FASB Proposed Changes: The Past, Present, and Future of Purchased Credit Deteriorated Assets

By Michael Bailey September 13, 2023

The Current Expected Credit Loss Standard (CECL) was issued in 2016 under Accounting Standards Update (ASU) 2016-13 and has since undergone the Financial Accounting Standards Board (FASB) post-implementation review process to address stakeholder concerns over the practical implications of implementing and applying the standard at banks and financial institutions. This review found that the two separate accounting models prescribed under the standard for Purchased Credit Deteriorated (PCD) assets and non-PCD assets are causing undue complexity in implementation. Further, the subjectivity in applying those specific models is leading to potential issues with comparability between financial institutions.

In this article, we’ll dive into:

• the history of accounting for impaired asset purchases;
• the current accounting under the CECL standard
• the proposed changes by the FASB, and
• the implications of the standard on mergers and acquisitions (M&A) in the industry.

A bit of history

Prior to the implementation of CECL, PCD assets were known as Purchased Credit Impaired (PCI) assets. A PCI asset was defined as an asset with evidence of credit quality deterioration since origination. In this instance, it is probable that the buyer will be unable to collect all of the contractual cash flows from the borrower.

By replacing the PCI classification with the PCD classification, the FASB intended to allow for broader application by changing the criteria to any loans with “more than insignificant” credit deterioration. This is not specifically defined in the standard. In addition, buyers are no longer required to specifically factor in the probability of collection in their analysis. The PCD classification also includes analysis of broader factors such as the credit quality of guarantors, deterioration in risk ratings since issuance, and other considerations.

PCI to PCD. What does it mean?

In practice, this means that all loans that were classified as PCI under the old standard are classified as PCD under the new standard. If it is determined that such credit deterioration is applicable to the purchased assets based on the buyer’s policy, the asset is accounted for under the gross-up approach.

PCD Loan Purchase: The Gross-up Approach

For example, a loan with a par value of $1,000,000 is purchased for $900,000 and is determined to have more than insignificant credit deterioration since origination. The buyer estimates expected credit losses of $50,000.

The initial purchase would be recorded as follows:

Dr. Loan		$1,000,000 (Par value)
	Cr. Loan discount (non-credit)		$50,000 (Discount, net of expected credit loss)
	Cr. Allowance for credit losses		$50,000 (Estimated credit loss at purchase
	Cr. Cash		$900,000 (Purchase price)

Note that there is no earnings impact to this initial recognition. Related discounts and credit losses are netted with the par value of the loan to calculate the adjusted amortized cost basis. The adjusted amortized cost basis of the loan is $950,000. The non-credit discount is accreted into income over the life of the loan using the effective interest rate method. The difference between the adjusted cost basis and the purchase price is the non-credit discount or premium.

Non-PCD Loan Purchase

Using the same fact pattern as above, let’s assume that the purchaser determined that the purchased loan was non-PCD under the existing standard. The purchaser incorporates the newly purchased loan into their CECL model and determines a lifetime expected credit loss of $10,000.

In this situation, the discount is recorded as the difference between the purchase price and the par value.

The full discount is amortized over the life of the loan using the effective interest rate method. However, the purchased loan is now part of the buyer’s loan portfolio and must be evaluated for expected credit losses consistent with newly originated loans under the CECL standard.

Dr. Loan		$1,000,000 (Par value)
Dr. Provision for credit losses		$10,000 (Expected credit losses)
	Cr. Loan discount		$100,000 (Par value less purchase price)
	Cr. Allowance for credit losses		$10,000 (Expected credit losses)
	Cr. Cash		$900,000 (Purchase price)

Under this scenario, the expected credit losses are recorded as provision for credit loss expense at the purchase date similar to the origination of a new loan. The discount being accreted is inclusive of any expected credit losses. This results in more interest being accreted into income over the life of the loan when compared to the gross-up method. However, credit losses are recorded in income on Day 1 as opposed to PCD assets, for which credit losses are reflected through a reduced loan discount being accreted over the life of the loan. For non-PCD loans, the yield includes the accretion of the total discount (credit and non-credit), while the yield for PCD loans includes only the non-credit discount.

It’s important to note that the impact of this move from PCI accounting also means that the benefits of a loan that performs above expectations are not reflected in net interest income metrics. Instead they are reflected as provision adjustments, which may impact budgeting and financial analysis.

What does full compliance with CECL look like?

For institutions with existing PCI assets that transition to the PCD classification under the CECL model, the existing PCI assets should be adjusted to the gross-up method. PCI loans under the old standard qualify as initial PCD assets under CECL and are not required to be re-evaluated as either PCD or non-PCD.

PCI loans are originally recorded at amortized cost with the difference between par value and the purchase price being the discount or premium. If the buyer does not expect to collect all contractual cash flows, the difference is recorded as a nonaccretable difference that does not accrete into income. As expected, cash flows change, the nonaccretable difference is adjusted and the yield of the loan changes. The buyer is required to regularly re-evaluate the expected cash flows and adjust the balance, accordingly, resulting in burdensome accounting.

To transition to the gross-up approach, the buyer should adjust the amortized cost basis of the existing assets by removing any nonaccretable differences and recording an allowance for credit losses. The existing discount or premium that is related to credit risk is reclassified to the allowance for credit losses account. The remaining discount or premium represents non-credit risk and continues to be amortized over the remaining term of the loan.

Impact on M&A in the Industry

As you can see, the standard as written today allows for inconsistencies in the timing and classification of income and expenses depending on the ultimate determination of whether or not a loan is PCD. The proposed ASU would remove the requirement for purchasers to determine whether or not a loan is PCD and require that all purchased assets be accounted for under the gross-up method. This eliminates the gray area in the guidance and allows for consistency between all purchased assets. This consistency in approaches between institutions has become even more crucial in recent years due to the prevalence of M&A in the industry.

Under the PCD rules of CECL, the classification of purchased assets could vary from one institution to another based on broader subjective policy differences. This means that the acquired assets may be valued differently depending on who acquires them, which complicates the due diligence required for M&A.

In addition, forecasting expected financial results of potential M&As requires more insight into the unique accounting policies for all involved.  Requiring all purchased assets to be accounted for under the gross-up method helps to ensure an apples-to-apples comparison between different institutions.

Also note that the PCI classification required regular evaluation and could result in yield changes throughout the term of the loans. Under the PCD rules, credit risk is reflected with a reduced yield over the life of the purchased asset and does not require the same re-evaluations. In addition, the proposed ASU would eliminate the non-PCD classification, which would mean the initial recording for all purchased loans would have no impact on the income statement on Day 1.

Where to go from here

The adoption of CECL has highlighted the inherent risks of subjectivity in relation to accounting standards. This proposed ASU is an attempt to streamline the approach for asset purchases while promoting consistency and comparability between institutions, especially in an environment where mergers and acquisitions are prevalent. The FASB’s public comment period for this ASU ended on August 28 and any feedback received will be considered before implementation. Ultimately, the final ASU, if issued, will be a step in the right direction for the application of the CECL standard and should provide some much needed relief to accounting departments working diligently to be in compliance with it.