experience clarity //

CPAs & ADVISORS

ALLL / CURRENT EXPECTED CREDIT LOSS (CECL) MODEL, TDR’S AND PCC Gordon Dobner, Director

ABOUT BKD

• Among the largest firms in the U.S. – BKD has clients in all 50 states & internationally

• 33 offices in 15 states • Helping clients succeed for 90+ years • Strength in numbers

– Approximately 2,200 personnel firmwide – Approximately 260 partners – Growing, reputable, financially stable firm – $425 million in revenue – Industry leader – Strong leadership

• One-to-five partner-to-staff ratio

2 // experience perspective

FINANCIAL SERVICES GROUP

Serve approximately 1,200 financial institutions nationwide in an audit, tax &/or consulting capacity

180 CPAs & advisors

Focus on serving financial services industry

Dedicated teams for specialized services, including regulatory compliance, loan review, internal audit, information technology & more

3 // experience perspective

ACUIA PRESENTATION

Financial Instruments Project - Impairment Model

Trouble Debt Restructurings (TDR’s)

Private Company Council (PCC)

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FINANCIAL INSTRUMENTS PROJECT – CREDIT IMPAIRMENT MODEL

Key Take-Aways

• Still a lot of operational uncertainty on how to implement based on current exposure draft

Lack of historical information about life of loan losses

Inability to forecast beyond a foreseeable future

• Feedback has been overall negative

Support is mostly from investor groups and regulators

• Appears convergence with IASB will not happen

• Impacts all financial assets not just loans (debt securities)

• Information gathering should start as soon as final standard is issued, if not before

• This is coming and maybe sooner than you think

FASB recently stated they expect to issue a final ASU in the second half of 2014

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FINANCIAL INSTRUMENTS PROJECT – CREDIT IMPAIRMENT MODEL

WHERE WE HAVE BEEN…

Financial Crisis Advisory Group (FCAG) • Formed in 2008 by FASB & IASB

Recommendation • Explore alternative to ‘incurred loss model’

• Reduce complexity by having a single model

• Utilize more forward-looking information

Response • Proposals that result in more timely recognition of credit losses

• FASB model—recognize all (lifetime) expected credit losses

• IASB model—recognize some (12 months) expected credit losses until significant deterioration threshold is met, then recognize lifetime expected credit losses

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WHERE WE HAVE BEEN…

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WHERE WE HAVE BEEN…

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WHERE WE ARE TODAY…

Probable incurred loss model

2 primary components

• General reserve

• Specific reserve

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WHERE WE ARE TODAY…

General reserve

• ASC 450-10 (FAS No. 5)

• Starting point

Historical losses over some period

• Qualitative factors

Adjust historical losses to reflect the current portfolio

Internal factors, i.e., changes in underwriting

External factors, i.e., changes in economy

Check for directional consistency

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WHERE WE ARE TODAY…

Specific reserve

• ASC 310-10 (FAS No. 114)

• Identify impaired loans

• Specifically evaluate impaired loans for reserves

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WHERE WE ARE GOING…

History

IASB’s 2009 ED

Expected (life of loan) cash flow model

Recognize impairment over time (as interest income is recognized)

Conceptual appeal (to some) of reflecting the economics of lending

Major concerns with operational issues

• FASB’s 2010 ED

Expected (life of loan) cash flow model

Assume existing conditions remain the same

Interest income recognized by multiplying effective rate times net carrying amount of asset

• Boards redeliberate together

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WHERE WE ARE GOING…

History (continued)

• Jan 2011 “joint supplemental document (SD)”

Removes the concept of “probable”

Introduces good book/bad book concepts

Boards continue to redeliberate based on comments about SD

Both boards develop 3 bucket approach

FASB conducts outreach on model being developed

July 2012 FASB tells IASB it has significant concerns about operability of 3 bucket model based on significant feedback from US constituents (preparers, auditors & users)

Constituents question understandability, operability, auditability & workability

FASB develops Current Expected Credit Loss (CECL) model

IASB continues to develop 3 bucket model

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WHERE WE ARE GOING…

Similarities in the models

• Expected credit loss models, reflecting more forward-looking information

• No initial recognition threshold

• Assets that have deteriorated significantly since initial recognition, i.e., performing & underperforming assets, recognize lifetime expected credit losses

• Measurement of expected credit losses (ECL)

Reflects management’s expectation based on past events, current conditions, & reasonable & supportable forecasts

Reflect the risk of loss, i.e., the possibility that a loss will occur, as opposed to reflecting the most likely outcome (statistical mode)

Reflect the time value of money

Entities can revert to long term mean average as part of the estimate for periods beyond the foreseeable future

• Provide enhanced disclosures compared to current GAAP/IFRS

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WHERE WE ARE GOING…

Differences in the Models

• Measurement approach—single vs. dual

• Initial recognition—lifetime vs. 12 month

• Interest recognition for non-performing assets—nonaccrual vs. applying effective rate on balance net of allowance

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WHERE WE ARE GOING…

Feedback on the models

• Strong support for IASB model from IASB constituents

• Although user feedback is subject to debate

• Strong (3-1 margin) user support for FASB proposal

• Preparers generally do not support recognition of full life time losses on day 1

• Concern with projecting losses beyond a reasonably foreseeable time period

• Concern that CECL does not reflect economics of lending

• Strong support for PCI model

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CURRENT PROPOSAL DECEMBER 2012

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OPERATION OF CURRENT PROPOSAL

At each reporting date, recognize an allowance for expected credit losses on financial assets (i.e. loans, securities, derivatives, etc.) • Expected credit losses are a current estimate of all contractual cash flows not expected to

be collected

Practical expedient – meet both of the following, may elect not to recognize expected credit losses for financial assets measured at fair value with changes through OCI:

• Fair value is greater than amortized cost (unrealized gain)

• Expected credit losses are insignificant

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ESTIMATION OF EXPECTED CREDIT LOSSES – CURRENT PROPOSAL

Time Value of Money

• Explicit or implicit

• Discounted cash flow is an example of explicit – forecasts future cash flows (or cash shortfalls) and discounts those amounts back to present value using the effective interest rate

• Developing loss statistics on the basis of the ratio of amortized cost written off due to credit loss to total amortized cost basis of the asset is an example of implicit – computed loss statistic would then be applied to amortized cost balance as of the reporting date

• As a practical expedient for collateral-dependent financial assets, may use method that compares amortized cost with fair value of collateral

Must continue to estimate costs to sell

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ESTIMATION OF EXPECTED CREDIT LOSSES – CURRENT PROPOSAL

Multiple Possible Outcomes

• Requires estimate of expected credit losses reflect both

Possibility credit loss results

Possibility no credit loss results

• In making these estimates, a variety of credit loss scenarios are not required to be probability weighted when a range of at least two outcomes is implicit in the method. Example methods where this requirement is implicit:

Loss-rate method

Roll-rate method

Probability-of-default method

Provision matrix method using loss factors

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ESTIMATION OF EXPECTED CREDIT LOSSES – CURRENT PROPOSAL

Loan Commitments

• Required to recognize all expected credit losses for only those commitments not measured at fair value with changes through net income

• Estimate credit losses over full contractual period which the entity is exposed via legal obligation to extend credit, unless unconditionally cancellable by the issuer

• For the period of exposure, must consider:

Likelihood funding will occur

Estimate of expected losses on commitment expected to be funded

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EXAMPLES

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EXAMPLE 1 – LOSS-RATE APPROACH

Entity A is a financial institution that provides 5-year amortizing commercial mortgage loans

The entity estimates expected credit losses for pools of similar asset types by:

• Segregating into credit risk ratings

• Applying a current estimated loss-rate specific to each credit risk rating to the amortized cost basis of the assets in that rating category

Entity A develops historical loss rates on the basis of its historical loss data for 5-year commercial mortgage loans

• Form static pools by grouping borrowers by risk rating at beginning of year

• Follow each pool from that point forward through the life of the assets within the pool

• For each pool, a historical loss rate applicable to the risk rating is determined….

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EXAMPLE 1 – LOSS-RATE APPROACH (CONTINUED)

To develop its current expected loss rate, Entity A updates the historical data (computed on the previous slide) to reflect:

• Changes in current conditions

• Reasonable and supportable forecasts that differ from historical experience

Entity A has now developed the current expected loss rates by risk rating, based on its historical loss rates, adjusted for current conditions and reasonable and supportable forecasts about the future

For this example, let’s assume they have computed the following:

• 0.5% for loans with a “Pass Category 2” risk rating

• 3.0% for loans with a “Pass Category 4” risk rating

• 8.0% for loans with a “Special Mention” risk rating

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ENTITY A – EXPECTED CREDIT LOSS ESTIMATE

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Pass Category 2 Pass Category 4 Special Mention

Expected loss rates 0.50% 3.00% 8.00% 1.59% *

Ending balance 27,500$ 10,000$ 2,500$ 40,000

Expected credit loss estimate 138$ 300$ 200$ 638$

* The 1.59% weighted-average loss rate is calculated as the total expected credit loss estimate

divided by the ending balance.

December 31, 20X1

($ in 000s)

Risk Rating Category

DAY 2 ACCOUNTING – LOSS-RATE METHOD

Assume the following quarter Entity A expects the loss rates used on the previous slide will be the same for this quarter end, because conditions remain consistent with the economic conditions expected at March 31, 20X2.

Also, assume various activity has occurred such as some credits have deteriorated, some have paid down, etc.

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ENTITY A - DAY 2 – EXPECTED CREDIT LOSS CALCULATION

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Pass Category 2 Pass Category 4 Special Mention

Expected loss rates 0.50% 3.00% 8.00% 1.58% *

Beginning balance 27,500$ 10,000$ 2,500$ 40,000$

New originations 2,300 - - 2,300

Paydowns on O/S loans (1,510) (560) (130) (2,200)

Loans charged off - - (9) (9)

Credit migration (320) 115 205 -

Ending balance 27,970$ 9,555$ 2,566$ 40,091$

Expected credit loss estimate 140$ 287$ 205$ 632

* The 1.58% weighted-average loss rate is calculated as the total expected credit loss estimate

divided by the ending balance.

March 31, 20X2

($ in 000s)

Risk Rating Category

ENTITY A – ADJUSTMENT TO ALLOWANCE FOR MARCH 31, 20X2

Before the adjustment, Entity A would have an allowance for expected credit losses balance of $629,000 (that is, $638,000 allowance as of December 31, 20X1, minus the $9,000 of charge offs during the quarter)

As a result, the entity would record an additional provision of $3,000 for the quarter ended March 31, 20X2, increasing the ALLL to $632,000

Although Entity A’s estimate of expected credit losses has increased from the previous quarter, the estimate is largely consistent with the previous quarter

• Extent of credit-quality deterioration experienced during the quarter consistent with entity’s expectations

• Decrease in credit risk in the portfolio resulting from paydowns offset by increases in credit risk on new loans

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EXAMPLE 2 – PROBABILITY-OF-DEFAULT (POD) METHOD

Another acceptable method of estimating the loss rates – the product of POD statistic and loss-given default statistic

Under this method

• The POD statistic would reflect the likelihood of default occurring over the remaining life of the asset, which gives rise to a shortfall in collection of contractual cash flows

The POD statistic might be derived from:

• Entity’s own historical loss experience

• Externally available data such as a rating agency transition matrix, which uses the data over the full contractual term of financial assets to capture cumulative default experience

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EXAMPLE 2 – PROBABILITY-OF-DEFAULT (POD) METHOD

The POD statistic would then be updated to reflect current conditions and reasonable and supportable forecasts about the future

Next, the loss-given default statistic would reflect the severity of the credit loss if the borrower defaults

The loss-given default statistic could be based on studies performed on historical loss experience or based on externally available data

WHAT?

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EXAMPLE 3 – BASE COMPONENT & CREDIT RISK ADJUSTMENT

The base statistical estimate of credit loss may reflect historical average of credit losses that would be expected for financial assets with similar risk characteristics

The base statistical estimate alone will not be adequate because it does not consider current and forecasted conditions

Thus, the credit risk adjustment is necessary to adjust the base statistical estimate so the current expected credit loss estimate reflects current conditions and forecasts

The credit risk adjustment would be estimated using macro-level factors such as

• Management’s evaluation of current point in the economic cycle

• Evaluation of borrower behavior and collateral values

• Recent trends in economic conditions

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MANY OTHER ACCEPTABLE METHODS IN THE PROPOSAL

By-vintage basis

Collective estimation method and an individual asset estimation method

Provision matrix

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PURCHASED CREDIT IMPAIRED FINANCIAL ASSETS

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PURCHASED CREDIT IMPAIRED FINANCIAL ASSETS

Discount embedded in the purchase price that is attributable to expected credit losses should not be recognized as interest income

Allowance for expected credit losses shall be recognized at acquisition date as an estimate of all contractual cash flows not expected to be collected

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OPERATIONAL CONSIDERATIONS

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WHAT WILL YOU HAVE TO CONSIDER UPON IMPLEMENTATION?

Calculations of historical losses must still be tracked and measured – must decide how far back is appropriate for purposes of forecasting

Current requirements for documentation of qualitative factors must stay in place (and likely expanded)

Once an approach is selected, must determine what “systems” will or can be used

Forecasts will require detailed documentation and computational support which can be updated regularly

Monitoring processes over loans will need to be revised to allow that process to gather more data to assist in forecasting

Education of Board, senior management and various other lending personnel

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WHAT DOES ALL THIS MEAN?

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WHERE WE ARE GOING…

Operational concerns with FASB’s model

• Lack of historical information about “life of loan” losses

• Cannot forecast beyond foreseeable future

• Few securities will be eligible for practical expedient for FV-OCI

• Why continue with TDR guidance under a life of loan model?

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WHERE WE ARE GOING…

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FINANCIAL INSTRUMENTS PROJECT – CREDIT IMPAIRMENT MODEL

Key Take-Aways

• Still a lot of operational uncertainty on how to implement based on current exposure draft

• Feedback has been overall negative

Support is mostly from investor groups and regulators

• Appears convergence with IASB will not happen

• Impacts all financial assets not just loans (debt securities)

• Information gathering should start as soon as final standard is issued, if not before

• This is coming and maybe sooner than you think

FASB recently stated they expect to issue a final ASU in the second half of 2014

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TROUBLED DEBT RESTRUCTURINGS

What is a TDR?

• A restructuring/modification that meets both

Borrower is experiencing financial difficulty

Lender grants a concession

TDR Principles

• Lender for economic or legal reasons related to the borrower’s financial difficulty grants a concession that it would not otherwise consider

• Lender’s objective is to make the best of a difficult situation and maximize recovery of loan balance

Not all modifications are TDR’s

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TROUBLED DEBT RESTRUCTURINGS

What is financial difficulty?

• The following factors may indicate that the debtor is experiencing financial difficulties

The debtor is currently in default on any of its debt

The debtor has declared or is in the process of declaring bankruptcy

There is a significant doubt as to whether the debtor will continue as a going concern

The debtor has securities that has been delisted or are under a threat of being delisted

The debtor forecasts that its cash flows will be insufficient to service the debt for the foreseeable future

The debtor cannot obtain funds from sources other than the existing creditors at a market rate for a non-troubled debtor

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TROUBLED DEBT RESTRUCTURINGS

What is a concession?

• Types of concessions

Principal or interest forgiveness

Principal or interest deferral (forbearance)

Interest rate reduction

Extension of maturity date at a below-market rate for new debt with similar risk characteristics

Significant delays in payment

• Consideration may be given to “compensate” for modification

Additional collateral or guarantees received

Other beneficial terms to lender

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TROUBLED DEBT RESTRUCTURINGS

What is a concession? (cont’d)

• Lender Clarifications (ASU 2011-02)

Lenders are not allowed to use the borrower’s effective interest rate to determine whether a concession was granted

Assume that the restructuring is at a below-market rate if the borrower is unable to access funds at a market rate for debt with similar risk characteristics. Consider all aspects of the restructuring to determine if a concession has been granted

A temporary or permanent increase in the contractual rate does not preclude the restructuring from being considered a concession

An insignificant delay in payment resulting from a restructuring is not a concession. Consider cumulative effects of past restructurings

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TROUBLED DEBT RESTRUCTURINGS

Modifications of PCI loans

• PCI = Purchase Credit Impaired (ASU 310-30; SOP 03-3)

• Modifications of loans that are accounted for within a pool do not result in the removal of those loans from the pool, even if those modifications are TDR’s

• Loans accounted for individually are subject to the TDR accounting provisions within Subtopic 310-40 and exit from PCI accounting

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TROUBLED DEBT RESTRUCTURINGS

Fees and Costs

• Fees – any fees received at the date of modification should reduce the recorded investment of the loan

• Costs – any direct costs, including legal fees, should be expensed as incurred

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TROUBLED DEBT RESTRUCTURINGS

Fees and Costs

• Fees – any fees received at the date of modification should reduce the recorded investment of the loan

• Costs – any direct costs, including legal fees, should be expensed as incurred

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TROUBLED DEBT RESTRUCTURINGS

Once a TDR, always a TDR?

• Yes, unless paid in full, or otherwise settled, sold, foreclosed or fully charged-off

• A TDR is always accounted for as a TDR (i.e., an impaired loan), but do not have to be reported as a TDR if (in the year following the modification):

The loan is at market rate of interest at time of closing; and

The loan is performing according to terms

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TROUBLED DEBT RESTRUCTURINGS

Impairment measurement

• TDR’s are Impaired Loans (regardless of accrual status)

• Measurement based on

Present value of expected future cash flows

Discounted at loan’s original effective interest rate

• Allowance recorded for any difference between Net Present Value and recorded investment of the loan

Principal forgiveness should be charged off; Principal deferral may need to be charged off

• Other measurement options (practical expedients)

Collateral value (if the loan is collateral dependent or when foreclosure is probable)

Observable market price of TDR loan (rarely exist)

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TROUBLED DEBT RESTRUCTURINGS

In early 2014 FASB issued ASU 2014-14, Receivables – Troubled Debt Restructurings by Creditors (ASC 310-40), Reclassification of Residential Real Estate Consumer Loans upon Foreclosure

• Narrow-scoped and aimed at reducing diversity in timing of loan derecognition of foreclosed real estate properties

ASU clarifies that a foreclosure occurs and physical possession is considered to have been received when either of the following are met:

o Creditor obtains legal title upon completion of foreclosure

o Borrower conveys all interest in the property to satisfy the loan through a deed in lieu of foreclosure

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ASU 2014-14 CONTINUED

• In addition will require increased disclosures regarding foreclosed residential real estate held or in the process of foreclosing

• Effective for non-public entities for annual periods beginning after December 15, 2014 and interim periods beginning after December 15, 2015

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PRIVATE COMPANY COUNCIL

Created in 2012 to serve as the primary advisory body to FASB regarding implications GAAP for private companies

• Have issued or addressing accounting alternatives (“GAAP Lite”) for private companies is areas such as:

Goodwill

Interest rate swaps (specifically excludes financial insitutions)

Business Combinations

VIE’s

• The guidance includes a definition of what is a public entity and therefore scoped out of using these alternatives

Guidance states credit unions are NOT public entities and therefore could use PCC alternatives

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PRIVATE COMPANY COUNCIL - CONTINUED

Proceed with caution

• The NCUA and other regulatory bodies have not formally taken a stance on if the PCC alternatives will be allowable for regulatory filings

If you implement these alternatives and the NCUA does not accept it you may need to keep different sets of books for regulatory filings and internal financials

Best practice is to contact you’re your accountants and regulators if you are considering implementing one of the alternatives

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THANK YOU

FOR MORE INFORMATION // For a complete list of our offices

& subsidiaries, visit bkd.com or contact:

Gordon Dobner, CPA // Director gdobner@bkd.com // 713.499.4605

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