Preparing for transition
Purchased Loan Accounting for Financial Institution Acquisitions
An increasing number of financial institutions are getting involved in acquisitions, but accounting for acquired loans can be difficult. When an institution performs an acquisition, all financial instruments (i.e., assets and liabilities) are required by current accounting standards to be recorded at fair market value. The most challenging instrument to fair value is the loan portfolio.
Financial institution accounting and lending personnel need to carefully consider the ramifications of how they classify acquired loans, as these decisions have a significant impact on the complexity of the accounting after the acquisition.
Acquired loans are split into two buckets:
- Purchase performing loans. These loans are performing at the time of acquisition and it is likely the borrower will continue making payments in accordance with contractual terms. This would also include nonperforming revolving loans with draw capability (these loans are explicitly excluded from being accounted for under ASC 310-30). These two groups of loans are accounted for under ASC 310-20 (Nonrefundable Fees and Other Costs).
- Purchased impaired loans. These loans are not performing at the time of acquisition and the borrower will not likely make payments in accordance with contractual terms. These are accounted for under ASC 310-30, (Loans and Debt Securities Acquired with Deteriorated Credit Quality).
Purchased performing loans
Purchased performing loans (and nonperforming revolving loans) are accounted for under ASC 310-20, and each loan is assigned a fair value mark based on the yield and credit adjustments. The yield adjustment is to compensate for acquired loans not earning interest at market rates, and the credit adjustment is for the inherent risk that the borrower will default on payments. The combination of these two items form the discount or premium assigned to each loan. Under ASC 310-20, the entire fair value mark (discount/premium) is accreted/amortized into income.
The accretion period for the fair value mark for a fully amortizing loan is simply to the maturity date of that loan. When determining the accretion period for a loan with a balloon payment, it is important to consider the institution’s intentions regarding the loan. ASC 310-20 was intended to recognize the effective yield over the life of the loan. The balloon date would need to be examined to determine if a new loan is actually issued, or if it is merely a re-pricing tool of the same loan.
For example, if the institution prepares new loan documentation, charges new origination fees, performs new underwriting, etc., this would be considered a new loan, and the original fair value mark would be accreted to maturity. If no origination fee is charged or credit underwriting performed, it is a continuation of the original note, and the fair value mark would be accreted over the amortization period of the loan.
Refinancing that occurs during the loan’s current life, i.e., the loan is refinanced prior to the contractual maturity, requires analysis of the new cash flow to determine if the remaining fair value mark should be accreted into income or if the mark should continue to be accreted. In order for the mark to be accreted fully into income, it must meet the following requirements:
- The new debt’s effective yield must be at least equal to the effective yield for a comparable debt with similar collection risks not involved in a restructure.
- The modifications to the original debt are more than minor, which is defined as the present value of the cash flows of the new debt is at least 10 percent different from the present value of the remaining cash flows of the original debt.
If these two items are met, the restructure is considered new debt, and the remaining fair value mark is accreted into income immediately. If they are not, then the fair value mark would continue to be accreted.
Allowance for loan loss
Purchased performing loans are reserved for like any other loan in the portfolio, i.e., they fall under ASC 450 (formerly FAS 5) and ASC 310-10 (formerly FAS 114). When determining the needed reserve for purchased performing loans, institutions should compare the current discount to the reserve that would be required based on legacy historical loss rates. If the reserve needed based on these rates is greater than the discount, additional reserve would be included in the allowance for loan and lease losses (ALLL) calculation. If the discount is greater than the reserve need, no additional reserve is included.
If a loan becomes impaired after an acquisition, it would be accounted for under ASC 310-10. Any impairment would be determined based on principal balance of the loan net the discount.
For example, if you have a loan with a principal balance of $100,000, and a $10,000 discount, the carrying value is $90,000. If the collateral is worth $95,000, no additional impairment is needed. Charge-offs on these loans are recorded through the ALLL, as with any other loan. The amount of the charge-off would be based on the net carrying value of the loan on the date of charge-off.
Purchased impaired loans
Purchased impaired loans are accounted for under ASC 310-30 using one of three methods:
- Collateral ownership: If a loan is acquired primarily for the rewards of collateral ownership, i.e. the plan is to foreclose on the loan relatively quickly after acquisition, the loan is marked to fair value less costs to sell, and no income is accreted.
- Cost recovery: If an accurate cash flow projection cannot be created for a loan, the income should be recognized on a cost recovery basis. The loan is marked to fair value on the day of acquisition, and all payments are applied to the principal until it is recovered, then all payments are applied to income.
- Expected cash flow: The other option is the projected cash flow method. Income accretion is based on the projected cash flow. Cash flow is required to be updated on a quarterly basis. Impairment is recorded when cash flow performs worse than expected, and an increase in yield is recognized prospectively if cash flow is performs better than expected. The discount associated with these loans is divided into two items: nonaccretable and accretable. The accretable discount is the difference between your expected cash flow and the fair value. The nonaccretable discount represents the difference between total possible collections and expected cash flow. This is available for charge-offs if needed.
In Table 1, $572,986 of income would be accreted in 2015 based on the expected cash flow. $2 million of income would be accreted over the life of the loan, assuming the cash flow projection is accurate.
If the cash flow performs better than expected, it would look like Table 2.
The effective yield is raised to 45.69 percent in 2017 to adjust for the increase in cash flow expectation. The additional income is recorded prospectively over the remaining expense life.
In the event the cash flow performs worse than expected, it would look like Table 3.
In this scenario, the loans are impaired by $276,303 immediately in 2018, in order to continue to accrete at the original discount rate of 28.65 percent.
Allowance for loan loss
The only entries that are recorded through the reserve related to ALLL on purchase impaired loans are:
- Under the expected cash flow method when cash flow is worse than expected
- Under cost recovery or the collateral method when the collateral value of the property securing the loan decreases significantly
Impairment is taken in order to ensure interest income is still at the original discount rate selected for a purchase impaired loan.
Practical and other considerations
Troubled debt restructurings that are acquired are no longer classified as such. These loans are placed in one of the two buckets above. Generally, if the loan is performing under the current restructured terms, and there is no indication the borrower will not be able to continue paying, it would be classified as a purchased performing loan, and accounted for under ASC 310-20. If the restructured loan is below a current market rate for a loan with similar credit risks, the loan is generally classified as a purchased impaired loan and accounted for under ASC 310-30.
When deciding whether to classify a loan as purchased performing or purchased impaired, consider:
- For purchased performing loans, institutions can leverage the core accounting system to perform the ongoing accounting, requiring less manual intervention. Core systems currently are not equipped to automatically handle the accounting for purchased impaired loans.
- The ongoing accounting related to reserving purchased performing loans is similar to that of normal portfolio loans, which makes the ongoing management of the portfolio easier.
- Once a loan is classified as purchased impaired, it maintains the classification until the loan is charged off or foreclosed upon. Refinancing or extended purchased impaired credits do not alleviate ASC 310-30 accounting. This makes projecting cash flow challenging for loans expected to be on the books for a significant period of time, as refinances and extension need to be considered when projecting cash flow.
- Ideally, loans categorized as purchased impaired should be off the books in a relatively short time frame. This will eliminate the ongoing accounting once the loans are derecognized.
- Utilize the cost recovery method when possible for purchased impaired loans, as this comes with less ongoing accounting intervention. The down side is you do not recognize any income on these loans until the net carrying value is recovered.
How we can help
We can help institutions value loan portfolios, and implement the proper accounting protocols for acquired loans on an ongoing basis.