, current conditions and reasonable and supportable forecasts of the future Use reasonable and supportable forecast to estimate expected losses Historical loss experience will still be the building block of the loss estimate 8

9 The New Standard M&A Impact: Assets acquired with a more than insignificant credit deterioration will receive a gross up of the allowance and the fair value of the loan upon origination Allowance for acquired assets will be measured in the same manner as originated assets Assets acquired with only insignificant credit deterioration will be treated similarly to originated assets (record allowance at acquisition through the income statement) 9

10 The New Standard Example of Acquisition Performing: ABC Company purchases a $10,000,000 portfolio of performing loans at a price of $9,800,000. ABC s allowance model indicates that a 5% reserve is appropriate on these loans. How does ABC record the transaction? As illustrated on next slide ABC will record an expense of $490,000 ($9.8 million * 5%) to set up an allowance at the time of purchase of these loans 10

11 The New Standard ABC s Entries Debit Credit (Record the purchase of loans) Loans $9,800,000 Cash $9,800,000 (Record the 5%) Provision Expense $490,000 Allowance for loan losses $490,000 11

12 The New Standard Example of Acquisition Purchased Credit Deteriorated (PCD): ABC Company purchases a $10,000,000 portfolio of PCD loans at a price of $7,500,000. ABC s allowance model indicates that a 20% reserve is appropriate on these loans. How does ABC record the transaction? As illustrated on next slide ABC will record a reserve of $2,000,000 ($10 million * 20%) to set up an allowance at the time of purchase of these loans, with an offset to the loan balance 12

13 The New Standard ABC s Entries Debit Credit (Record the purchase of loans) Loans $7,500,000 Cash $7,500,000 (Record the 20%) Allowance for Loan Loss $2,000,000 Loans $2,000,000 13

14 What Should Your Bank Be Doing Now? 14

15 What To Do Now? 2017 Data and pro-forma modeling 2018 Implement and test model 2019 Validate and refine model January 1, 2020 (public 2021 nonpublic) - Adopt 15

16 What To Do Now? Form an Implementation Committee Cross Functional Regular meetings Take minutes and document decisions Have appropriate senior leadership champion 16

17 What To Do Now? Determine loan pools by segregating loans based on loss drivers. Example loss drivers: Risk rating Loan to value FICO Score Debt service coverage Seasoning Vintage 17

18 What To Do Now? Consider Data Needs What data is available How is it stored Can it be easily accessed and used Has it been validated 18

19 What To Do Now? Consider Vendors Thought leadership and effective challenge Accounting expertise Credit modeling expertise Data management and programming expertise Source of industry data 19

20 Control Considerations Control design considerations Controls over completeness and accuracy of inputs Loan balances and pools Individual loans Discounts and premiums Loss data Loss drivers Risk Grades, LTV, FICO, etc Prepayment speeds 20

21 Control Considerations Control design considerations Controls over model calculations Change management Recalculation Controls over output Reconciliation to general ledger and inputs Comparison to KPIs Comparison to policy Model Validation 21

22 Continuing Allowance Challenges Qualitative factors Lack of support Provide more granularity addressing geography, staffing and lending practices Consider peer data in qualitative factors Impairment Analysis Cut off, particularly for appraisals received near or just after YE $0 impairment loans still need to document assessment 22

23 Continuing Allowance Challenges Impairment Analysis Con t Reserves for collateral dependent loans, charge off Impaired loan calculations using collateral value when they are not collateral dependent TDRs Insufficient documentation on whether a modification resulted in a TDR or not Use of proper method: collateral vs. cash flows 23

24 Continuing Allowance Challenges Internal Control Lack of audit evidence to sufficiently document preparer, reviewer, precision of review 24

25 Financial Instruments 25

26 The New Standard Overview: FASB and IFRS convergence to move towards fair value Effective next year for PBEs, first adoption period on 3/31/18 for SEC filers 1 year deferral for all other companies 26

27 The New Standard Key Changes: Equity securities No longer AFS treatment Separate presentation of financial assets and liabilities by measurement category and form of financial asset Disclosure changes - public entities to use exit price notion to measure the fair value of financial instruments for disclosure purposes 27

28 Equity Securities Challenges: FV changes through I/S greater volatility I.D. population of equity securities AFS Any mutual fund investments? Impact on regulatory capital Evaluate whether disposals are needed 28

29 FV Disclosure Financial Instruments Exit Price Notion: Current method for calculating FV for disclosure no longer allowed Can slow down financial reporting process Identify party who will perform calculation Outsource calculation In House? Outsourced market premium component Easier to calculate for consumer loans Cost considerations 29

30 Simplifications PBEs Eliminates requirement to disclose methods and assumptions to calculate FV Non-PBEs Eliminates disclosing FV information of FI in footnotes Are you a PBE? Assess based on criteria established by FASB 30

31 The New Revenue Recognition Standard 31

32 Overview The New Revenue Recognition Standard In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a new revenue recognition standard Revenue from Contracts with Customers. Since then, FASB has issued several amendments to the standard to clarify and interpret the requirements, with the latest amendments extending through FASB / IASB Converged Standards The core principle of Topic 606 is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. FASB ASC through 05-4 and through

33 Major Concept Changes Created single principle-based guidance Core Principle Focus is on analyzing the contract not analyzing the transactions by industry Changed From when Realized/Realizable and Earned To When Performance Obligations Satisfied Increased emphasis on disclosures 33

34 Major Structural Changes Eliminated 100 s of existing rules Created 5 step process for recognizing revenue from contracts with customers Guidance on accounting for costs to obtain and fulfill a contract with a customer Increased disclosure requirements 34

35 ive-step Process Contract Parties have approved ID of each party s rights re. goods or services to transfer ID payment terms Commercial substance Probable that the entity will collect substantially all consideration Performance Obligation Defined as a promise in a contract with a customer to transfer a good or service to the customer. Determine T.P. Defined as the amount of consideration to which the entity expects to be entitled in exchange for transferring promised goods or services to a customer. Allocate T.P. If more than one performance obligation exists, allocate consideration based on amounts that depicts satisfying each separate performance obligation. Recognize Revenue When entity satisfies PO by transferring promised good or service to customer who obtains control of the asset P.O. can be satisfied over time OR satisfied at a point in time Step 1 Identify Contract Step 2 Identify Performance Obligations Step 3 Determine Transaction Price Step 4 Allocate Transaction Price Step 5 Recognize Revenue Other Considerations Combination of two or more contracts entered into at or near same time other criteria met Contract modifications can result in new, part of existing, or combo Distinct Goods or Services Capable of being distinct and Distinct within the context of the contract Other Considerations variable consideration, constraining estimates of variable consideration, existence of significant financing component, noncash consideration Consideration payable to customer. Standalone Selling Price Observable selling price (best) Methods to estimate: 1. Adjusted mkt. assessment approach 2. Expected cost plus a margin approach 3. Residual approach 35

36 Scopes (Includes All contracts with customers, except: Leases Insurance contracts Financial instruments and other contractual rights and obligations Guarantees Sales of Non-Financial Assets Outside organizations ordinary activity 36

37 Specific Areas for Banks and Financial Institutions 37

38 How Will Banks and Financial Institutions be Affected? In scope of ASC 606 Performance fees Management fees Out of scope of ASC 606 (for the mortgage fees) Servicing fees received as part of a fee-forservice type arrangement may be in scope Asset management, administration and commissions Mortgage fees and related income* In scope of ASC 606 with some exceptions (i.e., securities lending, etc.) Securities underwriting and broker-dealer arrangements Advisory services more complex with gross vs. net implications + contract costs Investment Banking Fees Revenue Recognition Depositrelated fees* Credit card arrangements* In scope of ASC 606 ATM fees, NSF fees, maintenance fees, etc. Cardholder contract and associated fees are not in scope of ASC 606 Rewards programs and issues are not in scope either In scope if separate from lending Current rules are very prescriptive and based on transfer of risks and rewards and the level of continuing involvement New approach is principle-based, where judgment is required. Sales of real estate (OREO) Revenue is recognized at a point in time in which the buyer obtains control of real estate and the entity satisfies the performance obligation ASC 606 impact expected to be most concentrated in financial statement captions within noninterest income for Banking industry. * Working Draft Issue #5-1 Scope Issues 38

39 Sales of Real Estate (OREO) More Judgment New guidance ASC , Other Income Gains and Losses from the Derecognition of Nonfinancial Assets Less Prescriptive than previous guidance from ASC (i.e., initial and continuing investment) Identify the Contract (Step 1) Scope issue under ASC 606 Sale of non-operating assets are not part of Bank s ordinary activities Required to apply provisions of ASC to determine whether contract exists: a. Approval and commitment b. Rights identified c. Payment terms identified d. Commercial substance e. Probable collection of substantially all consideration (b) through (d) typically met Criterion (a) and (e) may require further analysis > Collectability * Identify Performance Obligations (Step 2) Generally straightforward related to the sale of OREO Working Draft Issue #5-4 Now finalized Transaction Price (Steps 2 and 4) Apply ASC 606 for measuring consideration Generally, TP = contract price, but may be less due to a price concession Bank-financed sales at a market rate presumed to not have a price concession Transfer of Control (Step 5) The seller has a present right to payment for the asset. The buyer has legal title of the asset. The seller has transferred physical possession of the asset. The buyer has the significant risks and rewards of ownership of the asset. The buyer has accepted the asset. * Consideration received from a customer reflected as a liability until contract criteria met, or occurrence of event noted in ASC Continue to evaluate arrangement until collectability and other contract criteria met. 39

40 Implementation Considerations 40

41 Effective Dates Current Effective Dates January 1, 2018 for calendar-year public companies If using retrospective transition contracts entered into in 2016 must be evaluated January 1, 2019 for calendar-year nonpublic companies 41

42 Transition Options Full retrospective application Apply new standard to all prior periods Certain practical expedients are allowed Retrospectively with cumulative effect adjustment No restatement of prior periods Apply new standard to in-progress contracts as of the initial application date and to subsequent contracts Recognize a cumulative effect adjustment at initial application date for effects of applying new standard to inprogress contracts Disclose in the period of adoption the effect on each line item in the financial statements as a result of adoption (i.e.,: how things would have been recognized differently under standards in effect for prior years) 42

43 Documentation considerations Support for conclusions reached by management in the entity s evaluation of ASC 606 and supporting documentation for transition adjustments Memos and additional analyses prepared by management (technical accounting) Assessment performed by management to evaluate the potential effects on the organization (entity specific) Management s contract assessment Supporting summaries and details of transition adjustments and disclosures Assess/Test internal controls over implementation and transition adjustment Consideration of the following areas of the organization likely to be affected by the new revenue standard Marketing and Sales Operations Legal (Key Legal Departments) Treasury and Finance (Debt Covenants) Income Taxes Financial Planning and Analysis (Budget/Forecast) Information Technology Geographic Impacts People (Internal Resources) Stakeholders 43

44 Resources and Reminders AICPA s Financial Reporting Center AICPA Alert Revenue Recognition: Accounting and Auditing Considerations (June 2016) Revenue Recognition Audit and Accounting Guide (December 2016) Depository Institutions 44

45 Leases: Not Just for the Footnotes Anymore 45

46 Significant Financial Statement Impact New lease standard generally requires all leases to be capitalized and recognized on the balance sheet. Exception for short-term leases Implementing the new leasing standard may: Change key ratios used for debt covenants Affect bonus and share-based payment calculations Alter dividend information Impact capital ratios 46

47 Key Questions in Accounting for Leases Definition Lease defined as the right to control the use of an identified asset for a period of time in exchange for consideration. Term: Noncancelable period for which lessee has right to use asset plus periods covered by. Rate: Implicit in the lease is rate that causes the PV of the net investment in the lease to equal sum of: FV of asset minus related investment tax credit. Capitalized initial direct costs incurred by lessor. Components Non-lease components accounted for separately. Do I have a lease? What is the term? What Is the discount rate? Are there non-lease components? Control Right to economic benefits. Right to direct use of asset. May require judgment. Substantive substitution rights, Option to extend if lessee is reasonably certain to exercise the option. Option to terminate if lessee is reasonably certain not to exercise option. Renewals or extensions of lease at option of lessor. Exception - with terms of 12 months or less. Other Considerations If rate can not be determined, use incremental borrowing rate. Private companies may use risk-free rate. Other Considerations Example: equipment lease contract also includes maintenance services. Allocate contract consideration and initial direct costs to components based on relative standalone price of separate components 47

48 Key Questions in Accounting for Leases Do I have a lease? WHY ASK If not within scope of lease standard, must look to different ASC. What is the term? Required for initial accounting. What is the discount rate? Required for subsequent accounting. Any non-lease components? Account for non-lease components differently. 48

49 Initial Measurement 49

50 Finance vs. Operating Lease FINANCE LEASE OPERATING LEASE Substantially the same as a capital lease plus Lease of specialized asset for which no alternative use at end of lease term. All leases that do not meet criteria for finance lease. 50

51 Lessor Accounting: What s the Same Lessor accounting largely unchanged from current. OPERATING LEASE CLASSIFICATION Most operating leases remain operating leases. Current lease classification is retained as well as accounting for each type. 51

52 Lessor Accounting: What s Changed Classification changed to align with lessee guidance Same classification criteria as finance lease in lessee model. Lessor to classify as direct financing if certain conditions are met. Operating leases + Incremental tests for leases involving real estate were removed. + Leveraged leases no longer exist. 52

53 Transition: Effective Dates Effective dates for public companies Fiscal years beginning after December 15, 2018, including interim periods e.g., calendar Effective dates for private companies Fiscal years beginning after December 15, 2019 e.g., calendar Modified retrospective application Must apply new standard as of beginning of earliest comparable period. 53

54 Transition: Practical Expedients You may be able to elect practical expedients to ease burden of adoption You do not need to You may Reassess whether expired or existing contracts are or contain leases. Reassess lease classification for any expired or existing leases. Reassess initial direct costs for existing leases. May use hindsight in determining lease term. 54

55 Possible Implementation Challenges POSSIBLE CHALLENGES Systems Operations Financial Reporting Lessees with significant lease portfolio may need to evaluate current system and evaluate whether it can capture relevant data for new standard. Compliance with debt covenants and other contracts. May affect lease vs. buy decisions. System change may require change to internal controls. Increased use of management judgment Does your remaining life for leasehold improvements match to the lease term used to estimate the ROU. Deferred taxes may be affected. New disclosure requirements. Asset size close to $500MM? 55

56 Implementation Next Steps Inventory all existing lease contracts. - Aggregate similar leases to avoid redundant analyses. - Identify short term leases that will not be capitalized. Assess implementation challenges and options. - Existence of substantive substitution rights. - Choice of discount rate. - Determination of lease term. - Practical expedients. Estimate impact implementation will have on financial statements, key ratios and metrics. - Evaluate impact changes will have on other contracts, e.g., loan agreements, management compensation. - If necessary develop plan to mitigate impact on other contracts. 56

57 Questions? 57

58 Contact Information Gina Anderson, Director Dixon Hughes Goodman LLP 809 Glen Eagles Court, Ste 200 Baltimore, Maryland Sara Dopkin, Senior Manager Dixon Hughes Goodman LLP 809 Glen Eagles Court, Ste 200 Baltimore, Maryland