Purchase accounting challenges with income recognition

Business combinations in the world of banks and credit unions come with several complex financial reporting and accounting processes. An often-overlooked component of purchase accounting is the ongoing income recognition (Day 2 Accounting) related to mark-to-market values.

Most financial instruments that are marked to fair value have an amortization schedule based on the valuation-date values. The depreciated values are then tested for impairment in the future through various techniques.

However, this is not the case for acquired loan portfolios, where accretion income must be recorded in conjunction with ASC 310-20. In summary, the portfolio must be split between loans with revolving features and those without.

Income recognition for business combinations

Revolvers have income recognized through a straight-line method, and non-revolvers must use an effective interest rate method (EIR). Prepayments can be projected, though the guidance is very technical should assumptions not play out as expected.

Therefore, in practice, most financial institutions recognize variances from original interest income projections that result from differences in actual payments as compared to contractual payments during the current period.

This variance is often called “accelerated” accretion and is compared to the “base” accretion amounts that would be recognized should loans pay exactly as their contractual terms would suggest.

There are many applications in financial services where this guidance is used to recognize income including:

• Loan origination fees and costs that must be deferred
• Nonaccrual interest paid when a loan moves back to accruing status
• Allocated carrying value differences on the retained portion of SBA loan sales.

Challenges with income recognition

Banks and credit unions most often use their core operating systems or manual spreadsheet processes to perform these calculations.

Over time, however, Abrigo Advisory Services has discovered there may be some difficulties and limitations in the ways the core systems and manual spreadsheets apply this guidance. While the impacts on earnings may be immaterial for the applications listed above, this may not be the case for purchased marks on loan portfolios.

These balances of purchased marks must be recorded at a single point in time for the entire portfolio rather than recording them as some balances run off and are replaced by new growth in the ordinary course of business.

This requirement is especially important during an environment of rapid interest rate movements like current conditions. The different methods can result in a material difference to the mark on the balance sheet.

The impact of interest rate changes

The chart below shows the aggregations of purchased marks that Abrigo has conducted Day 1 valuation services on over the past four years.

As can be seen, the aggregate interest rate marks have become significant over the past two years. It is very important for financial institutions to understand how this income is being recognized, project its recognition for budgeting purposes, and be able to defend the calculation for financial reporting review purposes.

Options for income recognition calculations

Relying on access to a core system for income recognition calculations may not result in accurate calculations. Using spreadsheets also creates a risk of errors. Furthermore, given how many financial institutions recognize accretion on purchase marks, they can spend a lot of time performing calculations over and over each period. That can be an efficiency burden for organizations—especially when they have other issues requiring their focus.

Other accurate, more efficient options for calculating accelerated and base accretion exist.

One option is to use income recognition software, which increases efficiency through automated processes while ensuring compliance with accrual accounting principles. Another is to work with purchase accounting advisors, who can analyze monthly results of base and accelerated accretion, provide monthly income recognition projections, and provide ongoing calculations for remaining discounts and premiums.

Financial institutions that take time to understand their options regarding Day 2 accounting will avoid making assumptions that could become a burden – either operationally or in the form of audit scrutiny – in the long run.

Improving the income recognition process may seem like a small decision or an optional one because of access to a core operating system. History tells us differently.

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