Understanding the Impact of ASU 2012-06

Deloitte Banking & Securities Alert

October 25, 2012

Background

On October 23, 2012, the FASB issued ASU 2012-06,1 which clarifies existing guidance on the subsequent measurement of an indemnification asset recognized as a result of a government-assisted acquisition of a financial institution. ASC 8052 specifies that an acquirer must record an indemnification asset at the same time as it recognizes the indemnified item in a business combination. The indemnification asset is initially measured on the same basis as the indemnified item (with a valuation allowance for amounts deemed uncollectible) and is subsequently also measured on the same basis as the indemnified item, subject to any contractual limitations on the asset’s amount (including an assessment of its collectibility when it is not measured at fair value).

The ASU was issued to eliminate the current diversity in practice in the interpretation of the terms “on the same basis” and “contractual limitations” in ASC 805-20 with respect to a government-assisted acquisition of a financial institution. Specifically, these terms have been interpreted differently when the performance of the indemnified asset has improved and the indemnification asset’s expected performance has therefore deteriorated. In such circumstances, most entities either (1) amortize the deterioration in the indemnification asset over the shorter of the remaining term of the loss-sharing agreement (LSA) or the term of the acquired loans or (2) impair the indemnification asset and recognize the impairment charge (i.e., the entire decrease in expected cash flows) immediately in earnings.

What Changed?

ASU 2012-06 clarifies that when a reporting entity recognizes an indemnification asset as a result of a government-assisted acquisition of a financial institution and there is a subsequent change in the amount of cash flows expected to be collected on the indemnified asset, the reporting entity should subsequently measure the indemnification asset on the same basis as the underlying loans by taking into account the contractual limitations of the LSA. For amortization of changes in value, the reporting entity should use the term of the LSA if it is shorter than the term of the acquired loans.

What Is the Scope of the ASU?

ASU 2012-06 affects both public and nonpublic entities that recognize, as part of a business combination, an indemnification asset (in accordance with ASC 805-20) that the government provides as part of a government-assisted acquisition of a financial institution. One example is a business combination for which the Federal Deposit Insurance Corporation (FDIC) enters into an LSA with the acquiring bank. The ASU does not apply to situations in which the indemnified asset is subsequently measured at fair value, and its scope does not expand beyond government-assisted acquisitions of a financial institution.

Example

Acquirer A purchases a pool of loans with a remaining term of 15 years as part of an FDIC-assisted bank acquisition (which meets the definition of a business). At acquisition, the acquired loans had a par value of $2 million and a fair value of $1 million (because of deteriorations in credit quality). In addition, the FDIC entered into an LSA with Acquirer A to reimburse 80 percent of certain losses on covered loans for the next five years. At acquisition, the fair value of the indemnification asset provided by the FDIC was assumed to be $400,000. After the acquisition date, the expected cash flows on the acquired pool of loan increased by $250,000 (which was accreted into income over the life of the pool of loans in accordance with ASC 310-30-35-2). As a result, the expected cash flows from the existing indemnification asset decreased by an assumed amount of $190,000, as determined under the terms of the LSA, and this amount would be amortized (on the same basis as the underlying loans) over the remaining term of the LSA.

What’s Next?

The amendments should be applied prospectively for fiscal years beginning on or after December 15, 2012 (and interim reporting periods within those years). Early adoption is permitted. The ASU applies to the unamortized balance of any existing indemnification assets as of the adoption date (rather than only to future changes in expected cash flows of unamortized indemnification assets existing as of the adoption date). Upon adoption, the amortization period for the remaining unamortized balance would be shortened to the remaining contractual life of the LSA, with the effect recorded in earnings for the period.

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1 FASB Accounting Standards Update No. 2012-06, Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution — a consensus of the FASB Emerging Issues Task Force.

2 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”