Reporting Back: 2018 AICPA Banking Conference

Carl Chatto, Managing Principal
October 4, 2018

John Marsh and I recently attended the AICPA National Conference on Banks and Savings Institutions from September 17-19. This annual conference brings together regulators, bankers and practitioners as panelists and presenters annually to cover developing issues relating to financial statements relating to banks and savings institutions.

While much of the conference was devoted to Current Expected Credit Losses (CECL), that was not the only topic covered. However, we’ll start there.

CECL

There is still a lot of angst about CECL implementation. Judging from what I heard for questions addressed to presenters and in talking with attendees, plus what the presenters themselves said, most banks fall into one of three categories:

  1. The information we’re gathering for CECL will help us make better credit and management decisions going forward
  2. CECL is a pain but we have to do it so we’ll find the most expeditious way to comply
  3. CELC was poorly thought through with too many unknowns and too hard to operationalize—they’re going to repeal this, right?

Most banks are in the second camp; the split is probably 10-70-20.

Somewhat surprisingly, and maybe defensively on their part, but the FASB representatives pretty much said that CECL is good for you and you should put yourselves in category 1.

One point that was made in several presentations is that CECL doesn’t change the total expected loss, only the timing of its recognition. That is true and worth remembering, but the change in timing and how much loss is recognized in a given year can be significant.

Most banks have created a CECL committee. This was a point made in several presentations. The CECL committee ideally has C-suite representation plus representatives from accounting, credit, risk, and IT. Often, internal audit participates as a resource too.

Data, data, data. Data challenges were mentioned often. Getting the right data for developing loss histories in categories that are meaningful but not so small as to be easily skewed was also cited as a challenge.

Development of CECL models was also a critical feature of CECL plans to date. Trying to model reasonable and supportable forecasts is obviously open to considerable interpretations and estimation. Many banks are looking at developing a range of estimates. The impact of qualitative factors might decrease since loss histories will now be life-of-loan, but the effect of longer term forecasts can be significant.

As the life-of-loan quantitative factors increase, there is an open question as to whether the capital requirements for banks should be reduced, since much of the uncertainty that capital was expected to cover will be moved to the allowance for loan losses under CECL. At this point, nothing has been proposed, other than the three-year phase-in period for capital effects proposed earlier this year.

The banking regulatory bodies sent representatives to discuss matters from their perspective. They said they are looking for good faith efforts to implement CECL, such as a plan with milestones and a plan to capture the needed data. They are not looking for banks to reconcile existing Q factors with new ones under CECL. They expect that a model will be based on inputs not outputs, meaning that the various factors used should be valid and supportable, in which case the output should be valid and supportable as well. However, it is also important to make sure the final CECL answer made sense and if not, inputs should be reviewed. Many bankers reported plans to run CECL parallel for two to four quarters as part of that back-end testing. If the CECL approach results in a lower allowance for loan losses, then management should be prepared to explain why to the examiners. The regulators also indicated that the call report is being revised for CECL and that should be ready for the first quarter call report in 2019.

As for modeling losses, it is interesting to note that the economist who spoke (see below) stated that one important economic indicator is the stock market. The market tends to predict future trends well and could be considered as an input into any CECL model. Models should also factor in local and regional economic forecasts too, which might require more subjectivity due to fewer information sources. Models should also be developed in part based on available data and with a careful consideration of causality of economic factors.

It’s important to remember that CECL affects debt security investments as well. There is a consensus that US treasury and government-sponsored enterprise debt can be assumed to have a zero expected loss.

There are a number of operational and accounting issues that are still being reviewed by FASB, with guidance hopefully coming soon enough to be helpful. Those include:

  • Treatment of recoveries
  • How to address expected prepayments
  • Accrued interest receivable –can probably continue existing accounting
  • Effect of subsequent events on the calculation
  • How to model loan extensions
  • Issues around PCI loans
  • Reasonable and supportable forecast period and subsequent reversion to the mean

A full list of open issues can be found here.

One part of CECL implementation that did not get much air time was the establishment of internal controls over both the implementation and the ongoing calculation. Both are almost certainly going to be key components of internal control over financial reporting from the perspective of management and the external auditor. Since CECL brings more subjectivity into the estimation process through reasonable and supporting economic forecasts, developing well-documented controls over inputs and changes to inputs over time will need to be carefully addressed. The AICPA is developing a white paper for use by auditors, but it should also be informative for preparers as well by giving insight into what external auditors will be focusing on. Likely areas of focus will be: segmentation, modeling and adjustments to the model, forecasting and adjustments to the forecast, management bias in selecting a point in the CECL range, and use of specialists and third parties.

Not everything was CECL, though. There were a number of other presenters covering a variety of topics.

Economic forecast

Marci Rossell, who was the chief economist for CNBC, gave her views on the economy. Among her points:
  • She believes that oil prices should stay in the $60-$70 per barrel price range since the US production has changed the supply and demand equation. This has shifted oil from a source of volatility to a source of stability.
  • There are some potential economic problems in some emerging markets—Argentina and Turkey, specifically—due to currency issues.
  • Often, the equity markets are better predictors of the economy than economists. The markets did a better job predicting the minimal effects of the US trade war than most economists.
  • She sees millennials (some of whom are now in their mid-thirties) moving to the suburbs in low tax states. This will have economic and political repercussions.
  • She believes the trade wars will be resolved sooner rather than later with some face-saving deals.
  • She does not see a national real estate bubble, although some local markets are susceptible to a pronounced downturn.
  • The US has historically been immune to a debt crisis despite metrics that would put most countries in that situation. With real interest rates less than 0%, she sees no political will to tackle the deficit.
  • Wages will not likely rise unless there is an increase in productivity, and productivity has not significantly increased since the Great Recession.

A speaker from Darling Consulting presented some thoughts on interest rate risk. He indicated that deposit rates might need to rise soon, especially as many banks look for additional funding at least on a national level. The probability of higher rates might mean adjustments need to be made to ALM models.

The yield curve is flat, which means it is important to understand the derivatives market.

It is also important to review ALM policies and make sure they reflect current business needs and consider revising them to include flexibility for new products such as callable CDs.

A panel of CFOs indicated that organic growth is harder to come by and branching in general doesn’t work as well as it used to. Small acquisitions can be a good source of growth.

Another speaker indicated that lower corporate income tax rates make mergers with operational synergies even more appealing from a net income standpoint.

SEC update

Wesley Bricker, the Deputy Chief Accountant of the SEC, presented some remarks.

The SEC encourages interim and transition disclosures of upcoming accounting changes to alert investors. He also noted that the processes and controls over CECL will be important. (See the observation in the CECL section about Internal Controls over Financial Reporting (ICFR). Bricker was one of the few speakers to highlight this.)

The new audit report will address Critical Audit Matters beginning in 2019 for large accelerated filers. The SEC views this as an important item and is looking for auditors and filers to share their experiences with the SEC.

Bricker also touched upon distributed ledgers (blockchain). A significant SEC concern is that a distributed ledger by itself does not verify ownership or related parties, meaning that related party disclosures might be incomplete or that transactions may not actually be at arm’s length. The change in fair values and contingent liabilities around digital assets are also emerging issues. As always, the controls over these areas are important.

There was another SEC session with two people from the Office of the Chief Accountant. They reinforced the emphasis on ICFR for new accounting standards.

Auditor independence is an area that has caused some issues involving auditors and loans to insiders of the registrant. In the eyes of the SEC, this is a joint responsibility of the auditor and the registrant.

It is not expected that the complete turnover of the PCAOB board will result in a wholesale shift of emphasis, but will probably result in some minor adjustments.

Leases

The new lease accounting rules got some exposure in a few sessions.

There is now an optional transition rule that allows showing a cumulative effect at 1/1/2019 rather than restating back to 1/1/2017; that will provide some operational relief in the implementation. There is also a practical expedient to allow combining rent and common area maintenance charges into one contract, rather needing to separate them, which will also allow for (somewhat) easier implementation.

Some implementation issues are cropping up. Finding leases buried in other contracts (embedded leases) is an issue in some cases. A review of monthly expenses, looking for items that provide control of an asset, is important. For instance, a lease that covers an ATM plus space for the ATM, use of a sky box at a sports venue, or a data center back-up site that allows for control of assets (space, computers) could be an embedded lease that falls under the new ASU.

Initial direct costs of a lease can be capitalized.

At the implementation date, a bank does not need to reassess the classification of existing leases.

Banking regulatory overview

A speaker from the law firm of Sullivan & Cromwell shared some regulatory insights. There has been change at the head of the FDIC and the OCC but those changes haven’t led to big directional changes at the agencies. For example, there is a new focus on guidelines vs. regulations, but how this plays out in the field is still an open question.

Money laundering has gotten some new focus since criminals have gotten smarter. Know Your Customer controls will be important still, and cryptocurrency will be important to control as well.

Crisis planning has also gotten some renewed attention. Good plans should have a rapid identification of issues with a protocol for internal and external communications. It’s also important to note that many internal crises have arisen in areas of the bank with unexpectedly large financial performance because polices were violated or ignored.

EGRRCPA (Economic Growth, Regulation Relief, and Consumer Protection Act) provides for banks under $10 billion an exemption from the risk-based capital and leverage capital rules if the bank’s leverage ratio is 8-10%, depending on certain circumstances. EGRRCPA also provides for short form call reports to be extended to banks under $5 billion.

The banking regulators also discussed auditor independence, with some violations detected in peer reviews of CPA firms where the audit firm prepared the financial statements, which creates a lack of auditor independence. Timely communication with the FDIC or OCC is important in those cases.

The agencies are also looking at audit committee members to make sure that there is the appropriate outside director composition.

Hedge accounting

The hedge accounting rules have been loosened somewhat, so that hedging might be more appealing. For instance, banks are now allowed to separate the risk from the forecasted transaction and hedge a specific risk, not just the entire contract.

There is also a “last-of-layer” concept that allows for macro-hedging of a portfolio rather than having to identify specific loans, for instance, that are being hedged.

There are still implementation issues, though, that need to be considered. Upfront documentation is still important and how initial values are amortized and allocation of fair value changes will need to be considered. And again, ICFR over hedging will need to be developed and documented.

Income taxes

The recent Tax Cuts and Jobs Act has a number of significant effects. Some of these have been discussed by BNN before.

  • The reduction in the federal tax rate will effectively increase the true cost of state and local taxes.
  • IRC 162(m) Limitation
    • Longstanding provision applicable to public companies that limits the annual deduction for compensation paid to certain executive officers to $1 million
    • New law expands the scope and application of this limitation by:
      • Expanding the number of executives and companies to which the limitation applies
      • Potentially expanding the time during which the limitation applies; and
      • Eliminating certain exceptions to the limitation that applied under prior law
      • Includes principal executive officer, principal financial officer, and 3 most highly compensated employees other than these two individuals, provided the compensation of these employees is required to be reported to shareholders under SEC rules
      • Applies a “once a covered employee, always a covered employee” rule beginning in 2017
        • This expansion may significantly increase the number of covered employees over time compared to prior law
      • These new provisions may expand the requirement to schedule the reversals of temporary differences related to accrued bonuses, stock-based compensation and deferred compensation
      • May be necessary to ensure a deferred tax asset is not carried on compensation accruals forecasted to be nondeductible upon reversal due to the $1 million limitation
  • Interest expense deduction is subject to an annual limitation. Generally 30% of EBITDA plus floor plan financing interest expense. Can be carried forward indefinitely. The limitation could impose a substantial burden on a bank’s commercial loan customers who are highly leveraged, making debt financing more expensive than other alternatives. Some of these customers may turn to leasing as a means of securing more tax-favorable financing.
  • Alternative Minimum Tax Changes – given that AMT credit carryforward realization no longer requires future taxable income, a bank could consider reclassifying these credits on the balance sheet as tax receivables, rather than deferred tax assets. This provides significant improvement to the treatment of AMT credit carryforwards in the regulatory capital calculations.
  • Discussed tax credit changes and what was retained such as R&D tax credit, Low Income Housing tax credit, energy credit and new markets tax credit. New credit available for certain compensation paid in 2018 and 2019 to employees on medical or family leave.
  • Qualified Opportunity Fund Investments –
    • Original gain is deferred until the earlier of
      • The date the QOF investment is sold or exchanged, or December 31, 2026
      • A portion of the original deferred gain is exempt from taxation if certain holding period requirements are met.
  • BOLI Transfers
    • New law applicable to transfer of BOLI policies may have unintended consequences for bank mergers and acquisitions. BOLI policies transferred for value lose their tax-exempt status upon transfer and produce taxable income going forward. This treatment is not new, but tax law changes seeking to apply these rules to transfers of equity interests in entities owning the policies failed to provide explicit exemptions for tax-free mergers and stock acquisitions. An acquirer would recognize taxable income when payment is received upon death or surrender of the policy for the amount in excess of the sum of: The value of consideration transferred for the policy, plus premiums or other amounts subsequently paid by the acquirer and require a deferred tax liability to be recorded against a portion of the post-acquisition cash surrender value (CSV) buildup and a tax liability to be recorded upon receipt of the death benefit. The application of the new rule to tax-free mergers and stock acquisitions appears to be inadvertent and is the subject of intense lobbying efforts to correct.
  • S-Corp. Banks
    • New law generally provides a 20% deduction for pass-through business income recognized by an S-corporation shareholder.
  • Discussed tax strategies for calendar year taxpayers who have not filed their 2017 returns
    • Bonus depreciation election
    • Cost segregation analysis
    • Qualified benefit plan contributions
    • Current deduction for loan origination costs and qualified short-term prepaid expenses
    • Fiscal year taxpayers can apply all of the aforementioned strategies
  • Deferred tax assets in Common Equity Tier 1 Capital
    • The prohibition on federal NOL carrybacks eliminates the unlimited class of DTAs justified through hypothetical carryback
    • It may also exacerbate the disallowed class of carryforward DTAs by causing all federal NOLs to fall into this category
    • If, given their refundable status, the AMT credits are reclassified from DTAs to tax receivables, there may be no limitation on the ability to count these DTAs in regulatory capital.

Other topics

The new revenue recognition accounting did not get much attention. For most community banks, the changes will not be significant. However, the lenders need to be aware that many loan customers might be reporting significantly different financial results once they implement the new accounting.

There was a discussion of helping banks determine whether they are public business entities (PBEs). That is important in determine the implementation dates of new accounting standards and the level of disclosures. In some cases, brokered CDs that trade on a market can be considered a security that trade without restriction and move a bank into the PBE designation.

If you have questions on any of these topics, please contact Carl Chatto or your BNN advisor 1.800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.