Notes from the Field – the 2023 AICPA National Conference for Banks and Savings Institutions
I recently attended the 2023 AICPA National Conference for Banks and Savings Institutions. Speakers at the conference, which took place September 11-13 in Washington, DC, covered the economy, digital assets, regulatory developments, financial innovation, artificial intelligence (AI) and other current topics affecting financial institutions as well as the accounting and auditing profession.
The AI Evolution of Banking
The keynote speaker opening the conference was Scott Klososky from Future Point of View (FPOV). Scott focused on important AI strategy questions for leaders to answer. He outlined ten important questions that will help leaders and organizations assure they are moving forward to take advantage of the opportunities AI brings. AI is a complex and recent toolbox with many implications for the human race (and economy), so leaders must be thoughtful and proactive with answering critical questions about AI’s use. Several important AI questions were as follows:
1. What is the working definition for AI at your organization?
Before going any further with AI, this question must be answered at your organization. There are many definitions for AI in the marketplace, probably too many. The definition can evolve over time, but there must be a starting point.
2. Who in the organization will own the exploitation of AI as a tool?
Too many organizations will hand it to the Chief Information Officer, who is already overwhelmed with projects. Others will fail to choose an owner at all which will result in them falling woefully behind. There does not need to be a single owner. In fact, having each department head own responsibility for different aspects of AI might be the best scenario. This depends on the size of the organization and the desire to move quickly with AI implementation.
3. How progressive do you want to be with AI versus your competitors?
When a powerful new tool comes along, there is potential to use it faster and better than competitors and amplify profits by growing topline revenue and lowering operational costs through the use of AI. In some way it is an arms race for digital capabilities. An important question is whether you want to be a year ahead or a year behind your competitors with AI usage. There are risks and rewards tied to this decision so make it carefully.
4. How will you manage AI risk?
Most powerful tools have coinciding risks. AI is an example of this for sure. The world was slow to respond to the risk from cybersecurity and lessons should be learned from this. Leaders must add AI risk to their current enterprise risk management program. Someone on the team must take the responsibility to stay current on AI risks and mitigation strategies. This must be done now – before AI spreads across the organization.
5. What new AI governance needs to be put in place now before some aspect gets out of control?
For example, an organization should already have an acceptable use policy for AI and an AI ethics policy in place to help set expectations with team members. Depending on how AI is implemented at your organization, other policies will be needed and, in some cases, you will not be able to just go to the internet and download one. Organizations may need to design some of their own governance along the way.
6. What should be in your organization’s AI ethics policy?
Technology companies like Google and Microsoft have had AI ethics policies for years. These were written for their scale and for the work they do. An AI ethics policy for a smaller organization or a specific industry like healthcare needs to be very customized. AI is not going away, and it has a unique property in that it can make decisions that human beings have traditionally made.
7. What could an ambient intelligent layer of AIs do for your organization?
This is a large question and requires significant thought. We are not going to implement one AI in an organization. There will be many of them and they will soon be talking to each other (sharing data). They will create an ambient intelligent layer that helps your organization operate.
8. What are the AI Engine uses that can easily improve core processes?
Every organization is made up of an inventory of core processes. These processes dictate how efficient, effective, safe, and profitable an organization operates. We have known for many years that it is possible to do process re-engineering and streamline and automate processes to create value. We are now being handed an AI toolbox with powerful new options for upgrading processes that have dependencies on humans making decisions or doing highly repeatable tasks. It is very important to gain the understanding from a design level where AI can help the most.
9. Where in your organization do you most need an AI to make better/faster decisions than your people do today?
The speaker feels that AIs will grow in their abilities to make decisions as well as, or better than, your team members. Every day at a mid-sized organization there are thousands of decisions that get made on behalf of the organization. Some of these have far ranging impacts, for example policy pricing decisions and claims payment decisions in an insurance organization.
10. Can an AI become conscious, sentient, or cognitive?
The reason to have an answer is because many people are wondering how intelligent AIs can become and how closely their intelligence will resemble ours. This question will be asked many times by many people for the next decade and will be debated hotly. The speaker’s take is that there are many other forms of consciousness besides human. For example, he pointed out that dogs are conscious and so are plants, but it is a different flavor of sentience than what humans experience.
From an economic perspective, AI has the potential to transform traditional industries and labor markets. Marci Rossell, Former CNBC Chief Economist (see The Economists below), sees AI as a driver of economic growth and change. She sees AI as a transformational tool for historically very labor intensive industries (e.g., legal, accounting and consulting professions), which will change the competitive outlook to smaller businesses, due to reductions in their expense structure. AI also has the potential to enhance productivity in many professions with Rossell commenting that she leveraged ChatGPT to generate certain polling questions for her presentation.
SEC Update – Office of the Chief Accountant (OCA)
Paul Munter, Chief Accountant and Jonathan Wiggins, Deputy Chief Accountant, discussed a variety of topics during their remarks. The OCA presented its views on high-quality financial reporting and also provided its perspective on the following topics:
- Risk assessment and its influence on financial reporting and its importance;
- The importance of the effectiveness of internal controls over financial reporting;
- Oversight of the PCAOB and the FASB; and
- The importance of the auditor’s responsibility
While banking regulators are focused on safety and soundness, the SEC approaches its role with an investor-focused mindset. Interest rate risk remains a focus for the SEC due to rising interest rates, unrealized losses in securities portfolios, and reductions in liquidity. They pointed out the importance of presenting economic events and transactions in a transparent and understandable manner to investors.
The OCA emphasized that registrants need to address issues created by the quickly changing economic environment through the traditional disclosure-based regime. They recommended that registrants take a renewed look at their Item 305 of Regulation S-K disclosures.
Financial Accounting Standards Board (FASB)
- Technical Agenda
- Standard Setting Update (CECL, Near-Term, On the Horizon, and Recently Issued)
- Research Agenda
The panel began its discussion by reviewing the status and activities resulting from the post- implementation review (PIR) process for CECL. PIR may identify areas of improvement and result in additional standard-setting projects. The process is on-going for several years after the latest effective date of the standard. PIR feedback has resulted in the FASB adding a project to its technical agenda and the release of a proposed Accounting Standards Update (ASU) on Purchased Financial Assets (PFA) in June 2023.
Accounting for PFAs
The proposed amendment eliminates the assessment of credit deterioration at acquisition and applies the purchased credit-deteriorated (PCD) gross-up approach to all financial assets acquired. For an asset acquisition, the concept of “seasoning” is introduced to determine if the financial assets are considered acquired or originated. Day 1 credit loss expense is not recognized for an acquired financial asset accounted for under this approach; instead, an allowance for credit losses is established by grossing up the acquired asset’s amortized cost basis on acquisition.
The panel provided a standard-setting update regarding several near-term projects:
- Accounting and Disclosure of Crypto Assets – Final ASU is expected to be issued during Q4 2023, which addresses the subsequent measurement, presentation, and disclosure of certain crypto assets. In-scope crypto assets would be subsequently measured at fair value through net income with separate presentation from other intangibles on the balance sheet. There also would be separate presentation of gains/losses from amortization and impairment of intangible assets on the income statement.
- Targeted Improvements to Income Tax Disclosures – Final ASU is expected to be issued during Q4 2023, which would enhance the transparency and usefulness of income tax disclosures with more disaggregated information.
- Segment Reporting – Final ASU is expected to be issued in Q4 2023, which would require enhanced disclosure of significant segment expenses, disclosure of other segment items for each reportable segment, and require all entities to provide segment disclosures, including single-segment entities, as well as create more interim disclosures around segments.
On the Horizon
The panel discussed projects that FASB is considering in the future such as:
- Accounting for and Disclosure of Software Costs
- Topic 815 – Hedge Accounting Improvements
- Definition of a Derivative
- Disaggregation – Income Statement Expenses
Recently Issued ASUs
CECL – TDRs and Vintage Disclosures (2022-02)
Objective: To remove TDR recognition and measurement guidance for creditors that have adopted CECL and enhance disclosures for modifications made to borrowers experiencing financial difficulty.
Effective Date: Fiscal years beginning after December 15, 2022, including interim periods therein.
Reference Rate Reform (2022-06)
Objective: To defer the sunset date for applying Topic 848, Reference Rate Reform, relief.
Effective Date: Upon issuance (December 2022).
Investments in Tax Credit Structures (2023-02)
Objective: To improve the accounting for equity investments made primarily for the purpose of receiving income tax credits and other income tax benefits.
Effective Date: For public business entities, fiscal years beginning after December 15, 2023, including interim periods therein, early adoption permitted. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2024, including interim periods within those fiscal years, early adoption permitted.
Transition: Retrospective or modified retrospective (prospective allowed for certain low income housing tax credits).
PCAOB Proposal – Noncompliance with Laws and Regulations (NOCLAR)
Members of a panel led by Dennis McGowan, VP of Professional Practice at the Center of Audit Quality, focused on key aspects of the PCAOB proposal – NOCLAR – which would expand auditor responsibilities related to identification of a company’s noncompliance with laws and regulations.
The NOCLAR proposal would expand the current standards to include identification of laws and regulations with which noncompliance could reasonably have a material effect on the financial statements. The feasibility of complying with the increased scope was a focal point of the panelists.
The panelists expected the proposal to increase, perhaps significantly, an auditor’s use of legal specialists.
Federal Banking Agencies
Lara Lylozian noted that there was an 11% increase in the allowance for credit losses (ACL) for January 2023 adopters of CECL for all size banks and a 5% increase in the ACL for banks with assets of less than $10 billion.
Similar to the examination process under the incurred loss model, the examination process under CECL will encompass a focus on methodology, data integrity, governance, internal control, and complete documentation of policies and procedures. Qualitative factors included in the CECL models will be evaluated similar to the incurred loss models.
CECL model validation requirements are not unique, as noted by Amanda Freedle. The ACL model validations continue to be subject to regulatory model risk management requirements, and the required work depends on the overall size and complexity of the model used.
The special assessment should be accounted for in accordance with Accounting Standards Codification 450 on contingencies. The current timing of the special assessment is not currently known but will be tied to posting in the Federal Register.
In response to questions on what the definition of uninsured deposits are, the regulators commented that uninsured deposits are defined within the Call report instructions within Schedule RC-O. They also referred to FDIC letter or FIL 37-2023, Estimated Uninsured Deposits Reporting Expectations.
Held-to-Maturity (HTM) Securities
The regulators commented that the level of HTM securities within financial institutions are viewed holistically relative to liquidity levels.
The regulatory agencies’ concern is that expanding the current PCD accounting approach to substantially all purchased financial assets eliminates the immediate recognition of credit loss expense at acquisition and obscures that expense as a reduction of interest income (yield) over the lives of the loans. Unlike existing requirements to record impairment for other types of assets, the proposed ASU could result in writing off a purchased financial asset before the expected credit loss is fully expensed. Further, financial institutions may be incentivized to purchase financial assets instead of originating them to avoid immediate recognition of credit loss expense. Purchasing financial assets instead of originating them would result in different financial reporting outcomes despite the financial assets being economically similar. The agencies are concerned that the gross-up accounting approach provides incentives to overstate expected credit losses at acquisition followed in later periods by overstatement of earnings when grossed-up allowances are reversed with a credit to provision expense (i.e., a negative provision).
Report on Internal Control over Financial Reporting (ICFR) Under AU-C 940
For those institutions with total assets of $1 billion or more, Shannon Beattie, Chief Accountant from the FDIC, clarified that the report on ICFR should reference the regulatory reports filed at the consolidated level. That is, the Call Report or FR Y-9C.
CECL – Best Practices for 2020 Adopters and a Look at 2023 Adopters
This session focused on the TDR update in ASU 2022-02 and the proposed FASB update to Topic 326 related to PFAs. It also discussed some key observations from the 2020 and 2023 adopters.
ASU 2022-02 – TDR update will require thoughtful discussion and consideration on the part of management, accounting and reporting, and credit administration. Even though TDRs will be going away, enhanced disclosures are being added, requiring institutions to enhance the identification, monitoring, and reporting of loan modifications.
The proposed update by the FASB to Topic 326 related to PFAs will have a significant impact on the accounting for acquired financial assets with the goal of eliminating the “double count issue.”
CECL modeling should be viewed as an ongoing continuous evolving process with re-assessments and enhancements performed by management on a regular basis.
Marci Rossell, Former CNBC Chief Economist and Douglas Duncan, Chief Economist at Fannie Mae, discussed the economy, interest rates and the housing market. Rossell viewed 2023 as one of those years where the economy is facing a significant turning point and expects the next ten years to look very different than the last 20 years. She mentioned that changes in demographics are significantly impacting global economies. China is experiencing a demographic shift due to an aging population, which was the largest over the past 20+ years. China is strained to continue to provide cheap labor, and economic factors will serve to make its economy look much different during the next decade.
Rossell sees demographics in the U.S. workforce changing as most Boomers are approaching retirement, millennials have established their careers, and a smaller generation, Gen Z, is entering the work force. This dynamic is ultimately reducing unemployment rates with fewer employees entering the workforce than leaving. Under this scenario, Rossell views technology as a way to grow as an alternative to acquisition. AI and its potential to impact industries and labor markets was discussed at length.
Rossell, to some degree, compared the current economic environment to that of the 1980s when interest rates were increased aggressively and caused a recession. However, other factors such as oil prices, inflation expectations and labor markets contribute to today’s scenario being different and thus far avoiding a hard landing. Duncan shared a similar viewpoint to Rossell.
Duncan focused on debt levels being at record highs with interest expense being significant. He warned that this could trigger negative consequences in the near future.
Duncan emphasized that over 90% of existing mortgages are over 300 basis points below the market rate. As such, there is a disincentive for people to move resulting in a low supply in the housing market. This has driven up housing prices and resulted in first-time home buyers seeking alternatives to existing homes, such as new homes or new markets.
Duncan pointed out that the pandemic contributed to a redistribution of real estate values, with people moving further out of cities they previously worked in. The increase in work from home scenarios resulted in a shift from higher cost locations such as New York and Washington, DC to markets in the Midwest and Southwest.
Emerging Tax Developments Impacting Your Institution
David Thornton, CPA, Partner, discussed various tax topics in his session.
- Tax Planning in a Rising Interest Rate Environment
- 1% Federal Excise Tax on Stock Repurchases
- IRS Audit Exposure Areas
- Miscellaneous Developments
Tax Planning Strategies Impacted by Rising Interest Rates – Thornton discussed strategies directly impacted by rising interest rates and interest expense. Examples included minimizing the bank Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) interest expense disallowance and minimizing the impact of Internal Revenue Code (IRC) Section 163(j). The TEFRA interest expense disallowance under IRC Sections 265(b) and 291(e) require a formula-driven allocation of interest expense to a bank’s investment in tax-exempt municipal bonds/loans. Often referred to as the “TEFRA penalty,” this formula applies only to a bank. Interest expense allocation is permanently nondeductible and impacts the effective tax rate. However, only 20% of allocated interest is disallowed for “bank qualified” municipal securities/loans. Many banks are seeing significant increases in the TEFRA penalty due to the sharp rise in interest rates/interest expense. Separating the municipal securities/loans from the bank will likely remove them from the TEFRA formula. Potential risks with this tax strategy is that the municipal securities/loans separated from the bank no longer receive the protection of IRC Section 582(c); so, losses incurred on these securities may be capital losses and not ordinary losses. Another risk is that the IRS may challenge the substance of the subsidiary. The subsidiary needs to be a legitimate functioning corporate subsidiary with its own corporate structure, books and records, and board of directors. Also, it is strongly recommended that there is another business purpose for creating the subsidiary other than tax savings – for example, state tax savings, offering a more competitive advantage if able to underwrite the municipal loans at a lower rate since the subsidiary does not have to absorb TEFRA, etc. IRC Section 163(j) imposes an annual limitation on net business expense. Application of 163(j) to a bank is rare. However, companies are pursuing planning strategies where they capitalize interest expense to the balance sheet and take the deduction through the basis in the asset.
Strategies That Defer the Payment of Income Taxes by Accelerating Deductions and Deferring Taxable Income Recognition – Other strategies focus on reducing the current tax liability in favor of deferring the liability to a future tax year. This can be accomplished by accelerating deductions and/or deferring taxable income. The value is that cash is retained through the deferment of tax payments and increasing the company’s cash position in a rising rate environment. Examples of strategies that defer the payment of income taxes include:
- Defer market discount accretion on qualifying securities;
- Adopting the bank “conformity election” for bad debts;
- Make sure current deduction for qualifying loan origination costs is being claimed;
- Elect bonus depreciation on qualifying fixed assets;
- Complete a “cost segregation analysis” on construction projects; and
- Make sure the current deduction for qualifying short-term prepaid expenses is claimed.
1% Federal Excise Tax on Stock Repurchases – This 1% federal excise tax applies to all corporations whose stock is traded on an established securities market (i.e., listed exchanges, OTC, “pink sheets”, etc.). Applies if total amount paid for stock repurchases during the year is greater than $1 million and is effective for repurchases of stock occurring after December 31, 2022. Cash used in mergers will trigger the 1% tax for the target. From an accounting perspective, the tax is likely to be recorded, for book purposes, through equity.
IRS Audit Exposure Areas – The Inflation Reduction Act provided $80 billion of new funding to the IRS to both modernize the IRS and expand enforcement efforts. The Congressional Budget Office expects the increased funding to raise over $200 billion of additional tax revenue. The presenter noted that the IRS will likely audit Employee Retention Credit (ERC) claims. The speaker’s view is that those ERC filers who meet the gross receipts reduction threshold tests or those impacted by a COVID-related direct government lockdown order have a strong case for eligibility. For those taxpayers who cannot point to a compulsory closure of one or more locations may qualify for the ERC, but the speaker feels that this is more subjective. Recent pronouncements clearly suggest the IRS believes many overly-aggressive ERC claims were filed by taxpayers. The statute of limitations for the IRS to audit Q3 2021 ERC claims has been extended to 5 years as opposed to the typical 3 year limit. Another area of IRS focus will be Captive Insurance Arrangements. Treasury recently issued regulations (REG-109309-22, April 11, 2023) and, if finalized, the regulations may negatively impact micro-captive insurance arrangements. Under the new regulations, Treasury will automatically designate micro-captive insurance companies as a listed transaction if they have an annual claim loss/premium ratio of less than 65% for a 10-year period. If the period during which the cumulative 65% loss ratio has not been met is less than 10 years, they will retain their current status as a “transaction of interest.” Another area mentioned by the speaker where the IRS often focuses their audit resources is R&D tax credits.
Federal Tax Credit Developments – For energy tax credit ventures on which construction begins on or after January 29, 2023, the tax credit percentage on qualifying costs remains at 30% as long as the newly imposed prevailing wage requirement is met and the newly imposed apprenticeship requirement is met. Energy credits can now be purchased on the secondary market. From an accounting perspective, the proportional amortization method is now available for all types of qualifying tax credit equity investments in flow-through entities.
Favorable Development on BOLI Reportable Policy Sales – The Tax Cuts and Jobs Act introduced a new reportable policy sale rule that applies to certain indirect corporate owned life insurance policies (including BOLI). In 2019, treasury regulation confirmed that direct merger transactions would cause the rule to apply, even if the transaction was otherwise a tax-free reorganization. In May of 2023, proposed new treasury regulations retroactively reversed this position. Under the proposed regulations a reportable policy is not triggered if (1) the transaction is a tax-free reorganization and (2) the target is a C-corporation conducting an active trade or business and life insurance contracts comprise no more than 5% of the gross value of its assets.
Law Changes for 2022 and 2023 – Beginning in 2022, a requirement to capitalize internally developed software costs begins. In 2023, the business meals allowance goes back to 50% from 100%.
The conference was well attended with a good mixture of financial institutions, regulators, auditors and accountants.
Several key accounting topics were covered that should be considered heading into year-end 2023 and then into 2024. To discuss these or any other banking topics, please contact Joseph Jalbert, our banking and financial institution practice lead, or your BNN advisor at 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, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.