What your M&A team needs to know now.
The newly issued CECL accounting rules are expected to have a significant impact on financial services companies by substantially changing how credit losses are accounted for and estimated.
While CECL will not become effective until 2020, investors need to be aware of how the new rules will impact target companies’ earnings, capital, and valuation well ahead of the effective date.*
Following the 2007-2008 financial crisis and subsequent recession, both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) sought to improve the existing impairment models. The IASB issued IFRS 9 and in June 2016, the FASB issued the new credit losses standard – ASU 2016-13. This new accounting standard will have a substantial impact on banks and other financial institutions as they will need to consider and quantify the impact of both current and expected lifetime credit losses in determining the amounts expected to be collected in their financial asset portfolios (e.g., loans, trade receivables, debt securities).
CECL will impact current and future investments in financial services firms. Investors will need to pay close attention to CECL’s expected impact on earnings, reserves, and capital and factor those impacts into their valuations. In addition, because the standard allows for flexibility and does not prescribe certain aspects of the credit loss estimation, investors will need to be aware of potential methodology inconsistencies across companies and develop due diligence processes to enable comparability.
CECL adoption will have broad impact on the financial statements of financial services firms, which will affect key profitability and solvency measures. Some of the more notable expected changes include:
Higher loan loss reserve levels and related deferred tax assets. While different asset types will be impacted differently, the expectation is that reserve levels will generally increase across the board for all financial firms. According to KPMG research, system-wide impact estimates range between 10 percent and 50 percent, depending on sources. Reserves for some specific loan categories may increase by as much as 200 percent to 300 percent.
Increased reserve levels may lead to a reduction in capital levels. As noted in question 3.2.20 of handbook, the agencies are monitoring the impact of CECL on regulatory capital and it remains unclear what, if any, action, regulators will take.
As a result of higher reserving levels, the expectation is that CECL will reduce cyclicality in financial firms’ results, as higher reserving in “good times” will mean that less dramatic reserve increases will be required in a downturn. The prescribed use of reversion to historical loss information in modeling scenarios could potentially lead to less volatile reserve levels.
The forward-looking modeling required by CECL relies on a number of macroeconomic variables. Unexpected changes to such indicators between periods could potentially result in greater earnings volatility from period to period.
Reserves may need to be adjusted in response to not only a firm’s actual experience, but also to external factors.
One of the more notable and less intuitive impacts of CECL will be the asymmetry in accounting between loan related income (which will continue to be recognized on a periodic basis based on the effective interest method) and the related credit losses (which will be recognized up front at origination). This will make periods of loan expansion seem less profitable due to the immediate recognition of expected credit losses. Periods of stable or declining loan levels will look comparatively profitable as the income trickles in for loans, where losses had been previously recognized. For both originated and purchased non-PCD (Purchased Credit Deteriorated) assets, an immediate expected lifetime credit loss is recognized in earnings.
These notable changes to financial firms’ financial statements may impact an investor’s valuation approaches and methods. At this moment, there is uncertainty about what the ultimate impact on valuations will be. An efficient markets view would
suggest that overall valuations should not change as the companies’ underlying economics and cash flow remain largely unaffected. However, a more bearish view would suggest that firms with lower reported book values
and earnings (even if due to non-cash loan accounting requirements) would ultimately suffer lower valuations than under current accounting. Interestingly, as earnings will be less cyclical, it is probable that financial stocks will be punished less severely in downturns, while commanding comparatively lower prices in good times.
Also, as mentioned earlier, the decision making flexibility permissible under the CECL standard may result in diversity of practice, which could bring about less comparability and potential lack of insight into key decisions among financial institutions. This may result in a preference for the use of non-GAAP measures
to enable comparability among firms, despite recent efforts from the SEC to reduce the use of non-GAAP measures further.
Despite the new standard not being effective until 2020 for public business entities and 2021 for others, those currently engaged in acquisitions or considering future acquisitions in the financial sector need to take into consideration how CECL rules will impact their investments.
Other secondary but important impacts will also need to be considered, such as the impact CECL may have on loan covenants and financing agreements definitions.
Private equity funds and other investors who already own financial services firms in their portfolios need to consider the impact of CECL as they plan their future exit strategies. Some of the issues to focus on include:
Determining the company’s readiness for CECL implementation – Implementing CECL will be a lengthy and costly process for most companies; an early evaluation of the required effort and costs is highly advisable.
Estimating how the impact of CECL might affect the timing of an exit – Investors should analyze how
CECL might affect their business models and the timing of their planned exit from any investment affected by the new CECL rules.
Exploring and considering alternative earnings and valuation metrics to best position the company for an exit – In cases where CECL’s financial statements impact is expected to be significant, post-CECL financial results will not be comparable to historical earnings. In those situations, a seller would be advised to emphasize other operating and cash flow metrics that may present a more consistent picture of the business performance over time.
Given the very significant impact CECL is expected to have on certain loan types and asset classes (e.g., mortgages, subprime), some companies may consider the use of the fair value option to account for all their lending activities,
as a way to solve the asymmetry in recognition in loan related income (over the life of the loan) and credit losses (immediately upfront). The use of the fair value option will in fact improve the correlation between expected loan income and losses. However, it may also result in greater accounting complexity and potential volatility, given the multiple external factors that may impact the valuation of loans and other financial instruments.
In addition to our extensive experience in both new accounting standard implementations and M&A transaction advisory services in the financial services industry, KPMG has developed several proprietary technology tools that can help improve your company’s evaluation of transactions under CECL and adoption of the new CECL requirements.
This diagnostic tool generates a readiness assessment based on companies’ responses to the detailed questionnaire embedded in the tool. This diagnostic will highlight potential areas of weakness in current credit modeling and accounting systems, processes and personnel in order to implement CECL, enabling a discussion of potential remedies or mitigations to address those deficiencies and plan a successful CECL implementation process.
Assist the bank in evaluating options based on the following criteria:
A prepopulated and highly detailed checklist of the technical accounting and risk modeling decisions required for effective CECL implementation that helps accelerate your expected credit loss program and facilitate the effective documentation of accounting and risk policies.
The KPMG data decomposition and disclosures taxonomy enables KPMG teams to rapidly map CECL data requirements to existing data within your risk and finance systems, identifying any gaps.
KPMG’s Capital Advisory practice can assist financial services companies raise additional capital if firms are confronted with the need to return to pre-CECL capital levels. Our capital advisory professionals provide objective advice on optimal financing solutions in support of our clients’ strategic objectives.