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Preparing for M&A in a CECL world

IntroductionOn January 1, 2020 the Current Expected Credit Loss Methodology (CECL) becomes effective for SEC filers (except Small Reporting Companies).1 While companies have had three years to prepare, less attention has been paid to the significant impact the new credit loss accounting will have on mergers and acquisitions. The impact of CECL has not yet been fully taken into account

in financial due diligence, transaction pricing, purchase accounting, or other merger factors. This needs to change. To price a transaction correctly and capture expected value, acquirers may need to calculate both the impact of CECL accounting on a target’s financials and the costs of CECL implementation and compliance during due diligence.

1The FASB decided as part of ASU 2019-10 that CECL will be effective for Public business entities (PBEs) that are SEC filers, excluding entities eligible to be smaller reporting companies (SRCs) as currently defined by the SEC, for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. For calendar-year-end companies, this will be January 1, 2020. The Board affirmed that the one-time determination of whether an entity is eligible to be an SRC will be based on an entity’s most recent assessment in accordance with SEC regulations as of the date that a final Update on effective dates is issued (for example, November 20, 2019). For all other entities, CECL will be effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.

Acquisition evaluation and

pricing

Pre-sign

— Conduct assessment of target Finance Function

— Initial valuation estimation

— Consider integration opportunities, synergies, risks and issues

— M&A strategy developed

Due diligence

Pre-close

— Perform accounting and finance integration diligence

— Estimate day 1 CECL for acquired assets

— Develop detailed plan for Day 1 and stabilization and short term integration

Business combination/asset

acquisition

Close

— Record acquired entity/assets at fair value and perform purchase accounting

— Calculate day 1 CECL on acquired amortized cost accounted assets

— Implement interim financial controls and policies

Post-close accounting

considerations

Post-close

— Consolidate financial reporting & issue first quarterly financials

— Implement target Finance Function operating model (organization, process, technology & controls)

— CECL business as usual under acquirer’s methodology

Exhibit 1. The deal lifecycle

For private companies that have not yet adopted CECL, the deal lifecycle would need to address the gaps between the legacy Allowance for Loan & Leases Losses concept and CECL as part of acquisition procedures.

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CECL requires entities to forecast expected credit losses for financial assets measured at amortized cost and record those losses on Day 1 of origination or acquisition. If the asset is a loan or other financing receivable, the acquirer is required to record the purchase of those assets at fair value in line with current accounting guidance and simultaneously model expected credit losses over the remaining contractual term of the acquired asset and record that loss on the balance sheet. This new requirement impacts not just the accounting for acquired assets but also commercial considerations, such as acquisition pricing and how lifetime losses would affect return on investment.

CECL also introduces a new approach to accounting for the purchase of distressed or credit-impaired assets. Changes in expected credit losses under CECL for purchased credit-deteriorated (“PCD”) assets—including both increases and decreases—will be recorded immediately on the income

statement with the offsetting entry adjusting the allowance for credit losses on the balance sheet. This is a significant change from the existing prospective yield adjustment approach, codified in Subtopic 310-30, which reflects improvements in expected cash flows through recalculating the effective interest rate rather than recognizing them immediately in net income. The initial estimate of lifetime expected credit losses for PCD financial assets under CECL is not recognized in the income statement; instead, it is recognized through a balance sheet ‘gross up.’ In contrast, lifetime expected credit losses of non-PCD financial assets and other in scope contracts are recorded on Day 1 as a charge to the acquirer’s income statement.

This article will discuss key considerations for CECL in M&A and describes best practices for how entities can address the effects of the new accounting procedure. We look at the implications of CECL in the deal context, in both pre-deal diligence and post-deal integration.

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Quantitative impact of CECL

The primary concern with CECL is its potential financial impact. CECL requires that entities estimate expected collections using historical information, current conditions and reasonable and supportable forecasts. One way of achieving this accounting requirement includes econometric and statistical methods incorporating independent variables such as macroeconomic forecasts and risk characteristics in order to estimate credit losses. This means the size of the allowance for credit losses (ACL) under CECL will be in part a function of how the performance of the underwriting, geographic, economic and idiosyncratic events are expected to impact collections and associated credit losses. While the current economic conditions could be described as benign, an expected downturn in the U.S. economy, for example, could result in entities having to record significant allowances for CECL in anticipation of greater expected credit losses. This new requirement to forecast changes in economic conditions is going to fundamentally change how organizations measure their allowance for credit losses and structure their internal processes and controls. As a result, CECL changes are gradually breaking down siloes that exist in current allowance and other financial and risk management processes driving many towards more integrated solutions. In addition, due to changes in the ACL, the need for appropriate management information and period-over-period analysis will increase dramatically.

Truly understanding the movements of the ACL and the ability to convey the story of earnings to investors and other stakeholders will become much more complicated than it is today.

In KPMG’s 2019 CECL Survey,2 most respondents said they expect CECL to result in an increase in the allowance for credit losses as recorded today by anywhere from 0 percent to 60 percent, with the average expected increase 29 percent (Exhibit 2).

The Survey also indicated that CEOs and CFOs are increasingly concerned that CECL will impact the portfolio composition and commercial practices, as certain product features can result in relatively higher CECL allowances.

This increased appreciation of the impacts of CECL on such issues as portfolio mix, pricing, and terms & conditions, means that the banking industry in particular is clearly beginning to see the potential impact of CECL on their business. Banking respondents showed the highest expectation of CECL impact by comparison to other industries. This makes sense because the banking industry relies on a concept of regulatory capital which is expected to be potentially significantly impacted by CECL estimates. Year-on-year, we observed more respondents identify the impact of CECL on product mix, product pricing, and product contractual features as being highly significant.

2CECL Survey 2019, KPMG https://advisory.kpmg.us/articles/2019/cecl-survey-2019.html

The expected entity level impact of CECL

Exhibit 2. By what percentage do you expect your existing allowance for credit losses to change when CECL becomes effective?

2019 2018 Average 2019 Average 2018

05 10 15 20 25 30 35 400

20

40

60

80

100

Increase in ACL

Cu

mu

lati

vere

spo

nd

ents

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Anticipating the financial impact that CECL will have on a target’s enterprise value and balance sheet is necessary for financial (and capital) modeling. However, acquirers have yet to fully contemplate the potential effects of CECL on the purchase price. Instead, acquirers are evaluating acquisitions under today’s accounting regime even though the target may have different enterprise valuations under CECL.3 Analyzing the impact CECL may have on enterprise value should be part of the deal calculus.

It is also important to understand the status of the target’s CECL readiness and adoption process. If an acquisition

target is not prepared for CECL (e.g. if the adoption date for the target is after 2022), this indicates a need for future expenditures on personnel, outside advisors and systems to assess CECL impact and adopt the CECL accounting requirements. CECL requirements can quickly overwhelm existing staff and systems and requires additional resources, which is a cost that acquirers should factor into due diligence and valuation processes. Sometimes CECL requirements can be fulfilled by a well prepared acquirer. In other situations, the acquirer may be less well prepared for CECL than the target, and uses the target’s know-how and systems to streamline its own CECL adoption.

3Enterprise value is defined as the market value of a company’s capital and debt less cash. A company’s capital is impacted by CECL.

Impact of CECL on acquisition evaluation and pricing

Risk and finance systems and operations:

Acquirer and target will have their own set of risk and finance systems and processes. This will cause additional complexity in integration with a centralized data repository and modeling methodology for CECL modeling. Accounting policy decisions have to be established early and operationalized in a timely manner. Rationalization of risk and finance processes and systems may provide cost savings and harmonization of the operating model.

Acquirers are also advised to consider the difference in adoption dates for CECL, meaning that private companies may still be applying the incurred loss model rather than CECL at the time of acquisition. Private equity companies should also take into account that portfolio holding entities under their management that have a January 1, 2023 CECL adoption date may need to accelerate the adoption of CECL if the exit strategy involves an IPO or sale to a public company. It is therefore advisable to not postpone the implementation of CECL too long.

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Accounting for purchased assets

ASC 805 requires that under the acquisition method, all assets acquired and liabilities assumed be measured at fair value, as defined by ASC 820 and using market participant assumptions. Asset acquisitions that do not constitute a business combination are also initially measured at fair value (ASC 310). When it comes to acquired loans and other receivables, fair value should incorporate the market participants’ expectations of future lifetime credit losses, in addition to prepayments, and consideration of market discount rates. Given these existing requirements, fair value in an acquisition should already incorporate not just incurred losses but also all future expected losses over the remaining term of a loan, which will also be required by CECL.

In practice, credit losses for valuations performed in accordance with ASC 805 are often estimated using one or more of the following techniques:

— Historical loss data/observations of the acquired loan portfolio

— Historical loss data/observations of comparable loan portfolios

— Econometric models with multiple variables

— Empirical studies or industry/regulator studies or whitepapers

— Management’s qualitative commentary

ASC 820 also requires that fair value be calculated using market participant assumptions while management’s expectation of credit losses and judgment under CECL are entity-specific. Market participant assumptions may consider the target and/or acquirer’s own views but should also consider the views of all market participants. Finally,

the technique used depends on the availability of data, and the limited time from legal Day 1 to close.

Post-CECL adoption, it may be a significant challenge to utilize calculated CECL estimates as an input to fair value calculations. For example, CECL requires estimated credit losses to be calculated over the remaining contractual term of an asset without consideration of term renewal and extension options that are within the lender’s control, even if the lender has a practice of extending the term. Additionally, CECL permits expected credit losses to be measured on an undiscounted basis. In contrast, the income approach toward estimating fair value uses market observed credit loss and prepayment assumption inputs to risk adjust contractual to expected cash flows, which are discounted at market rates.

As another example, in the case of a collateral dependent financial asset, a practical expedient may be used under CECL to estimate credit losses as the difference between the report date collateral value, less undiscounted costs to sell. However, the fair value of such an asset is calculated using the economic collateral value at expected disposition less costs to maintain, repair and sell the property. That net realizable value is discounted at market rates. Further, unfunded loan commitments that are unconditionally cancelable are not subject to CECL, but are included in the fair value calculation. The expected credit losses in the CECL estimate and credit mark losses in a fair value estimate may have some degree of overlap in terms of data and risk characteristics, but the application of that loss data can be significantly different when comparing a financial instrument’s exit price to management’s best estimate of credits losses under the new CECL standard.

Business combinations and asset acquisitions

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One CECL consequence involves a so-called credit loss “double-count” for non-PCD assets. This occurs because acquired assets are measured at fair value and should incorporate credit lifetime expected credit losses. However, a CECL allowance is required to be immediately booked; therefore, the losses associated with non-PCD acquired financial assets will be a charge against earnings and reduce capital—a real cost to entities (and effectively aligning with the accounting of originated loans). In

practice, acquirers may try to reduce the non-PCD allowance by the unamortized fair value discount expected at charge off.

Acquirers could classify a greater number of assets as PCD to limit a material impact of the potential double-counting issue and reduce the subsequent accounting effort. However, it is important that acquirers have documented policies to classify PCD and non-PCD acquired assets.

CECL supersedes the guidance in ASC 310-30 for Purchased Credit Impaired (PCI) assets, and introduces PCD accounting methodology for certain financial assets. Unlike the guidance in ASC 310-30, CECL requires an entity to establish an allowance for credit losses for PCD assets on acquisition. This allowance is added to the purchase price of the PCD asset to determine its initial amortized cost basis (referred to as a “gross-up” entry) that is used for interest income recognition. This approach is intended to make PCD assets less complex, facilitate better analysis, and prevent the accretion of the credit discount into interest income. The initial recognition of an allowance has no effect on net income.

The definition of PCD assets does not include a probability threshold regarding collection and requires only that there be a more-than-insignificant deterioration in an asset’s credit quality since origination. Consequently, the PCD definition encompasses more assets than the PCI definition. Furthermore, the scope of PCD is broader than PCI (e.g. direct finance leases, credit cards, home equity etc.). However, PCD accounting cannot be applied by analogy to assets that do not meet the PCD definition, while PCI accounting was permitted to be applied for certain assets that may not have met the PCI definition. Upon adoption of CECL, any existing PCI assets accounted for under ASC 310-30 (including assets for which PCI

Acquiring credit deteriorated assets

Exhibit 3. Dealmakers may need to include quantitative and qualitative CECL impact assessments within the transaction evaluation process in order to gain more insights into valuation and to help improve deal success.

Due diligence valuations

CECL’s impact on earnings cyclicality remains controversial, but is generally expected to contribute to more stable reserve levels over the economic cycle. Relative to today’s incurred loss framework, this stability could result in valuations that are punished less during economic downturns and more during economic expansion periods.

Specific considerations

M&A transactions prior to CECL’s effective date may give rise to certain product-specific issues to evaluate. For example, complexities may arise due to the differences in purchased credit-impaired (PCI) versus purchased credit-deteriorated (PCD) accounting.

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guidance has been applied by analogy), will automatically become PCD assets under CECL. Further, any existing assets not accounted for under ASC 310-30 will not be treated as PCD assets, even if they meet the PCD definition. New assets acquired after the adoption of CECL are assessed at the date of acquisition for application of PCD or non-PCD accounting. It is important to note that PCD accounting will also apply to PCI available for-sale debt securities on the date CECL is adopted.

Another significant change between PCI and PCD accounting is the treatment of changes in expected cash flows. For PCD assets, subsequent changes (either favorable or unfavorable) in expected cash flows are immediately recognized in net income by adjusting the

allowance. This contrasts with today’s PCI accounting where the effective yield is increased when subsequent changes in expected cash flows are both probable and significantly favorable, while an allowance is recognized immediately through net income when there is a subsequent decrease in expected cash flows. Additionally, the different methods for estimating credit losses under CECL may result in a different accretable yield at acquisition under PCD accounting than the accretable yield under PCI accounting. In summary, the effective interest rate may be significantly different for PCD assets than for legacy PCI assets. This seemingly subtle change to the yield may require some additional explanation to financial analysts and investors.

The adoption of CECL and PCD accounting have caused confusion and debate on several fronts. Here we summarize what acquirers will need to know, assess and address as they transition to CECL and PCD accounting.

Upon transition to CECL, entities are also able to elect the fair value option for existing financial assets in the scope of CECL (other than for held-to-maturity debt securities). An acquirer in a business combination completed prior to the adoption of CECL should consider whether to elect to apply the fair value option for the acquired portfolio of financial assets, rather than estimating expected credit losses under CECL. Subsequent to CECL transition, acquirers will continue to be able to elect the fair value option for newly acquired financial assets on the date of acquisition.

There is a significant amount of complex accounting to consider that CECL impacts including: pushdown accounting, indemnification assets, PCD accounting, negative allowances, credit enhancements, troubled debt restructuring assets, etc.

The concept of pushdown accounting in US GAAP is the use of the acquirer’s basis of accounting in the preparation of the acquiree’s financial statements. This includes the

effects of acquisition accounting as well as PCD accounting applied by the acquirer; partial pushdown accounting is not permitted. Entities are advised to carefully consider the potential effects of PCD accounting to the acquiree’s financial statements and address this in their accounting policies in advance of CECL adoption.

Under CECL, an entity is required to establish a policy for writeoffs (full or partial) of financial assets when they are deemed uncollectible. In some cases, an entity’s write-off policy may result in write-off of a newly-acquired PCD asset even though the entity expects some collections. The FASB recently proposed amendments that would require an entity to include expected recoveries of the amortized cost basis when estimating the allowance for credit losses for PCD assets, which may result in a “negative” allowance for PCD assets. The negative allowance would not include recoveries of the unamortized non-credit discount or premium. The consideration of write-offs will reduce the allowance for credit losses which in turn, for regulated banking institutions, will result in a positive impact to capital. At a September 2019 meeting, the FASB affirmed its decision and expects to issue a final standard in Q4 2019.

Additional accounting considerations

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How acquirers can prepare for CECL

Understanding the future impact of CECL on a target’s financial statements early in the due diligence process is critical in valuing a target and evaluating transaction economics, including cost and effort of CECL implementation post-acquisition. However, during due diligence, time is often extremely limited and obtaining the type of information needed to thoroughly analyze, scope and apply the analysis can be a challenge. Therefore, it is not feasible under existing financial due diligence processes to conduct a full CECL analysis, particularly if the target lacks adequate information to complete such an analysis. And it may not always be feasible to conduct a full CECL impact analysis, particularly if the target lacks adequate data and portfolio loss history. However, in instances where a target’s portfolio provides sufficient data elements to perform such an analysis, a forecasting tool such as the one KPMG has developed can be used to present a range of potential CECL impacts based on various economic forecasts.

The tool ingests the target’s data (typically loan tapes) and then develops a regression model utilizing various economic scenarios. Once the data is ingested, the tool is able to quickly run idiosyncratic cases based on the acquirer’s desired scenarios.

While not meant to be a final CECL estimate, the range of results provides acquirers with a CECL impact estimate and can help inform overall decisions and future implementation of CECL.4

In addition to evaluating the quantitative impacts of CECL, due diligence should include a readiness assessment,

policy and methodology comparison/harmonization, and a cost-to-completion estimate for CECL implementation. Acquirers must consider the time and cost for a potential target to meet CECL requirements on a stand-alone basis as well as post-close when finance and risk processes are integrated. Often, anticipated expenses related to CECL can be negotiated as a reduction to the purchase price.

Where the purchase price is partially based on a loan valuation—as it often is for lenders—acquirers may need to be able to explain the difference between the market value of the loans to the Day 1 CECL-adjusted book value of the

Actions during due diligence

4KPMG's Count Down to CECL https://advisory.kpmg.us/content/dam/advisory/en/pdfs/2019/countdown-to-cecl-2019.pdf provides an explanation of the implementation process to help you prepare for 2020.

Data for CECL

Depending on CECL modeling decisions for estimating credit losses, there may be a need for additional data (for example longer loss history, asset maturity dates, interest rates etc.). Acquirers are advised to assess the target for its existing data sources as much as possible, plan for both data storage, and integration of the target’s data into its own data sets for modelling and reporting purposes. A centralized data warehouse and robust controls over data could mitigate the risk associated with multiple data sources.

Due to the complex requirements of CECL, there could be a need to store multiple years of data. Data management techniques have to be implemented in collaboration with internal IT or third-party solution providers to ensure the success of data integration following an acquisition.

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loans (if those valuations differ). Acquirers to date have not had to perform that exercise, but it should be a core part of due diligence leading up to implementation of the new standard.

During pre-deal analysis, an acquirer may consider the following steps:

Identify PCD assets, non-PCD assets, commitments, and other contracts in the scope of CECL

Estimate the Day 1 fair value and the related adjustment to the acquirer’s amortized cost basis

Estimate the amortized cost basis that will remain at expected charge off date

Calculate the estimate of expected credit losses under CECL based on the best available information

Analyze the impact of the initial CECL charge to earnings on Day 1 of the combined entity and associated purchase price reduction, as warranted.

Consider other accounting impacts such as Goodwill, Indemnification assets and Deferred Tax Assets

Exhibit 4. CECL’s financial and valuation impacts will create challenges for dealmakers after adoption.

CECL changes can dramatically influence how acquirers think about integrating finance and risk management processes and improving post-close governance and controls related to financial planning, data, and financial reporting. Under CECL, post-close financial planning will require greater coordination and integration between risk and finance processes. Managing financial data and sharing data across departments will require stricter controls, especially when third-party data providers are utilized. Acquirers must evaluate the sources, quality, history and availability of financial data for their targets. In addition

to that, models, model risk management frameworks, management overlays will all need to be evaluated by acquirers. Finally, financial reporting processes should include streamlined and pragmatic financial modeling to avoid overwhelming existing resources and analytical platforms. As a result of these CECL-driven changes, M&A transactions are accelerating the development of stronger internal audit and oversight capabilities as part of the finance target operating model (TOM) while emphasizing the sustainability and “auditability” of revised processes.

1

2

3

4

5

6

Post-close CECL actions

Due diligence processes Due diligence processes may need to consider, for example, (1) differences in valuation multiples to reflect differences in CECL methodologies, (2) financial and valuation impacts arising from changes on forward-looking economic factors, and (3) potential shift to non-GAAP measures to enable comparability.

Comparability with prior periods Certain financial metrics subsequent to CECL adoption will no longer be comparable to prior periods. Reserves and earnings may be more volatile.

Fair value option CECL will exacerbate asymmetry between timing of interest income recognition and recognition of credit losses. To mitigate this asymmetry, entities may give consideration to use of the fair value option for future M&A transactions.

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ConclusionThe transition to CECL presents a range of issues and complexities for C-level executives to consider as part of the M&A process. As noted, public companies that are required to comply with CECL must adopt a new approach to accounting for the purchase of distressed or credit-impaired assets, because CECL uses the PCD model, not the PCI model required under Subtopic 310-30. Under CECL, whether an asset is PCD or not will impact

whether expected credit losses are recognized through earnings in connection with recording an acquisition and will create new complexities in credit loss accounting. The new standard may also impact earnings and tangible book value for most institutions and capital for regulated banking entities, possibly creating additional complexities in integrating risk and finance processes post-close.

Buyer/diligence considerations

— Estimate CECL impact during due diligence

— Financial, reporting, people, process, systems, data

— Consider earnings and valuation impact

— Use of fair value option upon adoption

— Purchase price allocation

— Evaluate differences in methodology

— Assess CECL impact on loan covenants and financing agreements

Exhibit 5. Investor impact areas:

Financial impact

— Increased loss reserves and deferred tax assets

— Reduction in capital levels

— Increased earnings volatility

— Asymmetrical accounting: interest income recognized when earned, lifetime credit losses recognized on Day 1

Valuation impact

— Uncertain impact on valuation multiples

— Comparability issues between pre and post-CECL periods

— Valuation methodology consistency issues

— Changes in market conditions

CECL readiness

— Determine entity’s readiness for CECL implementation

— Consider timing of acquisition versus CECL adoption

— Estimate cost and effort of implementation

1 2 3 4

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We have been helping leading financial institutions with CECL accounting matters since the new regulation was proposed. In addition, KPMG has been assisting clients with International Financial Reporting Standards (IFRS) 9 implementations and quantitative impact assessments for international banks and U.S. dual filers.

We have helped discover and transform the requisite data, integrate the necessary systems, align related critical data structures, develop the expected credit loss models, design and implement the underlying risk ratings, and identify the business impacts.

Our professionals are prepared and ready to work shoulder-to-shoulder with you. As part of our value proposition, we offer practical experience, the latest technological tools,

cross-functional experience including tax considerations, and our deep industry knowledge to create a sufficient sustainable path towards compliance and to help capitalize on the strategic opportunities CECL affords.

KPMG’s integrated service offering includes supporting you with financial due diligence, loan and business valuations, risk and finance integration post M&A deals, as well as the CECL end to end implementations.

Visit https://advisory.kpmg.us/services/data-analytics/risk-analytics/cecl-modeling-and-accounting.html to learn more about KPMG’s CECL modeling and accounting advisory services.

How KPMG can help

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Authors

Reza van Roosmalen Principal, Accounting Advisory Services 212-954-6996 rezavanroosmalen@kpmg.com

Chris Boyles Partner, Risk Analytics 213-955-8484 cboyles@kpmg.com

We would like to thank our contributors:

— John Lyons

— Scott Bain

— Adam Levy

— Yuval Ron

— Jason Woon

— Miguel Sagarna

— Loren Tama

— Dino Mauricio

— Prateek Panwar

For more information, contact us:

Tim Johnson Partner, Transaction Services 312-665-1048 tejohnson@kpmg.com

Jennifer van Dalen Principal, Economic and Valuation Services 212-872-3560 jvandalen@kpmg.com

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Some or all of the services described herein may not be permissible for KPMG audit clients and their affiliates or related entities.

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