The Financial Accounting Standards Board (FASB) is looking to improve the accounting treatment for acquired financial assets that fall within the board’s current expected credit loss (CECL) standard, which was issued in 2016.
The reporting of financial assets acquired through a business combination or asset acquisition has been an area of CECL that has concerned investors, banks, and other stakeholders for several years.
Under current GAAP, if an acquired financial asset has experienced a more-than-insignificant deterioration in credit quality since origination, it’s accounted for under the purchased credit deteriorated (PCD) model—often referred to as the “gross-up approach”—with no credit loss recorded on acquisition. On the other hand, if the acquired financial asset hasn’t experienced a more-than-insignificant credit deterioration since origination, it’s accounted for in a manner consistent with an originated financial asset, or “non-PCD accounting,” the FASB said. Under non-PCD accounting, a Day 1 credit loss is recorded in addition to any credit discount reflected in the fair value of the acquired assets.
Several business combinations that were accounted for after an acquirer adopted the CECL standard reported significantly disparate ratios of financial assets classified as non-PCD and PCD as a percentage of total acquired assets, according to the FASB. For example, the board noted it observed several transactions completed in 2020 in which the acquired portfolio of assets appeared comparable in terms of credit quality and complexion of assets; however, the percentage of the acquired loan portfolio designated as PCD ranged from 15% to 50%. This observation is different from the FASB’s expectation that most acquired financial assets would be classified as PCD and accounted for using the gross-up approach at acquisition.
The FASB said:
Investors, lenders, creditors, and other allocators of capital and preparers noted that two acquisition accounting approaches (PCD and non-PCD) create unnecessary complexity and reduce comparability. The accounting for non-PCD assets, specifically, has been described by stakeholders as unintuitive because a loss is recorded upon the acquisition of financial assets without more-than-insignificant deterioration in credit quality since origination (non-PCD), whereas no loss is recorded upon the acquisition of financial assets with more-than-insignificant deterioration in credit quality since origination (PCD), which results in accounting that is not economically neutral. To the extent a credit discount is reflected in the fair value and again through a Day 1 allowance for non-PCD assets, the portion reflected in fair value is ultimately reversed as enhanced yield. To compensate for this result, many preparers provide supplemental non-GAAP information that excludes the acquisition accounting accretion effect on yield. In addition, investors explained that the criteria for identifying PCD assets are difficult to understand and are not applied consistently in practice. The majority of feedback (substantially all investors and a majority of practitioners and preparers) from the PIR [post-implementation review] process suggested that a uniform approach should be applied in the accounting for acquired financial assets and preferred the gross-up approach that is currently applied to PCD assets.
In a proposed Accounting Standards Update the FASB issued on Tuesday, the treatment of assets classified as PCD would be extended to all financial assets acquired in both a business combination and asset acquisition, with certain exceptions, such as available-for-sale debt securities. There would no longer be PCD and non-PCD distinctions for acquired assets. Instead, all assets would be classified as purchased financial assets and would be accounted for in the same way.
The proposal would essentially allow institutions to reclassify the Day 1 discount on purchased assets currently deemed as non-PCD into the Day 2 allowance, as it’s currently done with PCD assets. This would eliminate the so-called “double count” issue that currently exists under CECL, according to a summary of the FASB proposal from compliance and lending software provider Abrigo.
Larger banks, like BB&T (now Truist Financial Corp.) and TCF Financial (now a part of Huntington Bank), had told the FASB several years ago that CECL treats non-PCD and originated assets differently. They said the CECL standard requires a double-counting on expected credit losses for the non-PCD assets and “unnecessarily penalizes” the acquirer’s equity.
Public comments on the proposed ASU are due by Aug. 28.