With the implementation of ASC 326, commonly known as CECL, there has been a significant focus on loan portfolios within financial institutions. However, attention also needs to be directed towards the acquisition of bulk loans from other institutions or through mergers and acquisitions, which are equally impacted by the new accounting standard.
To provide guidance around these changes and on remaining compliant, Pinion advisors address some of the most frequently asked questions surrounding the new accounting standard.
What is a Purchased Credit Deteriorated (PCD) asset?
Under ASC 326, the accounting treatment for Purchased Credit Deteriorated (PCD) assets differs significantly from previous guidance under ASC 310-30. A PCD asset is defined as a purchased financial asset that exhibits a more-than-insignificant deterioration in credit quality since its origination. This is determined based on the comparison of the credit risk at the acquisition date, to that at origination.
When a financial asset is identified as a PCD asset, it is initially measured at its purchase price plus an allowance for credit losses. This differs from previous guidance where the asset was recorded at purchase price adjusted to an estimated recoverable amount, or a par value under ASC 310-30. For a PCD asset, an entity must record an allowance for expected credit losses at the time of acquisition. This allowance adjusts the amortized cost basis of the asset, but does not reduce the asset below its fair value less costs to sell. The initial allowance is a day-one loss in earnings under the CECL model.
How are earnings impacted after the initial booking of a PCD asset?
After the initial booking of the loan and the credit loss, the financial institution must continue to assess the asset for expected credit losses. Changes in the expected credit losses after acquisition are recorded in the income statement. This ongoing reassessment is a shift from the previous practice where changes in expected cash flow would adjust the “discount”, but not necessarily impact earnings immediately.
How should a group of acquired loans be assessed?
When multiple loans or other financial assets are acquired, financial institutions must determine if they meet the PCD criteria according to the scope of ASC 326, either at the level of the individual loan or on the basis of a group or a pool of loans. Due to practical challenges, an entity may assess these loans on a pooled basis, grouping them by similar risk characteristics (similar to how a financial institution would split these out for their CECL calculation). It’s important to note that loans that do not share similar risk characteristics cannot be grouped for the purposes of this analysis.
An entity, depending on circumstances, can choose to analyze some acquired loans at the group level and other acquired loans individually. The decision can be based upon multiple factors, including (but not limited to) the risk of the characteristics of the individual loans, current economic conditions, and the financial institution’s past credit experience with similar loans.
How is interest income recognized for PCD assets?
Interest income for PCD assets is recognized based on the effective interest rate (EIR), excluding the credit loss component. This is calculated on the carrying amount of the asset, including the initial allowance for credit losses. Notably, the purchase discount related to estimated credit losses at acquisition is not recorded as interest income, known as the PCD gross-up.
What happens when loans without significant credit deterioration are acquired?
In addition to PCD loans, a financial institution could also purchase loans without PCD. Purchased assets that have not experienced more-than-insignificant credit deterioration since origination are initially recognized at the purchase price, i.e., they are discounted to “fair value” on day one. Expected credit losses for these assets are measured under the applicable credit impairment model, with credit loss expenses recognized in the income statement upon acquisition. This treatment is similar to that of an originated financial asset. On day two, these loans are analyzed for any allowance for credit losses.
What should financial institutions do to ensure compliance and accuracy?
With the significant changes introduced by CECL, it’s crucial to update your policies, procedures, and due diligence practices related to accounting for loans and other assets purchased with credit deterioration. Setting these up in the system correctly from day one is vital to ensure they are properly recorded and monitored throughout the life of the loans.
Connect with a Pinion Financial Institution advisor for additional detailed guidance and support tailored to your institution’s needs.
