The current expected credit loss (CECL) model is expected to fix the delayed recognition of credit losses and provide a uniform approach for reserving against credit losses on all financial assets measured at amortized cost. However, CECL introduces new complexities. In this article, we explore existing and future accounting and operational challenges faced by institutions acquiring financial assets with credit deterioration.
The Financial Accounting Standards Board (FASB) has historically recognized that collectability of contractual amounts is a crucial piece of financial information for investors to consider when making lending decisions. Current Generally Accepted Accounting Principles (GAAP) set by the FASB address impairment accounting by creditors by consistently incorporating concepts related to contractually required payments receivable, initial investment, and cash flows expected to be collected (see Accounting Standard Codification (ASC) Topic 310 – Receivables). Introduced in December 2003, purchased credit impaired (PCI) accounting requires entities to implement a complex accounting treatment of income and impairment recognition for PCI assets1 where expectation of collectability is reflected in both purchase price and future expectations of cash flows, while contractual cash flows are ignored. Since adoption, entities struggled with operational challenges, income volatility, and comparability of PCI versus originated assets accounting.
The current expected credit loss (CECL) model, taking effect in 2020 for public business entities that are SEC filers, attempts to align measurement of credit losses for all financial assets held at amortized cost and specifically calls out potential improvements to the accounting for PCI assets. CECL changes the scope by introducing the concept of purchased credit deteriorated (PCD) financial assets and makes the computation of the allowance for credit losses for PCDs, as well as recognition of interest income, more comparable with the originated assets.
In this article, we will focus on changes in the accounting for loans2 with evidence of deterioration of credit quality since origination. We will also explore potential complexities which remain despite the attempt to align the accounting for purchased and originated assets.
Definitions and scope
To understand how CECL changes the accounting for purchased loans, it is important to start with definitions. According to the current GAAP, PCI loans are loans that:
- Are acquired by the completion of a transfer.
- Exhibit evidence of credit quality deterioration since origination.
- Meet a probability threshold, which indicates that upon acquisition, it is probable the investor will be unable to collect all contractually required payments receivable.
Accurately defining which acquired assets should be considered PCI presents an operational challenge, given the often inadequate amount of data available to the acquirer at the time of acquisition. While being conservative, entities end up scoping in assets that, over their remaining life, significantly outperform the expectation and for which all contractually required cash flows are subsequently collected. Once an asset is designated as a PCI, it remains a PCI regardless of its performance (unless it is modified as a troubled debt restructuring). Most core banking systems are not set up to handle special accounting based on expected cash flows, causing financial institutions to implement systems and processes on top of what is used for the originated book.
CECL, which completely supersedes current accounting for PCI financial assets, continues to require different treatment at initial recognition for purchased loans with evidence of credit quality deterioration, and defines PCD assets as:
- “Acquired individual financial assets (or acquired groups of financial assets with similar risk characteristics) that,
- As of the date of acquisition, have experienced a more-than-insignificant deterioration in credit quality since origination, as determined by an acquirer’s assessment.”
Compared to the current GAAP, CECL changes the scope by adding the more-than-insignificant criterion and removing the probability threshold. Identifying PCD assets will most likely continue to present an operational challenge when defining more-than-insignificant deterioration. The FASB suggests considering multiple qualitative factors,3 and the abilities to systematically consume large amounts of data points, apply data rules, and appropriately tag the acquired assets are key in accurate PCD designation.
How does PCD designation affect the financials at acquisition and beyond? To demonstrate, Figure 1 summarizes the basis of accounting for the acquired loans under current and future GAAP and reviews changes to day 1 and day 2 accounting requirements.
Figure 1. Comparison of current and future GAAP for PCD assets
Source: FASB
