Accounting for purchased loans: How to determine the appropriate standard

In light of record-high at-risk bank figures, increasing regulatory pressures, a low-interest rate environment and the continued struggle for capital, many banks have, and are continuing to seek increased growth via mergers and acquisitions.

The acquisition of loan portfolios, particularly those of failed institutions or those succumbing to the aforementioned pressures can present healthier institutions with a unique opportunity to rapidly expand their current footprint, enhance their deposit base and provide value to shareholders, oftentimes at significant discounts.

Though these acquisitions can be attractive, what may be less attractive are the associated GAAP purchase accounting standards, in all their complexities. Such complexities make accounting for purchased loans easier said than done.

When we speak of GAAP purchase accounting, it is often related to “Fair Value Accounting.” This is due to the fact that all acquired loans are initially measured at their fair value, which includes estimation of life-of-loan credit loss. Consequently, this also means that any associated ALLL is no longer carried over to the acquirer’s balance sheet with the loans, as in the past, since the fair value of such loans already, presumably, takes into account any applicable discounts for credit quality.

For “Day Two” accounting (accounting for the loans after the financial close date of the business combination), there are two prevailing standards:

1. ASC 310-20 (FAS 91): Nonrefundable Fees and Other Costs
2. ASC 310-30 (SOP 03-3): Loans and Debt Securities Acquired with Deteriorated Credit Quality.

The standard under which each loan must be accounted for is determined on a loan-by-loan basis at acquisition, and transitioning between standards subsequent to the acquisition date is prohibited.

When making the determination, the question an institution asks is: “Should this loan be accounted for based on its contractual or expected cash flows?”

ASC 310-30 (SOP 03-3) uses the acquirer’s “cash flow expected at acquisition” as the benchmarking for calculating the yield (interest income) on the investment in the loan, as well as for purposes of determining whether the loan is impaired and how that impairment should be measured.

ASC 310-20 (FAS 91) measures yield and impairment utilizing contractual cash flows as benchmarks. Each of these standards has specific (and somewhat complex) accounting requirements.

To assist in managing the complexities of purchased loan accounting, many institutions rely on third-party software or consultants to help reduce the burden, as they often lack both the time and specialization necessary for the accounting standards.