FINANCIAL INSTITUTION UPDATE
Newsletter by Hawkins Ash CPAs
In this edition
July 26, 2018

Revenue Recognition Standard for Financial Institutions

Tax Reform Pod Cast

Current Expected Credit Losses (CECL) – The Migration Analysis Method

Excise Tax on Executive Compensation

Revenue Recognition Standard for Financial Institutions
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09 – Revenue from Contracts with Customers (Topic 606) which attempts to clarify the principles for recognizing revenue. Although the ASU was issued in 2014, the FASB provided a long implementation period. For entities that are not considered public business entities (PBEs), the standard becomes effective for annual reporting periods beginning after December 15, 2018, which means January 1, 2019 for calendar year-ends.

What Changed?
The recognition of revenue under current accounting standards requires the consideration of two factors; being realized or realizable and being earned. FASB believes ASU 2014-09 will significantly enhance the comparability of revenue recognition practices while also providing a framework to ensure the guidance remains relevant. Specifically, the core principle of ASU 2014-09 is “that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” To achieve the core principle, ASU 2014-09 provides a list of steps to be taken:

  1. Identify the contract(s) with a customer.
  2. Identify the performance obligations in the contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to the performance obligations in the contract.
  5. Recognize revenue when (or as) the entity satisfies a performance obligation.

Each entity will apply this five-step approach to determine when revenue and gains included within the scope of the standard should be recognized.

How This Affects Financial Institutions 
At first glance, the new standard will have minimal effect on financial institutions. The reason is that many of a financial institution’s sources of revenue are not included within the scope of ASU 2014-09:
  • Interest income (loans, lease financing, securities)
  • Loan servicing fees
  • Credit card fees (such as balance transfer fees, cash advance fees, and annual fees)
  • Mortgage servicing income
  • Loan origination/commitment fees
  • Loan late/prepayment fees

Some of the more common sources of revenue that DO fall within the scope of ASU 2014-09 include: 
  • Service charges on deposit accounts
  • Gains/losses on the sale of other real estate owned (OREO)
  • Interchange fees
  • Insurance premiums related to loans (such as gap insurance)
  • Asset management fees
  • Safe deposit box fees
  • Trust income
  • Credit card loyalty program income

Although the new standard may apply to these sources of income, the effect of the new standard may ultimately look the same as current accounting practices. For example, under current practice, revenue from the sale of an OREO is typically recognized at closing. The accounting will likely not change under the new standard, except for instances in which the sale is a seller financed sale. In those instances, additional consideration will need to be given to whether or not it is probable the financial institution will collect substantially all of the consideration it is entitled to.

Big Picture
Financial institutions will need to apply the five-step process to all of their noninterest income to ensure proper revenue recognition under the new standard.

If you have any questions regarding the revenue recognition standard (ASC 606), please contact us.
Contact: Jeff Danen, CPA, CVA
Direct: 920.337.4546
Email: jdanen@hawkinsashcpas.com
Tax Reform Pod Cast

In these lively interviews, Jeff Dvorachek, CPA, provides guidance on the new tax laws to help businesses and individuals understand how their individual tax situation will be affected.
Current Expected Credit Losses (CECL) – The Migration Analysis Method
As discussed in the May 2018 newsletter, the calculation of the allowance for loan losses will be changing in the upcoming years, and there are a variety of methods which can be used to calculate the current expected credit loss, or CECL. The May issue discussed the Vintage Analysis method; this issue provides an explanation and example using the Migration Analysis method.

Migration Analysis

The Migration Analysis method predicts credit losses by segmentation (credit quality factor, risk rating) of a portfolio without consideration of new loans. Using this method may provide management a better understanding of how loans have performed in each segment over time and calculate a more accurate loss rate compared to the Vintage method. To properly implement this method, the Credit Union will need to segment loans beyond its traditional pools and further segregate these pools according to risk classification. The Migration Analysis method evaluates the losses of the portfolio over a selected timeframe. Qualitative/environmental factors will still need to be considered when making this calculation.

This method will require proper historical data collection especially related to credit quality and loss experience on a detailed segment level. Furthermore, if a loan pool is not very large, anomalies within the pool may distort the average historical loss rate calculated for the pool. The benefits of using a Migration Analysis is that it highlights changes in portfolio composition and quality.

To properly implement the Migration Analysis method, the risk rating methodology should be consistent over the timeframe of the analysis. You will want to first segment loans into homogeneous pools and then sub-segment these pools by risk classification. Secondly, you will need to select a time period to be used for each segment. This could be over the life of the loans or another period that is appropriate for the segment. It is also important to document the procedures used for the analysis so it can easily be defended when the analysis is questioned by an examiner.

The following is a simple example of how the Migration Analysis might be used to estimate the expected credit loss at December 31, 2017.

Credit Union A has a residential real estate 5-year balloon loan pool that it tracks by year of origination, credit losses, and credit quality (risk rating). The loan pool is $175 million at December 31, 2017. Since the term of the pool is five years, the analysis will start on December 31, 2012. At December 31, 2012, the pool is $100 million, and the loans are assigned credit risks as follows:
The losses of this loan pool are accumulated over a period of five years and the loss rate is applied to the balance of the existing loan pool at December 31, 2017.
Conclusions:
  • The CECL loss rate at December 31, 2017 is only 0.109% ($190,000 / $175 million) compared to the December 31, 2012 loss rate of 0.140%. The loss rate decreased because the credit quality of the loan pool improved over the five-year period.
  • Environmental factors should be applied to the loss rate based on particular circumstances.
  • The Migration Analysis method can be a relatively simple model to use but it may require enhanced data gathering techniques to track credit quality indicators and losses by loan.

For more information, please contact Jeff Danen or Dan Lightfuss in our Green Bay office at 920-336-9850.
Contact: Dan Lightfuss, CPA
Direct: 920.337.4552
Email: dlightfuss@hawkinsashcpas.com
Excise Tax on Executive Compensation
Prior to the enactment of the Tax Cuts and Jobs Act (TCJA), tax-exempt entities [non-profits] had to comply with “reasonableness” requirements with respect to executive compensation. There was no excise tax with respect to compensation paid as long as the amount was reasonable. For tax years starting in 2018, the new law imposes a 21 percent excise tax on compensation over $1 million as well as “excess” severance paid by covered tax-exempt organizations to certain employees.

These “certain employees” do not have to be executives or officers. In fact, it was after December 31, 2016 that the term “covered employee” was any employee of the covered organization who is one of the five highest paid employees in any year. There are several exclusions to these rules, including political organizations, government entities, licensed medical professionals (e.g., doctors), and public universities.

The TCJA utilizes the term “remuneration” which includes wages that are payable to a covered employee that are subject to federal income tax withholding. It also includes any amounts that are subject to taxation under Code Section 457(f), which applies to most forms of nonqualified deferred compensation arrangements of covered tax-exempt entities. 

There are questions left open for debate: What about fiscal year filers? How is the tax paid? Clearly, we are awaiting further guidance from the IRS to help answer these and other questions.
 
It is also important to note that the TCJA provides that, in determining the total amount paid to a covered employee for excise tax purposes, any compensation paid by a related organization to the employee for employment services is also counted.

Organizations which regularly pay executives greater than $1M should take a close look at this provision and make budgetary allowances for this tax for the 2018 tax year. Other organizations which anticipate vesting in deferred compensation plans should also plan on this tax if the extra amount of compensation will take the executive over the $1M threshold for a particular year. 
Contact: David Howell, EA
Direct: 920.337.4550
Email: dhowell@hawkinsashcpas.com
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