Written by Luis Valente, Managing Partner LogiqTree

If your financial institution has been involved in an acquisition or is contemplating an acquisition that includes a portfolio of loans, you’ve likely heard about ASC 310-30 (formerly SOP 03-3). ASC 310-30 is the pronouncement that provides the accounting guidance for loans acquired with evidence of impairment. Most folks are not familiar with the complex accounting required by ASC 310-30 and thus are apt to dismiss it, thereby turning their backs on one of the most useful pieces of accounting guidance ever written. Guidance that provides for an earnings protection opportunity while at the same time allowing you to recognize increased returns if the loans perform better than expected.

In 2009, the American Institute of Certified Public Accountants (AICPA) communicated to the Securities and Exchange Commission (SEC) that it understood the latter would not object to a company using an expected cash flow model to account for their entire acquired loan portfolio. Since then, regulatory agencies have published accounting advisory documents indicating the same approach, provided certain requirements are met. This is a key element, as it opens the door for any acquired loan to be included in the expected cash flow methodology at acquisition whether or not it possesses clear evidence of impairment.

Upon acquisition, your institution will normally complete a valuation of the acquired loans using internal resources or by engaging a third party. The valuation normally includes a credit loss component calculated through the use of the probability of default times loss given default (“PDLGD”). PDLGD is based on historical losses or market trends. It also includes a time value of money component representing the discount for the rate at which the loans should be recognized.

With the PDLGD analysis you can use an expected cash flow model by creating a non-accretable difference to represent the credit component. Let’s refer to the non-accretable difference as the “built in reserve” that will serve as protection for any potential losses in the loan. These losses may not have yet manifested themselves in the form of past dues, documented borrower financial difficulty, restructuring or loan credit risk classification nor actual charge-offs however the built in reserve will provide protection in the event of a downturn in your loan portfolio.

In order to benefit fully from the accounting pronouncement, you must properly establish pools for loans with similar risk characteristics. These pools are treated as a single unit of accounting providing for volatility protection when certain loans perform better or worse than expected. The guidance allows for reallocation of the built in reserve within the pool. The evaluation of improving or deteriorating cash flows is done at the pool level rather than at the individual loan level if the loan is in a pool. You can also benefit from some of the reporting requirements associated with pooled loans.

But the genius of ASC 310-30 does not stop there. If the acquired portfolio experiences improved cash flows you would reclassify the built in reserve to an accretable yield account and recognize additional income. The additional income is recognized over the life of the loan or pool of loans at a higher rate than the original discount rate.

The idea to use Excel spreadsheets to handle the accounting may have also been discussed. There is significant risk to using spreadsheets even for a small portfolio. Two separate studies, one from The University of Hawaii [1] and the other from Oregon State University [2] concluded that a large majority of spread sheets contain errors originating from typographical, logic and formula mistakes. In addition, while Excel is a powerful tool, it was never intended to track the amount of information required by ASC 310-30 on a monthly basis nor execute the complex allocations that truly maximize the benefits of the accounting.

So you may be asking yourself why don’t all banks implement ASC 310-30? Unfortunately, many banks do not receive adequate technical expertise nor do they obtain a robust solution to correctly implement the accounting requirements and reap the benefits. The right solution does not require Excel manipulation vulnerable to errors. The right solution runs parallel to and avoids making any changes to your core loan application system. The right solution tracks all of the components of the carrying value- additional contractual cash flows, non-accretable difference and accretable discount / yield, by loan, allowing for transparent internal and external reporting. The right ASC 310-30 solution complies with the accounting requirements and provides your team with accurate information to astutely manage your acquired loan portfolio.

Recommended reading:

• Financial Accounting Standards Board: Accounting Standards Codification
• AICPA: Communication with SEC Regarding Expected Cash Flows Model
• Office of the Comptroller of the Currency (OCC) Accounting Advisory Series

About LogiqTree
LogiqTree’s mission is to become a leader in bank consulting services by providing sound strategic advice and complete software solutions addressing their clients’ needs and surpassing their expectations. LogiqTree offers the LAWEI Solution, automating ASC 310-30 accounting and reporting as well as ATLAS, a troubled loan assistant and ALLL solution.