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The hidden tax cost of bank incentive rewards

10.09.18

Banks often provide awards to lure new customers or to strengthen customer loyalty. Awards can take the form of a simple gift (cash or non-cash) or can be more complex, such as a sweepstakes involving some element of chance, or a reward points program.

If you have received an award from a bank, the IRS, always ready to claim the government’s share, may come knocking on your door. Taxation is dependent on how you receive the awards, what the award is, and its value. In certain situations, banks are required to, and may send a Form 1099, which reports the award value to the IRS and the award recipient. Here are some different award scenarios and corresponding actions to take.

Awards for Opening an Account
Awards for opening accounts are generally considered interest income and are taxable to the account holder. If an award is paid in cash, the amount of interest income is the amount of cash paid. However, an award may also be non-cash, such as a gift card or a specified item (e.g., an item of merchandise from a rewards brochure). Gift cards are normally valued at the amount of the gift on the card and merchandise at retail value. Once the value of all rewards are tallied, the value should be added to any other interest earned on the account. If the total is at least $10, the IRS requires you to file a Form 1099-INT.

Cash awards are generally easier to administer as the award can be deposited to the customer’s account and credited as interest. In-kind awards often present additional complexity when filing Forms 1099. These awards are often purchased in bulk, and given to customers when they open an account. Therefore, you don’t include the value in the customer account and you can only capture it in the 1099 reporting processes using manual intervention. To ensure these values are captured, you should develop procedures to address any manual processes.

Miscellaneous Awards Programs
Awards provided for something other than the use of money (e.g., opening an account) may also be taxable. For example: amounts provided under a birthday gift program could be taxable. Assume, under a birthday gift program, all customers under the age of 19 receive a $5 gift on their birthday. As the amounts do not appear to be for the use of money (no new account necessary and no specified account balance necessary), these payments would NOT be included on Form 1099-INT.

However, the government still wants their portion. Oftentimes, amounts under these types of programs are very low and do not require tax reporting. If reporting is required, amounts would be included on Form 1099-MISC rather than Form 1099-INT.

You need to consider these payments under the 1099-MISC reporting rules. These rules, different than the 1099-INT rules, only require reporting when the aggregate payments during the year exceed $600. Therefore, no IRS reporting would be required under this program unless payments under this program and any other program which would require a 1099-MISC, exceed $600.

Account Opening Sweepstakes
Occasionally, an incentive program may take the form of a sweepstakes or similar give-away. Winners are chosen randomly, from a pool consisting of customers opening a new checking account during a specified time period and, perhaps, non-customers if a no-purchase required entry option is available. As these prizes are limited and determined by luck (not by skill or by virtue of having an account, other than it qualified them for entry) this is more properly reported as a gambling winning. Gambling winnings are reported on Form W-2G (when in excess of $600).

IRS rules require mandatory withholding for certain gambling prizes. IRS rules also require income tax withholding for proceeds of more than $5,000. The IRS provided an example in their rules that states when no wager is placed, withholding is not required. The example concerns those entered into the sweepstakes simply by virtue of purchasing a magazine subscription for which they paid the regular subscription price. As new checking account customers generally are not paying additional amounts or receiving different terms than the regular terms an account holder receives, they are not considered to have made a wager. Therefore, we believe withholding is not required because there is a withholding exception if no wager is placed.

Reward Points Programs
Benefits from reward points programs are more complex and may not be subject to tax and reporting, depending on the provisions of the program.

The IRS has ruled that a program that is not transferable and is not convertible into cash or cash equivalents should not create gross income to the enrollees. Therefore, amounts earned and collected under a similar program would not be subject to information reporting rules, and not included on Form 1099-MISC.

Furthermore, in some circumstances cash-back options do not create gross income because the cash-back options are treated as a discount on the purchase or a rebate. In short, you have actually paid less for your merchandise because of the discount/rebate provided by the credit card.

However, if there is an award or cash provided simply for signing up for the card (no purchase necessary) the benefit may be taxable and includible on Form 1099-MISC, if the minimum threshold of $600 is satisfied.

Incentive programs to acquire and retain customers may result in taxable income to the customer. Additionally, information reporting may be required if the aggregate amount of all benefits provided exceeds certain thresholds.

We recommend banks review their procedure with regard to incentive programs to ensure proper tax reporting. We also suggest developing a customer-facing communication plan when incentives involve a significant benefit, so that customers are informed of their obligations and not surprised by hidden and unexpected tax costs. We are happy to assist in this area.

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Read this if you file taxes with the IRS for yourself or other individuals.

To protect yourself from identity thieves filing fraudulent tax returns in your name, the IRS recommends using Identity Protection PINs. Available to anyone who can verify their identity online, by phone, or in person, these PINs provide extra security against tax fraud related to stolen social security numbers of Tax ID numbers.

According to the Security Summit—a group of experts from the IRS, state tax agencies, and the US tax industry—the IP PIN is the number one security tool currently available to taxpayers from the IRS.

The simplest way to obtain a PIN is on the IRS website’s Get an IP PIN page. There, you can create an account or log in to your existing IRS account and verify your identity by uploading an identity document such as a driver’s license, state ID, or passport. Then, you must take a “selfie” with your phone or your computer’s webcam as the final step in the verification process.

Important things to know about the IRS IP PIN:

  • You must set up the IP PIN yourself; your tax professional cannot set one up on your behalf.
  • Once set up, you should only share the PIN with your trusted tax prep provider.
  • The IP PIN is valid for one calendar year; you must obtain a new IP PIN each year.
  • The IRS will never call, email or text a request for the IP PIN.
  • The 6-digit IP PIN should be entered onto your electronic tax return when prompted by the software product or onto a paper return next to the signature line.

If you cannot verify your identity online, you have options:

  • Taxpayers with an income of $72,000 or less who are unable to verify their identity online can obtain an IP PIN for the next filing season by filing Form 15227. The IRS will validate the taxpayer’s identity through a phone call.
  • Those with an income more than $72,000, or any taxpayer who cannot verify their identity online or by phone, can make an appointment at a Taxpayer Assistance Center and bring a photo ID and an additional identity document to validate their identity. They’ll then receive the IP PIN by US mail within three weeks.
  • For more information about IRS Identity Protection PINs and to get your IP PIN online, visit the IRS website.

If you have questions about your specific situation, please contact our Tax Consulting and Compliance team. We’re here to help.

Article
The IRS Identity Protection PIN: What is it and why do you need one?

Read this if you are at a financial institution with employees working remotely.

Working remotely is not a new concept. Over the past 20 years, technology enhancements have increased the ability for employees to connect remotely and perform many job functions without ever leaving their homes. When the COVID-19 pandemic began in early 2020, working remotely became a necessity for essential businesses like financial institutions to provide safe environments for both employees and customers and remain open.

One of the benefits of an increase in working from home during the pandemic is that it provided financial institutions and other businesses an opportunity to learn how to perform essential job functions and manage teams from a distance. In addition, many organizations experienced indirect benefits, including a more flexible work environment, higher job satisfaction, increased productivity, and improved employee retention. Now that employees are being asked to return to the office, many financial institutions are considering if a permanent work-from-home arrangement is possible. 

What you need to know

For starters, financial institutions need to know where their employees are providing services. Is it across state lines or across the country? What if you have two or more employees who want to work out of state—and they are all different states? What are the tax implications? Are there legal concerns?

Nexus

Nexus is the connection that taxpayers have with a state that permits the state to assess various types of taxes, including income tax. Nexus rules vary from state to state, but generally a business with nexus in a state is required to register with the Secretary of State/Department of Revenue, file tax returns, and pay various taxes to the state. 

Employees working in a "different state" (a state which income tax returns are not already being filed) may create nexus to that state for tax purposes. Even if your financial institution has only one employee working in a state and otherwise has no other connection to the state, there may be tax implications. Some states have established nexus waivers because of the pandemic, providing relief to some businesses and employees who have temporary work-from-home arrangements. These waivers, however, will soon expire or have expired already. 

The following details should be considered before offering out-of-state remote employee work arrangements.

State income tax filing requirements

  • If your financial institution has an employee working remotely from a different state, the financial institution has created physical presence nexus in that state. Once nexus has been established, the financial institution may be subject to state and local income taxes, gross receipts taxes, unique taxes specific to financial institution, or franchise taxes. When it comes to taxing a financial institution, not all states assess tax in the same manner. 
  • After nexus has been established, your financial institution will also need to understand how the state apportions wages in determining income tax liability to the state. One example is a factor approach: Total payroll paid to employees working in the state divided by total payroll paid to all employees. In a simplified example, the fraction would be multiplied by taxable income resulting in amount of taxable income in that state. One employee in a state is not likely to create a significant income tax liability to the state, however, many states have minimum tax liabilities and other fees—some more significant than others—which should also be considered along with additional administrative costs. 

State tax withholding

  • Employees will need to pay personal state income tax based on their primary state of residence as well as the state in which they work. If your financial institution's remote employee is performing most of their work from home in a different state than the financial institution, and travels to the financial institution for occasional meetings or in-person days, this could result in the employee having a personal state income tax liability in both states. It may be necessary for your financial institution to track the employee’s location and properly withhold state income taxes from the employee’s pay based on the state that the employee is providing services. 
  • Failure to properly withhold state income taxes could create a liability for both the employee and the employer including penalties and interest. Proper policies should be in place regarding the responsibility of tracking where employees are performing their work may mitigate these concerns. You should encourage your employees to work with their individual tax advisors on state tax issues as each employee's tax filing position is unique (we generally advise against providing tax advice to your employees). 

Unemployment taxes and workers’ compensation

  • Unemployment is typically paid to the state in which an employee has their permanent place of work. Your financial institution should review the state’s unemployment rules to determine if the financial institution is required to collect and remit unemployment tax to a state that it has employees. If your employee is working in a different state on a temporary basis or due to the pandemic, we believe there is no need for unemployment to change from the state where the financial institution is located.
  • Workers’ compensation is also typically paid to the state in which the employee is permanently assigned. If the out-of-state work arrangement is temporary, we do not feel you need to change your workers’ compensation. However, if the out-of-state arrangement from home becomes permanent, you may need to change your policy. Some states require employers to have a minimum number of employees in the state before requiring a workers’ compensation policy in that state. We recommend working with BerryDunn’s employee benefits experts on state rules and discussing with your insurance carrier.

Personal property and other taxes

  • Employees working from home are often provided furniture and equipment for their remote office set up. Financial institutions should consider whether they want to provide these items without retaining ownership to the property, as owning property in another state could result in the financial institution needing to file and remit personal property taxes to the state. It also would be considered a best practice to develop a policy that provides consistency among all remote employees, regardless of their location. 
  • Sales and use tax implications and other special or unique state and local taxes should be researched and understood prior to entering any state to determine the impact on existing products and services which may be offered to out of state customers who reside or relocate out of state. We will provide more information about the state tax issues related to providing services in a future installment of this state tax series. 

Other considerations

  • We recommend you discuss with your financial institution's attorney regarding the need to file a business license or update the financial institution's charter as these are legal matters. Here are some topics to consider as you have these discussions:
    • Your financial institution may be required to register with the state department of revenue/taxation
    • Registering as a foreign corporation is often necessary to access the legal system
    • Your financial institution may want to consider whether other regulatory licenses may be needed, such as insurance broker or license for trust services
  • Health insurance and other employee benefit plans should be reviewed to ensure that a remote employee eligible to receive benefits still qualifies and receives the same level of coverage that is available to in-state employees. 

In summary, even one employee working out of state could create additional compliance costs and exposure to a state’s laws and regulations. You may be wondering how risky it is to have only one employee located in a state, and how likely is it that the state would make the connection to your out-of-state financial institution.

While  the risk may seem low, states are always looking to generate additional tax revenue, and many have the ability to cross check internal systems. Withholding and remitting state income taxes on behalf of an employee is likely going to require your financial institution to register with a state's income tax withholding agency. The state will then be aware of your financial institution’s connection to its state as the financial institution’s EIN will be in the system for payroll purposes. While the exposure may still be low, the state may start looking for an income tax filing and at least payment of minimum tax. Failure to file in a state means that the statute of limitations for the financial institution’s exposure to that state will not start.

The risks shouldn’t necessarily prevent your financial institution from allowing employees to work from home, and as many financial institutions want to offer more flexible work arrangements given what has been learned in recent years, it is possible to minimize tax risk and remain compliant with proper planning and awareness. 

For more information

To discuss your specific tax situation and state compliance risks, please contact the BerryDunn Financial Services team. We’re here to help.

Article
State tax issues impacting your financial institution part one: Remote employees

Read this if you are a Chief Financial Officer or Controller at a financial institution.

Back in April, we wrote about recently released Accounting Standards Update (ASU) No. 2022-02, Financial Instruments – Credit Losses (Topic 326). Here, we are going to look at the standard in more depth. 

One of the most notable items this ASU addresses, is that it eliminates the often tedious troubled debt restructuring (TDR) accounting and disclosure requirements. Accounting for loan modifications will now be maintained under extant US generally accepted accounting principles, specifically Accounting Standards Codification (ASC) 310-20-35-9 through 35-11. However, rather than eliminate loan modification disclosure requirements altogether, the Financial Accounting Standards Board (FASB) created some new requirements, inspired by voluntary disclosures many financial institutions made during the coronavirus pandemic. 

Rather than disclosing information on TDRs, financial institutions will now be required to disclose information on loan modifications that were in the form of principal forgiveness, an interest rate reduction, an other-than-insignificant payment delay, or a term extension (or a combination thereof) made to debtors experiencing financial difficulty. These disclosures must be made regardless of whether a modification to a debtor experiencing financial difficulty results in a new loan or not. 

ASC 310-10-50-42 through 50-44 establishes these new disclosure requirements, and ASC 310-10-55-12A provides an example of the required disclosures. 

New Loan Modification Disclosure Requirements

Financial institutions have long had internal controls surrounding the determination of TDRs given the impact such restructurings can have on the allowance for credit losses and financial statement disclosures. Banks may find they are able to leverage those controls to satisfy the new modification disclosures, with only minor adjustments. Similar to previous TDR determinations, the above disclosures are only required for modifications to debtors experiencing financial difficulty. Therefore, financial institutions will need to have a process —or defined set of parameters—in place to determine debtor “financial difficulty”, thus triggering the need for modification disclosure. Banks may also find that the specific data gathered for preparation of these new disclosures will change, but should be readily available, with (hopefully) only minor manipulation required.

ASU No. 2022-02 is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years—the same effective date for those who have not yet adopted ASU No. 2016-13, more commonly referred to as CECL (Current Expected Credit Loss). As always, if you have any questions as to how this new ASU may impact your financial institution, please reach out to BerryDunn’s Financial Services team or submit a question via our Ask the Advisor feature.

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New loan modification disclosure requirements: A deeper dive

Read this if you are a depository institution.

Environmental, Social, and Governance (ESG) matters are all the rage right now. From new disclosures to personal, professional, investor, and social media pressures, ESG presents itself as a vast topic, encompassing many facets of an organization. It can be daunting to even know where to begin ESG efforts. 

ESG issues seem pervasive and may be best thought of as residing on a spectrum, with some industries further along this spectrum than others. However, each industry can make its own mark, with initiatives that can propel it along the ESG spectrum. Even within one industry, individual organizations may have their own initiatives and areas of focus. Equal importance does not need be given to the E, the S, and the G, and some industries may be better equipped to address one of these pillars over the others. We would like to share what we believe to be four areas of opportunity for banks as they think about ESG, their customers, and their employees.

Credit decisions

Many financial institutions currently base credit decisions on an array of financial metrics of the prospective borrower. Their reviews include financial forecasts, historical financial results, collateral values, etc., all with the intent of predicting if the prospective borrower will be able to repay the credit. Given the increasing regulatory and social pressure regarding ESG, bankers should be aware of how ESG requirements and industry initiatives could impact a borrower’s financial condition. For instance, consider the following:

  • Where does the prospective borrower reside on the ESG spectrum, collectively and individually (the separate E, the S, and the G spectrums)? 
  • If they are a carbon-intensive company, what additional risks does that pose to the relationship, if any? (E)
    • Are there pending regulations (or fines) that could significantly impact their operations?
    • Although their finances may be strong currently, are there alternative products or services that are seen as “greener” that may jeopardize future profits and cash flows?
    • If the company plans to become less carbon-intensive, either voluntarily or out of necessity, are there significant costs anticipated to be incurred during this transition?
  • Do they have, or anticipate, community investment initiatives? (S)
  • Are they viewed as a reputable company in their respective communities? (S)
  • Is there adequate Board and execute management oversight? (G)

ESG-specific products

Financial institutions can reward borrowers for their stewardship. This concept is not new, as “green bonds” have been around for years to incentivize climate and environmental projects. Some financial institutions, such as TD Bank and Barclays, offer preferred interest rates to ESG-conscious borrowers, such as those that purchase houses that meet certain energy efficiency ratings. Financial institutions could further expand on this idea and offer loans earmarked for certain ESG-related purposes, such as development of low-carbon manufacturing techniques or investment in the company’s workforce. Such products can be a great way to position your financial institution as an ESG leader in the community and assist borrowers on their ESG journey. 

Financial institutions can act as a connector for like-minded parties

Financial institutions are in a unique position, as aside from the borrower themselves, a financial institution likely knows the most about the borrower’s business. Financial institutions may become aware of customers further along their ESG journeys and could help connect those resources to other customers who may want to know and learn more. Customers are increasingly looking for more from their financial institution outside of traditional banking services. Given their unique position, financial institutions are best equipped to act as a connector for like-minded parties. 

Customers and employees may want their supply chain/employer to be ESG conscious

Customers, whether they be individuals or businesses, and employees are increasingly considering the actions of potential vendors and employers before partnering with them. Likely a result of their own ESG mission, customers are starting to realize that, even if they feel as if they are ESG conscious, it is their responsibility to also hold their vendors accountable. Therefore, customers may elect to go to another financial institution that is more ESG conscious even if your financial institution offers a better product. Employees are also factoring this into employment decisions. Employees want to feel as if they are part of a larger mission. Focusing on ESG could give your financial institution a competitive advantage.

When considering ESG matters, some believe they are faced with two mutually exclusive decisions: (1) what makes the most sense financially, and (2) what will propel our organization further along the ESG spectrum? What some leading companies have found, however, is that by focusing first on where they lie on the ESG spectrum and defining where they want to be in the future helps clarify future decision-making so that cost and ESG progress are aligned rather than opposing forces. As always, BerryDunn’s Financial Services team is here to help.

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Propelling along the ESG spectrum: Four considerations for your financial institution

What the C-Suite should know about CECL and change management

Read this if you are at a financial institution. 

Some institutions are managing CECL implementation as a significant enterprise project, while others have assigned it to just one or two people. While these approaches may yield technical compliance, leadership may find they fail to realize any strategic benefits. In this article, Dan Vogt, Principal in BerryDunn’s Management and IT Consulting Practice, and Susan Weber, Senior Manager and CECL expert in BerryDunn’s Financial Services Practice, outline key actions leaders can take now to ensure CECL adoption success.  

Call it empathy, or just the need to take a break from the tactical and check in on the human experience, but on a recent call, I paused the typical readiness questions to ask, “How’s the mood around CECL adoption – what’s it been like getting others in the organization involved?” The three-word reply was simple, but powerful: “Kicking and screaming.”  

Earlier this year, by a vote of 5-2, the FASB (Financial Accounting Standards Board) closed the door to any further delays to CECL adoption, citing an overarching need to unify the industry under one standard. FASB’s decision also mercifully ended the on-again off-again cycle that has characterized CECL preparation efforts since early 2020. One might think the decision would have resulted in relief. But with so much change in the world over the past few years, is it any wonder institutions are instead feeling change-saturated?  

Organizational change

CECL has been heralded as the most significant change to bank accounting ever, replacing 40+ years of accounting and regulatory oversight practices. But the new standard does much more than that. Implementing CECL has an effect on everything from executive and board strategic discussions to interdepartmental workflows, systems, and controls. The introduction of new methods, data elements, and financial assets has helped usher in new software, processes, and responsibilities that directly affect the work of many people in the organization. CECL isn’t just accounting—it’s organizational change. 

Change management

Change management best practices often focus on leading from optimism—typically leadership and an executive sponsor talk about opportunities and the business reasons for change. Some examples of what this might sound like as it relates to CECL might include, by converting to lifetime loss expectations, the institution will be better prepared to weather economic downturns; or, by evolving data and modeling precision, an institution’s understanding and measure of credit risk is enhanced, resulting in more strategic growth, pricing, and risk management. 

But leading from optimism is sometimes hard to do because it isn’t always motivating—especially when the change is mandated rather than chosen.  

Perhaps a more judiciously used tactic is to focus on the risk, or potential penalty, of not changing. In the case of CECL, examples might include, your external auditor not being able to sign-off on your financials (or significant delays in doing so), regulatory criticism, inefficient/ineffective processes, control issues, tired and frustrated staff. These examples expose the institution to all kinds of key risks: compliance, operational, strategic, and reputational, among them.

CECL success and change management

With so much riding on CECL implementation and adoption going well, some organizations may be at heightened risk simply because the effort is being compartmentalized—isolated within a department, or assigned to only one or two people. How effectively leadership connects CECL implementation with tenets of change management, how quickly they understand, then together embrace, promote, and facilitate the related changes affecting people and their work, may prove to be the key factor in achieving success beyond compliance.  

One important step leaders can take is to perform an impact assessment to understand who in the organization is being affected by the transition to CECL, and how. An example of this is below. Identifying the departments and functions that will need to be changed or updated with CECL adoption might expose critical overlaps and reveal important new or enhanced collaborations. Adding in the number of people represented by each group gives leaders insight into the extent of the impact across the institution. By better understanding how these different groups are affected, leaders can work together to more effectively prioritize, identify and remove roadblocks, and support peoples’ efforts longer term.           

 
No matter where your institution is currently in its CECL implementation journey, it is not too late to course-correct. Leadership—unified in priority, message, and understanding—can achieve the type of success that produces efficient sustainable practices, and increases employee resilience and engagement.

For more information, visit the CECL page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions. For more tips on documenting your CECL adoption, stay tuned for our next article in the series, revisit past articles, or tune in to our CECL Radio podcast. You can also follow Susan Weber on LinkedIn.

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Implementing CECL: Kicking and screaming

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its first quarter 2022 Quarterly Banking Profile. The report provides financial information based on Call Reports filed by 4,796 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In first quarter 2022, this section included the financial information of 4,353 FDIC-insured community banks. BerryDunn’s key takeaways from the report are as follows:

Community banks continue to feel the impact of shrinking net interest margins and inflation.

Community bank quarterly net income dropped to $7 billion in first quarter 2022, down $1.1 billion from a year ago. Lower net gains on loan sales and higher noninterest expenses offset growth in net interest income and lower provisions. Net income declined $581.3 million, or 7.7 percent from fourth quarter 2021 primarily because of lower noninterest income and higher noninterest expense.

Loan and lease balances continue to grow in first quarter 2022

Community banks saw a $21.5 billion increase in loan and lease balances from fourth quarter 2021. All major loan categories except commercial & industrial and agricultural production grew year over year, and 55.3 percent of community banks recorded annual loan growth. Total loan and lease balances increased $35.1 billion, or 2.1 percent, from one year ago. Excluding Paycheck Protection Program loans, annual total loan growth would have been 10.2 percent.

Community bank net interest margin (NIM) dropped to 3.11 percent due to strong earning asset growth.

Community bank NIM fell 15 basis points from the year-ago quarter and 10 basis points from fourth quarter 2021. Net interest income growth trailed the pace of earning asset growth. The yield on earning assets fell 28 basis points while the cost of funding earning assets fell 13 basis points from the year-ago quarter. The 0.24 percent average cost of funds was the lowest level on record since Quarterly Banking Profile data collection began in first quarter 1984. 

Community bank allowance for credit losses (ACL) to total loans remained higher than the pre-pandemic level at 1.28 percent, despite declining 4 basis points from the year-ago quarter.


NOTE: The above graph is for all FDIC-Insured Institutions, not just community banks.

The ACL as a percentage of loans 90 days or more past due or in nonaccrual status (coverage ratio) increased to a record high of 236.7 percent. The decline in noncurrent loan balances outpaced the decline in ACL, with the coverage ratio for community banks emerging 57.9 percentage points above the coverage ratio for noncommunity banks. 

The banking landscape continues to be one that is ever-evolving. With interest rates on the rise, banks will find their margins in flux once again. During this transition, banks should look for opportunities to increase loan growth and protect and enhance customer relationships. Inflation has also caused concern not only for banks but also for their customers. This is an opportune time for banks to work with their customers to navigate the current economic environment. Community banks, with their in-depth knowledge of their customers’ financial situations and the local economies served, are in a perfect position to build upon the trust that has already been developed with customers.

As always, please don’t hesitate to reach out to BerryDunn’s Financial Services team if you have any questions.

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FDIC issues its First Quarter 2022 Quarterly Banking Profile

Read this if you are interested in GASB updates. 

The Governmental Accounting Standards Board (GASB) issued GASB Statement No. 99, Omnibus 2022 on May 9, 2022. The statement enhances comparability in accounting and financial reporting and improves the consistency of authoritative literature by addressing (1) practice issues that have been identified in previous GASB Statements, and (2) adding guidance on accounting and financial reporting for financial guarantees.

We’ve reviewed the statement in its entirety, and broken down key components for you to know. Here are the highlights.  

Accounting and financial reporting for exchange or exchange-like financial guarantees

Financial guarantees is a guarantee of an obligation of a legally separate entity or individual, including a blended or discretely presented component unit, that requires the guarantor to indemnify a third-part obligation holder under specified conditions, in an exchange or exchange-like transactions. 

An entity that extends an exchange or exchange-like financial guarantee should recognize a liability and expense related to the guarantee when qualitative factors and historical data indicate that is it more than likely not a government will be required to make a payment related to the guarantee.

Statement 99 excludes guarantees related to special assessment debt, financial guarantee contracts within the scope of Statement 53, or guarantees related to conduit debt obligations. 

Certain derivative instruments that are neither hedging derivative instruments nor investment derivative instruments

Derivative instruments that are within the scope of Statement 53, but do not meet the definition of an investment derivative instrument or the definition of a hedging derivative instrument are considered other derivative instruments. These “other derivative instruments” should now be accounted for as follows:

  1. Changes in fair value should be reported on the “resource flows statement” separately from the investment revenue classification.
  2. Information should be disclosed in the notes to financial statements separately from hedging instruments and investment derivative instruments.
  3. Governments should disclose the fair values of derivative instruments that were reclassified from hedging derivative instruments to other derivative instruments. 

Leases

If your entity has leases please review the following as Statement 99 clarifies numerous issues from Statement 87, specifically:

  • Lease terms as it relates to options to terminate and option to purchase the underlying assets, in paragraph 12 of Statement 87 has been clarified;
  • Short-term leases in paragraph 12 of Statement 87 has been clarified as it relates to an option to terminate the lease;
  • Lessee and lessor recognition and measurement for leases other than short-term leases that transfer ownership has been clarified, and
  • Lease incentives in paragraph 61 of Statement 87 has been further defined.

Public Private and Public-Public Partnerships (PPPs)

If your entity has PPPs, Statement 99 clarifies the following: 

  • PPP terms
  • Receivable for installment payments (transferor recognition)
  • Receivable for the underlying PP Asset (transferor recognition)
  • Liability for installment payments (operator recognition)
  • Deferred outflow of resources (operator recognition)

Subscription-Based Information Technology Arrangements (SBITAs)

Subscription terms and definitions have been clarified, specifically as it relates with options to terminate, short-term SBITAs, and measurement of subscription liabilities.

If your entity has SBITAs, review the provisions of each SBITA to ensure compliance with Statement 99 paragraphs 23–25.

Replacement of LIBOR

Check with your banking institutions to confirm when they have phased out of LIBOR. Confirm with your banking institutions what specifically has replaced LIBOR and update Financial Statement disclosures as needed. 

SNAP

State governments should recognize distributions of benefits from Supplemental Nutrition Assistance Program (SNAP) as a nonexchange transaction. Review Financial Statement disclosure and determine if a disclosure is needed. 

Disclosure of Nonmonetary Transactions

If you engage in one or more nonmonetary transactions during the fiscal year, you will need to disclose those transactions in the notes to the financial statements the measurement of attribute(s) applied to the assets transferred, rather than basis of accounting for those assets.

Pledges of future revenues when resources are not received by the pledging government

When blending the financial statement of a debt-issuing component unit into the financial statements of a primary government pledging revenue for the component unit’s debt, the primary government should reclassify an amount due to the component as an interfund payable and an interfund transfer out simultaneously with the recognition of the revenues that are pledged.

Focus of the government-wide financial statement

Statement 99 reiterates that there should be a total overall government-wide column within the MD&A, Statement of Net Position, and Statement of Activities. This column should exclude all fiduciary activities, including custodial funds. 

Terminology updates

No action is needed. Terminology has been updated in previous pronouncements, for terminology as it relates to Statements 63 and 53. 


Effective dates

The requirements related to the extension of the use of LIBOR, accounting for SNAP distributions, disclosures of nonmonetary transactions, pledges of future revenues by pledging governments, clarification of certain provisions in Statement 34 and terminology updates related to GASB 53 and 63 are effective upon issuance.

The requirements related to leases, PPPs, and SBITAs, are effective for fiscal years beginning after June 15, 2022.

The requirements related to financial guarantees and the classification and reporting of derivative instruments within the scope of Statement 53 are effective for fiscal years beginning after June 15, 2023.

Earlier application is encouraged and permitted for all.

If you would like more information regarding Statement 99, please contact our Audits of Governmental Component Units team. We’re here to help.

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Key considerations from GASB Statement No. 99 

Read this if you are a financial institution.

Choosing a method for estimating lifetime expected losses is a commitment. A commitment that signals, in spite of any other option, you’re certain this method is the right one for you—your segment, portfolio, and institution. While you might be able to support a change in method later, it is much more likely you’ll be living with this decision a good long while. So, how exactly does one know which method is the right one? Let’s take a few minutes to answer some frequently asked questions about selecting methods for CECL.

How many CECL methods are there?

This depends on who you ask. Section 326-20-30-3 of the standard names five (5) categories: discounted cash flow, loss-rate, roll-rate, probability of default, and aging schedule. Some categories, like loss-rate, have several methods. Additionally, some methods seem to be referred to by different names, giving people the impression that there are exponentially more options out there than there really are. With this in mind, I tend to think of two (2) broad categories, and seven (7) unique methods:  

  • Loss-rate methods
    • Snapshot (open pool, static pool, cumulative loss rate)
    • Remaining Life and Weighted Average Remaining Maturity (WARM)
    • Vintage
       
  • Other methods
    • Scaled CECL Allowance for Losses Estimator (SCALE) (option for banks with assets <$1 billion)
    • Discounted Cash Flow (DCF)
    • Probability of default 
    • Migration (roll rate, aging schedule)  

What’s the difference?

The loss-rate methods use actual historical net charge-off information in different ways to derive a loss rate that can then be used to calculate expected losses over the remaining life of a pool. In general, they do this by holding the mix of a group of loans constant (e.g., by year of origination) and then tracking net losses tied to that grouping over time. The “other” methods employ a variety of mathematical techniques and/or credit quality information to estimate expected lifetime losses. For a quick overview of each method and corresponding resources, access our CECL methodologies guide here.

How do I know which to use?

This is the CECL equivalent of the proverbial million-dollar question. Technically, any institution could use any one, or all of these methods. But there are considerations that make some of them a more or less likely fit. For example, if your institution has >$1 billion in assets, SCALE is not even an option for you, and you can cross it off the list. If you are not in a position to afford software, or lack the internal expertise to build a similar model internally, then discounted cash flow and probability of default methods would likely be extremely burdensome in the normal course of business. For that reason, you may need to cross those off your list. If you lack large pools with consistently diverse performance over time, then migration methods will be difficult to support. If you have a relatively stable loan mix, consistent credit culture, and a lot of reliable historical loss data—especially through multiple economic cycles—the loss-rate methods may be a good fit, with or without software. If your portfolio has undergone a lot of changes—products, underwriting standards, merger and acquisition activity—and/or there are significant gaps in key data that cannot be restored, then you might want to re-consider software and one of the “other” methods. 

What are the pros and cons of the various methods?

One pro of the loss-rate and SCALE methods is they have been shown to be manageable without software. Examples of all of these methods have been illustrated using Excel spreadsheets. The use of Excel is also potentially a con, given that more spreadsheets and, maybe more people, are likely going to be involved in computing the Allowance for Credit Losses (ACL). As a result, version control as well as validation of spreadsheet macros, inputs, formulas, math, and risk of accidentally overwriting or deleting values should be addressed. One pro of the discounted cash flow method is that it is a bottom-up approach, meaning each loan’s discounted cash flow (DCF) is computed and then rolled up to the segment level. Because of this, DCF can more easily handle mixed pools, e.g., loans of all vintages, sizes, terms, payment and amortization schedules, etc. A potential con of DCF is that it really requires software, staff trained to use the software appropriately, and an understanding of the vast array of choices, levers, and decisions that come with it.     

Does my choice of method affect my qualitative adjustment options?

How’s this for commitment: maybe. In general, I think it’s safe to say that CECL requires additional thought be given to the nature and degree of adjustments. This is especially true when you look at the combination of potential segmentation changes, new elements of the calculation, and the variety of methods now available. Consider the example of a bank using a loss-rate method and facing a potential economic downturn. If that bank has sufficient history and a relatively stable portfolio mix, credit culture, and geography, then it might elect to use a different time period—say, historical loss-rates observed from the last recession—rather than those more recently computed. In this case, the loss-rate method would already be using a recessionary experience. 

How then, would the bank approach additional qualitative adjustments for changing economic outlooks to ensure it is not layering (or double counting) reserve? Going back to the original “maybe” response, perhaps the answer is less about inherent conflicts between methods and qualitative adjustments. Rather, it’s about understanding that given your chosen method, you may be faced with even more decisions about if, where, and how much adjusting you are doing.

CECL adoption is required. Struggling to adopt isn’t. We can help.

No matter what stage of CECL readiness you are in, we can help you navigate the requirements as efficiently and effectively as possible. For more information, visit the CECL page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions.

For more tips on documenting your CECL adoption, stay tuned for our next article in the series. You can also follow Susan Weber on LinkedIn.

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Questions to ask when deciding your CECL Method

Read this if you are a financial institution.

As you know by now, ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326), better known as the CECL standard, has already been implemented for some and will soon be implemented for all others (fiscal years beginning after December 15, 2022 to be exact). During your implementation process, the focus has likely been on your loan portfolio, and rightfully so, as CECL overhauls 40+ years of loan loss reserve practices. But, recall that the CECL standard applies to all financial instruments carried at amortized cost. So, it therefore includes held-to-maturity (HTM) debt securities. And, although not carried at amortized cost, the CECL standard also makes targeted enhancements to available-for-sale (AFS) debt securities. As if re-hauling your entire allowance methodology wasn’t enough! Before tearing out your hair because of another CECL-related change, let’s quickly review what is currently required for securities, and then focus on how this will change when you implement CECL.

Current US GAAP

Under current US generally accepted accounting principles (GAAP), direct write-downs on HTM and AFS debt securities are recorded when (1) a security’s fair value has declined below its amortized cost basis and (2) the impairment is deemed other-than-temporary. This assessment must be completed on an individual debt security basis. Providing a general allowance for unidentified impairment in a portfolio of securities is not appropriate. The previous amortized cost basis less the other-than-temporary impairment (OTTI) recognized in earnings becomes the new amortized cost basis and subsequent recoveries of OTTI may not be directly reversed into interest income. Rather, subsequent recoveries of credit losses must be accreted into interest income.

CECL: Held-to-maturity securities

Then comes along CECL  and changes everything. Once the CECL standard is implemented, expected losses on HTM debt securities will be recorded immediately through an allowance for credit loss (ACL) account, rather than as a direct write-down of the security’s cost basis. These securities should be evaluated for risk of loss over the life of the securities. Another key difference from current GAAP is that securities with similar risk characteristics will need to be assessed for credit losses collectively, or on a pool basis, not on an individual basis as currently prescribed. Also, contrary to current GAAP, since expected losses will be recorded through an ACL account, subsequent improvements in cash flow expectations will be immediately recognized through earnings via a reduction in the ACL account. CECL effectively eliminates the direct write-down method, with write-offs only occurring when the security, or a portion thereof, is deemed to be uncollectible. 

In practice, there may be some types of HTM debt securities that your institution believes have no risk of nonpayment and thus risk of loss is zero. An example may be a US Treasury debt security or possibly a debt security guaranteed by a government-sponsored enterprise, such as Ginnie Mae or Freddie Mac. In these instances, it is acceptable to conclude that no allowance on such securities is necessary. However, such determination should be documented and changes to the credit situation of these securities should be closely monitored.

Financial institutions that have already implemented CECL have appreciated its flexibility; however, just like anything else, there are challenges. One of the biggest questions that has risen is related to complexity, specifically from financial statement users in regards to the macroeconomic assumptions used in models. Another common challenge is comparability to competitors’ models and estimates. Each financial institution will likely have a different methodology when recording expected losses on HTM debt securities due to the judgment involved. These concerns are not unique to the ACL on HTM debt securities but are nonetheless concerns that will need to be addressed. A description of the methodology used to estimate the ACL, as well as a discussion of the factors that influenced management’s current estimate of expected losses must be disclosed in the financial statements. Therefore, management should ensure adequate information is provided to address financial statement users’ concerns.  

CECL: Available-for-sale securities

Upon CECL adoption, you are also expected to implement enhancements to existing practices related to AFS debt securities. Recall that AFS debt securities are recorded at fair value through accumulated other comprehensive income (AOCI). This will not change after adoption of the CECL standard. However, the concept of OTTI will no longer exist. Rather, if an AFS debt security’s fair value is lower than its amortized cost basis, any credit related loss will be recorded through an ACL account, rather than as a direct write-down to the security. This ACL account will be limited to the amount by which fair value is below the amortized cost basis of the security. Credit losses will be determined by comparing the present value of cash flows expected to be collected from the security with its amortized cost basis. Non-credit related changes in fair value will continue to be recorded through an investment contra account and other comprehensive income. So, on the balance sheet, AFS debt securities could have an ACL account and an unrealized gain/loss contra account. The financial institution will be responsible for determining if the decline in the value below amortized cost is the result of credit factors or other macroeconomic factors. In practice, the following flowchart may be helpful:

Although changes to debt securities may not be top of mind when working through CECL implementation, ensuring you reserve time to understand and assess the impact of these changes is important. Depending on the significance and composition of your institution’s debt security portfolio, these changes may have a significant impact on your financial institution’s financial statements from CECL adoption forward. For more information, visit the CECL page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions.

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Don't forget about me! Changes in debt security accounting resulting from CECL