FINANCIAL INSTITUTIONS ACCOUNTING AND TAX UPDATE

FINANCIAL INSTITUTIONS ACCOUNTING AND TAX UPDATE Key 2017 year-end accounting and tax issues for financial institutions November 15, 2017

Presenters Mike Lundberg, National Financial Institutions Assurance Leader Doug Jenen, Senior Tax Manager.

Agenda Introductions 5 Accounting Topics 30 Tax Topics 20 Q&A 5

PUBLIC BUSINESS ENTITY

PBE Definition Significant uncertainty and confusion around PBE definition, in particular, related to FDICIA banks AICPA recently issued TQA reflecting consensus view https://www.aicpa.org/interestareas/frc/recentlyissuedtech nicalquestionsandanswers.html Generally, most community banks with a holding company as the reporting entity will not meet criteria e of PBE definition Consider ASU 2013-12 and section 7000 of the TQA above to apply to your institution

RECOGNITION AND MEASUREMENT OF FINANCIAL INSTRUMENTS (ASU 2016-01)

Overview of ASU 2016-01 Effective dates: PBEs FYs beginning after 12/15/17, including interim periods (1 st qtr 2018 for CYE) All others FYs beginning after 12/15/18 (12/31/19 for CYE). and interim periods within FYs beginning after 12/15/19 (1 st qtr 2020). Can early adopt on PBE effective date Certain provisions could be early adopted as of the beginning of a fiscal year after issuance Recognition of changes attributable to credit risk of financial liabilities accounted for under FVO Non-PBEs eliminate FV disclosures for financial instruments not recognized at FV Today, we will focus just on some disclosure changes Link to whitepaper: http://rsmus.com/what-we-do/services/assurance/financial-instruments-fasbissues-standard-on-recognition-and-me.html

Classification and measurement Changes to disclosure requirements: - New requirement for disclosures by measurement category and also form for financial assets - PBEs required to disclose FV of amortized cost financial instruments computed in accordance with ASC 820 Not required for short-term receivables, payables and demand deposit liabilities No longer required for institutions that are not PBEs - New disclosures related to practicability exception for equity securities

Focus on loan portfolio disclosures For Public Business Entities (PBE), loan portfolio fair value disclosures must be based on an exit price Current practice varies, but many are disclosing an entrance price - Assume all contractual cash flows will be received - Change discount rate to a current market rate Exit price will generally be more complex - Project actual cash flows (less than contractual due to credit risk) - Change discount rate to a current market rate - Similar to the model used to value an acquired portfolio in a business combination Quarterly for SEC filers

CREDIT IMPAIRMENT

Credit Impairment ASU 2016-13 issued in June 2016 Apply new current expected credit loss (CECL) model to financial assets measured at amortized cost - Loans and loan commitments - Lease receivables - HTM debt securities Retain current guidance (with some modification) for AFS debt securities - Impairment recognized through allowance Financial assets carried at fair value through earnings generally not in scope - Trading securities - Loans held for sale - Financial assets for which fair value option has been elected

Effective dates PBEs that are SEC filers - Years beginning after 12/15/19, including interim periods in that year PBEs that are not SEC filers - Years beginning after 12/15/20, including interim periods in that year Non-PBEs - Years beginning after 12/15/20, and interim periods in the following year Early adoption is permitted - Years beginning after 12/15/18, including interim periods in that year

Reality Check on CECL Timeline Standard was issued on June 16, 2016 SEC Filers - Effective for Q1 2020 (CYE) - 1294 days between issuance and 1/1/20-517 days have passed (40% of the total) Non PBEs - Effective for Q4 2021 (CYE) - 1933 days between issuance and 10/1/21-517 days have passed (27% of the total)

What can we do now? (From 2016) Re-evaluate portfolio segmentation Identify what data is available Consider various methodologies available Identify data gaps - Can missing data be restored? - Can we start to retain necessary data? - Can we make accommodations until we have more data? - Discuss needs with core provider Consider impact on capital plan and any potential acquisitions

What can we do now? - 2017 Get caught up on anything left from 2016 list Trial run (A) - Select a smaller, manageable portfolio segment - Select 1-3 loss estimation methodologies Loss rate PD / LGD Vintage - Compute life of asset loss rate - Identify loss drivers Forecastable Non-forecastable - Identify forecast sources (A) There are many different ways to approach the CECL estimation process. This trial run discussion represents one option to get started and contains simplifying assumptions that may not be appropriate in all circumstances.

Trial run historical loss Loss rate MF18 - Gather detail listing of loan originations for by year in that segment (go back as far as practical, ideally twice the expected life) - Identify loans as Paid in Full or Loss - Compute loss rate PD/LGD - Similar to loss rate, but break losses into PD/LGD or Probability of Loss / Magnitude of Loss Vintage - Similar to loss rate, but break losses into year buckets (year 1, year 2, etc.)

Slide 17 MF18 Remove "for" Miller, Faye, 11/9/2017

Trial run loss drivers Identify loss drivers - Look back at the losses identified above and identity what events or conditions were correlated with loss events Unemployment rates Property or other collateral values Underwriting criteria Others - Look to current qualitative factors

Trial run forecasts Identify loss drivers as forecastable or nonforecastable Examples: - Forecastable - Unemployment - Future increases in unemployment are expected to result in increased loan losses of the current loan portfolio unemployment should be forecasted - Non-forecastable - Underwriting - Future changes in underwriting would not impact loss rates for current loan portfolio underwriting changes should not be forecasted Identify sources for forecastable inputs

Interagency Frequently Asked Questions on CECL Questions 1-23 issued 12/19/16 - Summarize CECL and highlight areas of change - Views on methods, segmentation, use of vendors, scalability, data needs and processes - Outline steps to take to prepare Questions 24-37 issued 9/6/17 - Views on qualitative factors, data needs, collateral dependent practical expedient - Accounting for changes in expected losses for PCD assets - Definition of PBE and how it effects implementation - How to incorporate CECL in regulatory reports

Implementation - Management action items

Implementation - Governing body considerations

RSM thought leadership CECL resource center

PREMIUM AMORTIZATION ON DEBT SECURITIES

Premium Amortization on Purchased Callable Debt Securities (ASU 2017-08) Current GAAP generally requires amortizing premiums on callable debt securities over the contractual life EXISTING AMENDED ASU shortens the amortization period for certain callable debt securities held at a premium - Requires the premium to be amortized to the earliest call date - Discounts continue to be amortized to maturity - If call option is not exercised at earliest call date, reset the effective yield using the payment terms of the debt security

Premium Amortization on Purchased Callable Debt Securities (ASU 2017-08) Effective date for calendar year-ends Public business entities Other entities Permitted Required Permitted Required 2019 2020

IMPACT OF REVENUE RECOGNITION STANDARD

Effective dates of the revenue recognition standard PBEs - annual reporting periods beginning after 12/15/17 (including interim periods) 1 st Qtr 2018 for CYE Non-PBEs - annual reporting periods beginning after 12/15/18 and interim periods beginning after 12/15/19 12/31/19 for CYE

Understanding the scope The following are not in scope : Interest and dividend income and fee income on loans (including credit card fees) Servicing and sub-servicing income within scope of ASC 860 Financial guarantee fees within scope of ASC 460 Insurance and investment contracts within scope of ASC 944 Sale of financial assets within the scope of ASC 860

Understanding the scope The following are examples of revenue streams in scope: Service charges on deposit accounts Asset management fees Broker-dealer commissions Foreclosed real estate sales and transfers of in substance nonfinancial assets If a financial asset is promised or transferred to a counterparty in a contract along with nonfinancial assets and substantially all of the fair value of the assets is concentrated in nonfinancial assets, the financial assets are deemed to be in substance nonfinancial assets

TAX UPDATE

Tax Legislation Status Tax Cuts and Jobs Act House of Representatives H.R. 1 Initial Draft November 2 nd Amendment #1 November 6th Amendment #2 November 9 th House Ways and Means Voted out of committee to the full House for a vote Senate Chairman s Mark of the Tax Cuts and Jobs Act (JCX-51-17) Initial Draft November 9 th Senate Mark-up commenced November 13th

Tax Legislation Status Tax Cuts and Jobs Act What s next? Here s the plan: House of Representatives H.R. 1 Full House vote this week Senate Committee on Taxation Full Senate vote by Thanksgiving? Conference Committee December resolve differences in House/Senate bills and send back for a vote White House Send to President for signature, veto, or non-action on New Year s Day January 1, 2018

Headline House business tax provisions Corporate rate reduced from 35 percent to 20 percent (25 percent for personal service corporations) Top pass-through rate of 25 percent for qualified business income of individuals with complex limits for active owners 34

Other favorable House business tax provisions Expanded use of cash method of accounting for small C corporations and partnerships with C corporation partners Repeal of the corporate alternative minimum tax (AMT) Faster depreciation of capital investments including 100 percent bonus depreciation through 2022, and $5 million section 179 deduction allowance 35

Other major House business tax provisions Limit allowable deductions for net interest expenses to 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA), with exceptions, including for real estate and small business Mostly end net operating loss (NOL) carrybacks except in limited circumstances; limits on NOL carryforwards Limit like-kind exchanges to real property Eliminate the work opportunity tax credit Retain research and development credit 36

Other Senate changes to House business provisions Materially higher rates on pass-throughs than House Unlimited carryforward of unused interest deductions Modest differences in cost recovery rules 37

Selected House individual tax provisions Condense the number of tax brackets from seven to four, including 12, 25, 35 and 39.6 percent brackets Repeal deduction for personal exemptions Increase the standard deduction to $12,000 for individuals and $24,000 for married couples ($12,200 and $24,400 in 2018) Repeal the overall Pease limitation on deductions Eliminate itemized deductions for: State and local income taxes, but allow deduction for up to $10,000 for state and local property taxes Casualty and theft losses, medical expenses and alimony Preserve deduction for charitable contributions Increase the adjusted gross income (AGI) limitation for cash contributions to public charities and certain private foundations from 50 percent to 60 percent 38

Selected House individual tax provisions (cont.) Limit the home mortgage interest deduction for newly purchased principal residences to interest on $500,000 of indebtedness, while grandfathering mortgages existing as of Nov. 2, 2017 No deduction for home equity loans or second homes Phase-out exclusion of gain on sale of principal residence for taxpayers with AGI over $500,000 married filing joint ($250,000 single) Repeal the AMT Retain pre-tax contribution limits for 401(k) plans Double the current estate tax exemption to approximately $11 million, effective January 2018, with complete repeal of the estate (and GST) tax in 2025 Retains the gift tax and the step-up in basis for inherited property 39

Key items retained (or undisturbed) in House bill Income tax The 3.8 percent tax on investment income under section 1411 and the.9 percent Medicare tax on compensation Tax rates on capital gains and dividends Ability for beneficiary to stretch individual retirement account (IRA) withdrawals Estate and gift tax Current design flexibility of grantor retained annuity trusts (GRATs), no minimum 10-year term Treatment of grantor trusts 40

Senate Republicans selected individual provisions Keeps seven individual income tax brackets Replace current 15 percent bracket with a 12 percent bracket Top rate of 38.5 percent applies at incomes of $500,000/$1 million Simplifies the kiddie tax Doubles the standard deduction to $12,000 for individuals and $24,000 for married couples Eliminates federal deductions for state and local taxes Repeals AMT Preserves medical expense deduction Retains current mortgage interest deduction, but not for home equity loans Preserves exclusion of gain on sale of residence but extends required period of ownership and use as residence 41

Senate Republicans selected individual provisions (cont.) Retains pre-tax contribution limit for 401(k) plans, but eliminates catch-up contributions for those earning more than $500,000 Retains charitable contributions and increases AGI limit for cash contributions to 60 percent Repeals all miscellaneous deductions (that are subject to the 2 percent rule) Doubles the exemption for the estate tax but does not eliminate it, retains current 40 percent rate and stepped-up basis Gift tax remains in place Alters rules on taxation of some deferred compensation plans Clarifies rule for determining basis in a sale of a cash value life insurance policy 42

Headline business tax provisions Current law House bill Senate bill Observations Pass through income 39.6% top rate (+3.8% NIIT) 25% top rate; bifurcation between labor and capital 17.4% deduction (limited to 50% of wages) House guardrails Senate equal treatment Doesn t apply to service businesses Carryovers Corporate income 35% top rate 20% flat rate (effective 2018) 20% flat rate (effective 2019) Rate increased to 25% for PSCs 43

Comparison of estimated top federal rate rates Current law House Senate proposal proposal S corporation active 40.8% 35.2% 31.8% S corporation passive 44.6% 28.8% 35.6% Partnerships active 43.6% 38.0% 34.6% Partnerships passive 44.6% 28.8% 35.6% C corporation 35% 20% (2018) 20% (2019) 44

Proposed Tax Legislation Summary C Corp Banks Significant Favorable Provisions Reduced Corporate tax rate to 20% Repeal of AMT & Refund of AMT Credits Repeal of NOL carry-forward expiration Increased 179 limitation & 100% bonus depreciation Significant Unfavorable Provisions Reduction in dividends received deductions Reduced applicability for like-kind exchanges Potential limitation on deduction of interest expense Elimination of tax exempt tax credit bonds and tax exempt nature of private activity bonds Repeal of multiple tax credits Taxation of deferred compensation upon vesting Limitation of FDIC premium payment deductions for large banks 162(m) executive compensation changes 45

Proposed Tax Legislation Summary S Corp Banks Significant Favorable Provisions Reduced Individual tax rates Special flow-through tax rates for business income Increased gross receipts threshold for cash basis method Increased 179 limitation & 100% bonus depreciation Significant Unfavorable Provisions Additional taxes under Affordable Care Act left intact Self employment tax assessed on S Corporation income Limitation on deductions for state & local, sales, and property taxes Potential limitation on deduction of interest expense Reduced applicability for like-kind exchanges Limitation of FDIC premium payment deductions for large banks 46

Proposed Tax Legislation Observations C Corp Banks Observations C Corporations How will the proposed reduction in C Corporation tax rate impact earnings? Should Banks hold off making large capital investments until proposed tax legislation is finalized? Making new BOLI or Municipal Bond investments? How will the proposed reduction in C Corporation tax rate impact the value of DTAs for financial reporting purposes? When should a Bank account for these changes for financial statement reporting purposes? Would the elimination of AMT have any impact? Should the AMT credit now become a allowable DTA in capital? Are ISO stock options now more attractive? How will the potential change in NOL carry-forward / carry-back rules impact Banks with DTAs off balance sheet? Impact portion of DTA allowable in capital? How will states conform to these new rules once enacted? How will compensation be impacted for key executives of public company type entities? DTA tax deductions are more valuable in 2017 than in 2018 Accounting method planning is critical What tax credits shall remain once the dust settles? 47

Proposed Tax Legislation Observations S Corp Banks Observations S Corporations Banks may need to revisit whether S status continues to make sense under the new proposed tax rates How does special tax rate on capital and labor sourced income impact tax distributions for taxes? What impact will self employment taxes on S Corporation labor income and S Corporation wages have on banks? How will states conform to these new rules once enacted? Tax deductions are more valuable in 2017 than in 2018 Accounting method planning is critical Would cash method of accounting become a more viable option for smaller community S Corporation banks? What tax credits shall remain once the dust settles? 48

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