Bank Accounting Advisory Series August 2017 Message From the Chief Accountant I am pleased to present the Office of the Chief Accountant’s August 2017 edition of the Bank Accounting Advisory Series (BAAS). The BAAS expresses the office’s views on accounting topics relevant to national banks and federal savings associations (collectively, banks or institutions, unless otherwise specified). We hope that you find this publication useful. In the past, our office has updated the BAAS for newly issued accounting standards after they became effective. We are changing our approach beginning with this edition of the BAAS, because many Accounting Standards Updates (ASU) issued by the Financial Accounting Standards Board (FASB) now have different effective dates for public business entities (PBE) and private companies. This edition reflects ASUs issued by the FASB through March 31, 2017, that, (1) while not yet effective for all institutions, must be adopted by PBEs beginning in 2018 and may be adopted early by other institutions or (2) are not yet effective for any institutions but early adoption is allowed. To differentiate these two scenarios, we have added two color schemes—lavender for content applicable to PBEs and early adopters and gold for content applicable to early adopters only. The responses in lavender and gold text boxes replace the initial staff responses for applicable entities and should not be read in conjunction with the original staff responses. The following questions have been added, updated, or deleted in the 2017 edition of the BAAS: Topic 1A Investments in Debt and Equity Securities Questions 16, 17, and 18 W E Topic 3B Lessee Classification and Accounting Questions 1, 2, 3, 4, and 5 N Topic 9A Transfers of Financial Assets and Servicing Questions 8, 9, and 10 Topic 1A Investments in Debt and Equity Securities Questions 6, 7, and 20 Topic 1B Other-Than-Temporary Impairment Questions 3, 7, and 20 D Topic 3A Lessor Classification and Accounting Questions 1, 2, 3, 4, 5, and 11 E T A Topic 3C Sale-Leaseback Transactions Questions 1, 3, 4, 5, and 6 D P Topic 3D Lease Exit Costs Questions 1, 2, and 3 U Topic 5A Other Real Estate Owned Questions 13, 14, 15, 16, 17, 18, 21, 22, 23, 24, 25, 29, 30, 38, and 39 Topic 9A Transfers of Financial Assets and Servicing Question 7 D Topic 1A Investments in Debt and Equity Securities Questions 16, 17, 18, 19, 20, and 21 E T E Topic 1B Other-Than-Temporary Impairment Questions 17 and 18 L E D Topic 2C Commitments Question 3 As part of our annual review process, we also made minor edits to some existing entries and renumbered others. Bank Accounting Advisory Series i August 2017 Banks are reminded that the BAAS does not represent official rules or regulations of the Office of the Comptroller of the Currency (OCC). Rather, the BAAS represents the OCC Office of the Chief Accountant’s interpretations of generally accepted accounting principles and regulatory guidance based on the facts and circumstances presented. Nevertheless, banks that deviate from these stated interpretations may be required to justify those departures to the OCC. Louis A. (Rusty) Thompson Jr. Deputy Comptroller and Chief Accountant Office of the Comptroller of the Currency Bank Accounting Advisory Series ii August 2017 Contents Message From the Chief Accountant ................................................................ i Topic 1 Investment Securities ........................................................................................1 1A. Investments in Debt and Equity Securities ..................................................... 1 1B. Other-Than-Temporary Impairment ............................................................. 13 Topic 2 Loans ................................................................................................................ 23 2A. Troubled Debt Restructurings ...................................................................... 23 2B. Nonaccrual Loans ........................................................................................ 49 2C. Commitments .............................................................................................. 65 2D. Origination Fees and Costs ......................................................................... 74 2E. Loans Held for Sale ..................................................................................... 79 2F. Loan Recoveries .......................................................................................... 89 2G. Acquired Loans ........................................................................................... 92 Topic 3 Leases .............................................................................................................. 99 3A. Lessor Classification and Accounting .......................................................... 99 3B. Lessee Classification and Accounting ........................................................ 107 3C. Sale-Leaseback Transactions ................................................................... 111 3D. Lease Exit Costs ....................................................................................... 116 Topic 4 Allowance for Loan and Lease Losses ........................................................ 118 Topic 5 OREO and Other Assets ................................................................................ 148 5A. Other Real Estate Owned .......................................................................... 148 5B. Life Insurance and Related Deferred Compensation.................................. 174 5C. Miscellaneous Other Assets ...................................................................... 178 Topic 6 Liabilities ........................................................................................................ 183 6A. Contingencies ............................................................................................ 183 6B. Other Borrowings ....................................................................................... 186 Topic 7 Income Taxes ................................................................................................. 188 7A. Deferred Taxes .......................................................................................... 188 7B. Tax Sharing Arrangements ........................................................................ 192 7C. Marginal Income Tax Rates ....................................................................... 195 Bank Accounting Advisory Series iii August 2017 Topic 8 Capital ............................................................................................................. 197 8A. Sales of Stock ............................................................................................ 197 8B. Quasi-Reorganizations .............................................................................. 199 8C. Employee Stock Options ........................................................................... 201 Topic 9 Income and Expense Recognition ................................................................ 202 9A. Transfers of Financial Assets and Servicing .............................................. 202 9B. Credit Card Affinity Agreements................................................................. 213 9C. Organization Costs .................................................................................... 214 Topic 10 Acquisitions, Corporate Reorganizations, and Consolidations ................ 217 10A. Acquisitions ............................................................................................. 217 10B. Intangible Assets .................................................................................... 226 10C. Pushdown Accounting ............................................................................ 233 10D. Corporate Reorganizations ...................................................................... 237 10E. Related Party Transactions (Other Than Reorganizations) ...................... 239 Topic 11 Miscellaneous Accounting ........................................................................... 244 11A. Asset Disposition Plans ........................................................................... 244 11B. Hedging Activities .................................................................................... 246 11C. Financial Statement Presentation ............................................................ 248 11D. Fair Value Accounting ............................................................................. 249 Appendixes ........................................................................................................................ 254 Appendix A. Commonly Used Abbreviations and Terms .................................. 254 Appendix B. Commonly Used Pre-Codification References ............................. 256 Appendix C. Commonly Used FASB Codification References.......................... 260 Bank Accounting Advisory Series iv August 2017 INVESTMENT SECURITIES 1A. Investments in Debt and Equity Securities Topic 1 Investment Securities PBEs and early adopters only In January 2016, the FASB issued ASU 2016-01, “Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Liabilities.” This guidance creates Topic 321, “Investments – Equity Securities,” which addresses accounting and reporting for investments in equity securities. ASU 2016-01 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, for banks that are PBEs. For banks that are not PBEs, the guidance is effective for fiscal years beginning after December 15, 2018, and for interim periods within fiscal years beginning after December 15, 2019. Early adoption of the provisions of the standard involving accounting for equity investments is prohibited. The following staff responses comply with existing GAAP guidance; to the extent that staff interpretations differ under ASU 2016-01, these are provided in separate lavender text boxes. 1A. Investments in Debt and Equity Securities Early adopters only In March 2017, the FASB issued ASU 2017-08, “Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities.” ASU 2017-08 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, for banks that are PBEs. For banks that are not PBEs, the guidance is effective for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted for all banks. The following staff responses comply with existing GAAP guidance; to the extent that staff interpretations differ under ASU 2017-08, these are provided in separate gold text boxes. Facts Under ASC 320, banks classify their investments in debt securities in one of three categories: HTM, AFS, or trading. HTM securities are carried at amortized cost, while AFS and trading securities are carried at fair value. Banks include the net unrealized holding gains (losses) on AFS securities in AOCI, net of applicable taxes, rather than as part of the bank’s net income (loss). If HTM or AFS debt securities are other-than-temporarily impaired, banks must determine the amount of impairment to be recognized in earnings. Net unrealized holding gains (losses) on trading securities are reported in net income (loss). Question 1 Should the net unrealized holding gains (losses) on AFS debt securities be included in the calculation of a bank’s lending limit? Bank Accounting Advisory Series 1 August 2017 INVESTMENT SECURITIES 1A. Investments in Debt and Equity Securities Staff Response It depends on the regulatory capital treatment of net unrealized holding gains (losses) on AFS debt securities for the bank. A bank’s legal lending limit is the amount that the bank may legally lend to one customer. It should be calculated, in accordance with 12 CFR 32, based on the bank’s tier 1 and tier 2 capital calculated under the applicable risk-based capital standards (set forth at 12 CFR 3 and presented in call report instructions), adjusted to include the portion of the ALLL excluded for tier 2 capital calculation purposes. Under the 2013 revised regulatory capital rule, banks may be required to incorporate net unrealized holding gains (losses) on AFS debt securities into common equity tier 1 (CET1) capital, which is a component of tier 1 capital, as described below. For non-advanced approaches banks Under the 2013 revised regulatory capital rule, non-advanced approaches banks had a one- time irrevocable option to exclude (“filter”) certain AOCI components, comparable to the regulatory capital treatment before the 2013 revised regulatory capital rule. The AOCI opt-out election had to be made on the bank’s first call report filed after January 1, 2015. For any bank that did not exercise this option, its AOCI will be incorporated into CET1 capital, including unrealized gains and losses on all AFS securities, subject to a transition period through December 31, 2017. For advanced approaches banks Net unrealized gains or losses on AFS debt securities are reflected in CET1 capital, subject to a transition through December 31, 2017. Advanced approaches banks generally include those with $250 billion or more in total consolidated assets or $10 billion or more in on-balance-sheet foreign exposure, other banks that opt in to the advanced approaches, and depository institution subsidiaries of banking organizations that meet one of the aforementioned thresholds. Question 2 How should a bank account for the unrealized gains or losses on investments denominated in a foreign currency? Staff Response The net unrealized holding gains and losses on AFS investments denominated in a foreign currency should be excluded from net income and reported in AOCI. The entire unrealized gain or loss, including both of the portions related to interest rate and foreign currency rate changes, is accounted for as an unrealized holding gain or loss and reported in the separate component of Bank Accounting Advisory Series 2 August 2017 INVESTMENT SECURITIES 1A. Investments in Debt and Equity Securities stockholders’ equity. Therefore, the income statement effect of foreign currency gains and losses is deferred until the security is sold. The gain or loss attributable to changes in foreign currency exchange rates, however, would be recognized in income, if the investment is categorized as HTM. Banks should follow the accounting guidance provided in ASC 830 for such investments. Question 3 What is the appropriate accounting for transfers between investment categories? Staff Response In accordance with ASC 320-10-35, transfers between investment categories are accounted for as follows: • HTM to AFS: The unrealized holding gain or loss at the date of the transfer shall be recognized in AOCI, net of applicable taxes. • AFS to HTM: The unrealized holding gain or loss at the date of transfer shall continue to be reported in AOCI but shall be amortized over the remaining life of the security as a yield adjustment. This amortization of the unrealized holding gain or loss will offset the effect on income of amortization of the related premium or discount (see question 4). • All transfers to the trading category: The unrealized gain or loss at the date of transfer, net of applicable taxes, shall be recognized in earnings immediately. • All transfers from the trading category: The unrealized gain or loss at the date of transfer will have already been recognized in earnings and shall not be reversed. Transfers in and out of the trading category and from HTM to AFS should be rare. Facts A bank purchased a $100 million bond on December 31, 20X1, at par. The bond matures on December 31, 20X6. Initially, the bond was classified as AFS. On December 31, 20X2, the bank decides it intends to hold the bond until maturity and transfers the security to the HTM portfolio. The fair value of the security on the date of transfer is $92 million. The bank has appropriately determined that the decline in the security’s fair value is not OTTI. Question 4 How should the bank account for the transfer? Staff Response In accordance with ASC 320-10-35-10, at the date of transfer, the bank should transfer the security at its fair value, $92 million, which becomes the security’s amortized cost. The $8 million unrealized holding loss on the date of transfer is not recognized in net income but Bank Accounting Advisory Series 3 August 2017 INVESTMENT SECURITIES 1A. Investments in Debt and Equity Securities remains in AOCI. In addition, an unaccreted discount of $8 million offsets the security’s face amount of $100 million, so the security is reported at its fair value ($92 million) when transferred. Under ASC 320-10-35-16, the $8 million discount is accreted to interest income over the remaining life of the security. In accordance with ASC 320-10-35-10d, the unrealized loss amount in AOCI is amortized simultaneously against interest income. Those entries offset or mitigate each other. For regulatory capital purposes, the unamortized AOCI related to the security is treated in the same manner as a net unrealized gain or loss on an AFS debt security. See question 1 for further information on the regulatory capital treatment of net unrealized gains (losses) on the AFS debt securities. Question 5 Do any restrictions exist on the types of debt securities that may be placed in the HTM category? Staff Response Generally, there are few restrictions on how bank management chooses to allocate the securities in its portfolio among the investment categories. ASC 320 requires that a security, such as an IO strip, not be accounted for as HTM, if it can be contractually prepaid or otherwise settled, so that its holder would not recover substantially all of its recorded investment. Additionally, an institution may not include a convertible debt security as HTM. Convertible debt bears a lower interest rate than an equivalent security without such a feature, because it provides the owner with potential benefits from stock price appreciation. Use of this feature, however, requires the owner to dispose of the debt security before maturity. Accordingly, the acquisition of such a security implies that the owner does not intend to hold it to maturity. No restrictions prevent a bank from pledging HTM securities as collateral for a loan. A bank may also pledge HTM securities in a repurchase agreement if the agreement is not effectively a sale in accordance with ASC 860. Question 6 How should banks account for investments in mutual funds under ASC 320? Staff Response Investments in mutual funds cannot be classified as HTM because mutual funds are an equity investment, for which there is no maturity. Therefore, at acquisition, the bank must evaluate whether the investment should be classified as trading or AFS. A mutual fund bought principally for sale in the near term should be classified as a trading investment. For a mutual fund that is Bank Accounting Advisory Series 4 August 2017 INVESTMENT SECURITIES 1A. Investments in Debt and Equity Securities not bought principally for sale in the near term, a bank may elect to classify the fund as trading or AFS at the time of purchase. Net unrealized holding gains and losses on trading investments are included in income, while net unrealized holding gains and losses on AFS investments are included in AOCI until they are realized. PBEs and early adopters only D E Under ASU 2016-01, mutual funds will no longer be classified as either trading or available- T A for-sale; instead, they will generally be measured at fair value with changes in fair value D P recognized through net income. U Question 7 How should gains and losses be reported when mutual fund investments are sold? Staff Response Realized gains and losses should be included in determining net income for the period in which they occur. Realized gains and losses should be recorded in the call report as “Realized gains (losses) on available-for-sale securities” if the mutual fund investments were classified as AFS, or as “Trading revenue” if the mutual fund investments were classified as trading. If mutual fund investments classified as AFS are sold, the component in AOCI should be adjusted to remove any previously included amounts applicable to them. PBEs and early adopters only D Under ASU 2016-01, mutual funds will generally be measured at fair value, with changes in E T fair value recognized through net income. All changes in a mutual fund’s fair value should be A D reported in earnings at each reporting date. Therefore, the sale of a mutual fund would P U generally not give rise to a gain or loss except to the extent a bank has not yet recorded the mutual fund’s change in fair value to the point of sale. Question 8 When may a bank sell HTM securities and not “taint” the portfolio? Staff Response ASC 320 establishes the following “safe harbors” under which HTM securities may be sold without tainting the entire portfolio: • Evidence of a significant deterioration in the issuer’s creditworthiness. • A change in the tax law that eliminates or reduces the tax-exempt status of interest on the debt security (but not a change in tax rates). • A major business combination or disposition that necessitates the sale of the securities to Bank Accounting Advisory Series 5 August 2017