How CECL Impacts Acquisitive Banks

Bank buyers preparing to review a potential transaction or close a purchase may encounter unexpected challenges.

For public and private financial institutions, the impending accounting standard called the current expected credit loss or CECL will change how they will account for acquired receivables. It is imperative that buyers use careful planning and consideration to avoid CECL headaches.

Moving to CECL will change the name and definitions for acquired loans. The existing accounting guidance classifies loans into two categories: purchased-credit impaired (PCI) loans and purchased performing loans. Under CECL, the categories will change to purchased credit deteriorated (PCD) loans and non-PCD loans.

PCI loans are loans that have experienced deterioration in credit quality after origination. It is probable that the acquiring institution will be unable to collect all the contractually obligated payments from the borrower for these loans. In comparison, PCD loans are purchased financial assets that have experienced a more-than-insignificant amount of credit deterioration since origination. CECL will give financial institutions broader latitude for considering which of their acquired loans have impairments.

Under existing guidance for PCI loans, management teams must establish what contractual cash flows they expect to receive, as well as the cash flows they do not expect to receive. The yield on these loans can change with expected cash flows assessments following the close of a deal. In contrast, changes in the expected credit losses on PCD loans will impact provisions for loan losses following a deal, similar to changes in expectations on originated loans.

CECL will significantly change how banks treat existing purchased performing loans. Right now, accounting for purchased performing loans is straightforward: banks record loans at fair value, with no allowance recorded on Day One.

Under CECL, acquired assets that have only insignificant credit deterioration (non-PCD loans) will be treated similarly to originated assets. This requires a bank to record an allowance at acquisition, with an offset to the income statement.

The key difference with the CECL standard for these loans is that it is not appropriate for a financial institution to offset the need for an allowance with a purchase discount that is accreted into income. To take it a step further: a bank will need to record an appropriate allowance for all purchased performing loans from past mergers and acquisitions that it has on the balance sheet, even if the remaining purchase discounts resulted in no allowance under today’s standards.

Management teams should understand how CECL impacts accounting for acquired loans as they model potential transactions. The most substantial change relates to how banks account for acquired non-PCD loans. These loans first need to be adjusted to fair value under the requirements of accounting standards codification 805, Business Combinations, and then require a Day One reserve as discussed above. This new accounting could further dilute capital during an acquisition and increase the amount of time it takes a bank to earn back its tangible book value.

Banks should work with their advisors to model the impact of these changes and consider whether they should adjust pricing or deal structure in response. Executives who are considering transactions that will close near their bank’s CECL adoption date not only will need to model the impact on the acquired loans but also the impact on their own loan portfolio. This preparation is imperative, so they can accurately estimate the impact on regulatory capital.