Current Expected Credit Loss (CECL) rules are coming What your M&A team needs to know about CECL now kpmg.com
The newly issued CECL accounting rules are expected to have a significant impact on financial services companies by substantially changing how credit losses are accounted for and estimated. While CECL will not become effective until 2020, investors need to be aware of how the new rules will impact target companies earnings, capital, and valuation well ahead of the effective date.* *For public business entities that are Securities and Exchange Commission (SEC) filers, CECL is effective for interim and annual periods beginning after December 15, 2019 (i.e., January 2020). For all other entities, the standard is effective for annual periods beginning after December 15, 2020 (i.e., January 2021). All entities may choose to early adopt starting with fiscal years beginning December 15, 2018. 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 2
Background Following the 2007-2008 financial crisis and subsequent recession, both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) sought to improve the existing impairment models. The IASB issued IFRS 9 and in June 2016, the FASB issued the new credit losses standard ASU 2016-13. This new accounting standard will have a substantial impact on banks and other financial institutions as they will need to consider and quantify the impact of both current and expected lifetime credit losses in determining the amounts expected to be collected in their financial asset portfolios (e.g., loans, trade receivables, debt securities). Defining current expected credit loss The adoption of CECL has several impacts: CECL requires financial institutions to account for the impairment of many financial assets not accounted for at fair value based on expected lifetime losses (vs. the current incurred loss method). CECL requires companies to consider past, present and future information to determine the appropriate reserve levels, incorporating emerging risks that can be reasonably anticipated. The new rules are expected to reduce pro-cyclicality and maintain more stable reserve levels over the economic cycle. By adopting CECL, U.S companies will partially align to the international expected credit loss standard (IFRS 9), even though there are some significant differences between the two standards. The implementation process is likely to be complex and time consuming for many financial institutions, as it affects many aspects of a financial institution s credit risk management framework, including credit models, data processes and IT systems. 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 3
Key CECL considerations for investors CECL will impact current and future investments in financial services firms. Investors will need to pay close attention to CECL s expected impact on earnings, reserves, and capital and factor those impacts into their valuations. In addition, because the standard allows for flexibility and does not prescribe certain aspects of the credit loss estimation, investors will need to be aware of potential methodology inconsistencies across companies and develop due diligence processes to enable comparability. Financial impact CECL adoption will have broad impact on the financial statements of financial services firms, which will affect key profitability and solvency measures. Some of the more notable expected changes include: Higher loan loss reserve levels and related deferred tax assets. While different asset types will be impacted differently, the expectation is that reserve levels will generally increase across the board for all financial firms. According to KPMG research, system-wide impact estimates range between 10 percent and 50 percent, depending on sources. Reserves for some specific loan categories may increase by as much as 200 percent to 300 percent. Increased reserve levels may lead to a reduction in capital levels. As noted in question 3.2.20 of handbook, the agencies are monitoring the impact of CECL on regulatory capital and it remains unclear what, if any, action, regulators will take. As a result of higher reserving levels, the expectation is that CECL will reduce cyclicality in financial firms results, as higher reserving in good times will mean that less dramatic reserve increases will be required in a downturn. The prescribed use of reversion to historical loss information in modeling scenarios could potentially lead to less volatile reserve levels. The forward-looking modeling required by CECL relies on a number of macroeconomic variables. Unexpected changes to such indicators between periods could potentially result in greater earnings volatility from period to period. Reserves may need to be adjusted in response to not only a firm s actual experience, but also to external factors. 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 4
One of the more notable and less intuitive impacts of CECL will be the asymmetry in accounting between loan related income (which will continue to be recognized on a periodic basis based on the effective interest method) and the related credit losses (which will be recognized up front at origination). This will make periods of loan expansion seem less profitable due to the immediate recognition of expected credit losses. Periods of stable or declining loan levels will look comparatively profitable as the income trickles in for loans, where losses had been previously recognized. For both originated and purchased non-pcd (Purchased Credit Deteriorated) assets, an immediate expected lifetime credit loss is recognized in earnings. Valuation impact These notable changes to financial firms financial statements may impact an investor s valuation approaches and methods. At this moment, there is uncertainty about what the ultimate impact on valuations will be. An efficient markets view would suggest that overall valuations should not change as the companies underlying economics and cash flow remain largely unaffected. However, a more bearish view would suggest that firms with lower reported book values and earnings (even if due to non-cash loan accounting requirements) would ultimately suffer lower valuations than under current accounting. Interestingly, as earnings will be less cyclical, it is probable that financial stocks will be punished less severely in downturns, while commanding comparatively lower prices in good times. Also, as mentioned earlier, the decision making flexibility permissible under the CECL standard may result in diversity of practice, which could bring about less comparability and potential lack of insight into key decisions among financial institutions. This may result in a preference for the use of non-gaap measures to enable comparability among firms, despite recent efforts from the SEC to reduce the use of non-gaap measures further. 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 5
What a buyer should consider Despite the new standard not being effective until 2020 for public business entities and 2021 for others, those currently engaged in acquisitions or considering future acquisitions in the financial sector need to take into consideration how CECL rules will impact their investments. This entails: Estimating the expected impact of CECL on the target company during the due diligence process; Estimating the readiness, cost and effort of CECL implementation for the target; Considering the potential earnings and valuation impacts to the target, as described in the sections above; and Understanding the key decisions that targets have made around the measurement of their allowance under CECL. Other secondary but important impacts will also need to be considered, such as the impact CECL may have on loan covenants and financing agreements definitions. 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 6
What portfolio companies should consider A word on the fair value option Private equity funds and other investors who already own financial services firms in their portfolios need to consider the impact of CECL as they plan their future exit strategies. Some of the issues to focus on include: Determining the company s readiness for CECL implementation Implementing CECL will be a lengthy and costly process for most companies; an early evaluation of the required effort and costs is highly advisable. Estimating how the impact of CECL might affect the timing of an exit Investors should analyze how CECL might affect their business models and the timing of their planned exit from any investment affected by the new CECL rules. Exploring and considering alternative earnings and valuation metrics to best position the company for an exit In cases where CECL s financial statements impact is expected to be significant, post-cecl financial results will not be comparable to historical earnings. In those situations, a seller would be advised to emphasize other operating and cash flow metrics that may present a more consistent picture of the business performance over time. Given the very significant impact CECL is expected to have on certain loan types and asset classes (e.g., mortgages, subprime), some companies may consider the use of the fair value option to account for all their lending activities, as a way to solve the asymmetry in recognition in loan related income (over the life of the loan) and credit losses (immediately upfront). The use of the fair value option will in fact improve the correlation between expected loan income and losses. However, it may also result in greater accounting complexity and potential volatility, given the multiple external factors that may impact the valuation of loans and other financial instruments. 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 7
Conclusion The new CECL accounting standard has significant implications for investors, including financial and valuation impacts that will affect both corporate acquirers and private equity investors. Rather than a routine accounting change, CECL will have a transformational impact on the financial sector and the implementation process will likely be more complex and time-consuming than many executives expect. Our recommendation to all firms is to start their evaluation process early in order to analyze, evaluate and select their loss projection approach. Our advice to dealmakers is to include quantitative and qualitative CECL impact assessments as part of the transaction evaluation process in order to gain more insights in valuation and to help to improve deal success. 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 8
How KPMG can help In addition to our extensive experience in both new accounting standard implementations and M&A transaction advisory services in the financial services industry, KPMG has developed several proprietary technology tools that can help improve your company s evaluation of transactions under CECL and adoption of the new CECL requirements. CECL implementation readiness tool This diagnostic tool generates a readiness assessment based on companies responses to the detailed questionnaire embedded in the tool. This diagnostic will highlight potential areas of weakness in current credit modeling and accounting systems, processes and personnel in order to implement CECL, enabling a discussion of potential remedies or mitigations to address those deficiencies and plan a successful CECL implementation process. Scoping Readiness diagnostic Evaluate modeling options Data requirements Data and accounting gaps Broader impact evaluation Transition options and implementation plan Understanding portfolio Link to classification and measurement Scope buckets of portfolios and current ALLL practice Identify key accounting, modeling, and operational questions for CECL Document inventory of options Provide research and assistance Assist the bank in evaluating options based on the following criteria Conceptual soundness Level of effort Financial statement impact New data needed Changes to existing data Evaluating sufficiency Low default/ new products IT requirements Perform detailed gap assessments comparing the current state to the bank s selected options Document recommended enhancements IT and operations Regulatory Treasury FP&A Origination and underwriting New IT and data infrastructure Parallel runs Implementation roadmap 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 9
gclas Our Global Credit Loss Accounting Solution (gclas) is a full service CECL accounting solution that functions as a modular add-on to existing risk and accounting systems and processes. CECL key topics list A prepopulated and highly detailed checklist of the technical accounting and risk modeling decisions required for effective CECL implementation that helps accelerate your expected credit loss program and facilitate the effective documentation of accounting and risk policies. CECL quantitative impact assessment Whether in preparation for a broader implementation or in contemplation of a transaction, KPMG can assist in generating initial estimates of the quantitative impact of implementing CECL, with the use of our gclas software. This scalable, off the shelf solution can be used in a deal setting or valuation setting to assess preliminary CECL financial statements impacts using available loan and security portfolio information. CECL data decomposition and disclosure taxonomy The KPMG data decomposition and disclosures taxonomy enables KPMG teams to rapidly map CECL data requirements to existing data within your risk and finance systems, identifying any gaps. KPMG s Capital Advisory practice can assist financial services companies raise additional capital if firms are confronted with the need to return to pre-cecl capital levels. Our capital advisory professionals provide objective advice on optimal financing solutions in support of our clients strategic objectives. 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 10
For more information, please contact: Miguel Sagarna Partner, Financial Due Diligence, Deal Advisory 212-872-5543 msagarna@kpmg.com Reza van Roosmalen Principal, Financial Instruments Accounting Change Leader 212-954-6996 rezavanroosmalen@kpmg.com Mike Rudolph Managing Director, Corporate Finance, Deal Advisory 312-665-1442 msrudolph@kpmg.com 2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. 11
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