Current Accounting Developments

9 Months Ended

Sep. 30, 2022

New Accounting Pronouncements and Changes in Accounting Principles [Abstract]

Current Accounting Developments

Note 3 – Current Accounting Developments

In September 2016 the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which eliminates the probable initial recognition threshold for credit losses in current U.S. GAAP, and instead requires an organization to record an estimate of expected credit losses over the

contractual term for financial assets carried at amortized cost (generally loans and held-to-maturity investment securities) in addition to certain off balance-sheet credit exposure. Under the current expected credit losses (“CECL”) methodology expected credit losses for financial assets are estimated over the contractual life of the financial asset, adjusted for expected prepayments, considering historical experience, current conditions, and reasonable and supportable forecasts. Additionally, under CECL the accounting for credit losses on available-for-sale debt securities is addressed through an allowance for credit losses which is a change from legacy GAAP which previously required the direct write-down of securities through the other-than-temporary impairment approach. The Company implemented CECL on January 1, 2022, using the modified retrospective approach to estimate lifetime expected losses on financial assets measured at amortized cost in addition to certain off balance sheet credit exposures. The January 1, 2022, increase in the Company’s allowance for credit losses, of $9.5 million on loans and leases and $0.9 million in off balance sheet credit exposures, net of the impact of deferred taxes, was reflected in a transition adjustment of $7.3 million to retained earnings. There was no cumulative effect adjustment related to our available-for-sale investment portfolio upon adoption and the company had no securities designated as held-to-maturity as of January 1, 2022. Results for reporting periods beginning after December 31, 2021, are presented under CECL whereas prior comparative periods are presented under legacy GAAP. The majority of the Bank’s loan and lease portfolio consists of loans, so hereafter within this document references to the loan and lease portfolio in general will reference loans as opposed to loans and leases.

The following table illustrates the impact of the adoption of CECL, and the transition away from the incurred loss method, on January 1, 2022. The impact to the Allowance for Credit losses (“ACL”) on the Loan Portfolio is broken out at the class level (dollars in thousands, unaudited):

Transition Impact on Allowance for Credit Losses
(dollars in thousands, unaudited)
	January 1, 2022
	Reserves Under Incurred Loss		Reserves Under CECL		Transition Impact Gross		Impact of Deferred Taxes		Impact to Retained Earnings
Real estate:
1-4 family residential construction	$	135	$	28	$	(107)	$	32	$	(75)
Other construction/land		228		254		26		(8)		18
1-4 family - closed-end		1,618		2,310		692		(205)		487
Equity lines		290		210		(80)		24		(56)
Multi-family residential		274		574		300		(89)		211
Commercial real estate - owner occupied		2,217		3,444		1,227		(363)		864
Commercial real estate - non-owner occupied		6,199		14,380		8,181		(2,418)		5,763
Farmland		737		340		(397)		117		(280)
Total real estate		11,698		21,540		9,842		(2,910)		6,932
Agricultural		465		382		(83)		25		(58)
Commercial and industrial		1,060		1,418		358		(106)		252
Mortgage warehouse lines		512		91		(421)		124		(297)
Consumer loans		521		279		(242)		72		(170)
Total allowance for credit losses - loans	$	14,256	$	23,710	$	9,454	$	(2,795)	$	6,659
Allowance for credit losses - unfunded loan commitments	$	203		1,134		931		(275)		656

The Company currently categorizes all of its loans as held-for-investment and following CECL implementation, reports loans on the amortized cost basis. The Company’s amortized cost basis is comprised of the principal balance outstanding, net of remaining purchase discount or premium and any deferred fees or costs. Notably, the Company elected the practical expedient available under CECL to exclude accrued interest receivable from the amortized cost basis of all categorizations of loans and investment securities, and resultingly did not estimate reserves on accrued interest receivable balances, as any past due interest income is reversed on a timely basis. Accrued interest receivable continues to be included in other assets on the Company’s balance sheet and as of September 30, 2022, measured at $8.3

million, $0.5 million and $4.7 million for available-for-sale securities, held-to-maturity securities and loans, respectively. Due to loans being placed on nonaccrual status, during the third quarter of 2022 an immaterial amount of interest receivable on loans was reversed against interest income and $0.1 million of reversed interest for the nine months ended September 30, 2022. For the same time periods no interest receivable on held-to-maturity or available for sale investment securities was reversed against interest income.

Similar to practice under legacy GAAP, the Company continues to place loans on nonaccrual status when management has determined that the full repayment of principal and collection of contractually agreed upon interest is unlikely or when the loan in question has become delinquent more than 90 days. The Company may decide that it is appropriate to continue to accrue interest on certain loans more than 90 days delinquent if they are well-secured by collateral and collection is in process. When a loan is placed on nonaccrual status, any accrued but uncollected interest for the loan and lease is reversed out of interest income in the period in which the loan’s status changed. For loans with an interest reserve, i.e., where loan and lease proceeds are advanced to the borrower to make interest payments, all interest recognized from the inception of the loan and lease is reversed when the loan and lease is placed on non-accrual. Once a loan and lease is on non-accrual status subsequent payments received from the customer are applied to principal, and no further interest income is recognized until the principal has been paid in full or until circumstances have changed such that payments are again consistently received as contractually required. Generally, loans are not restored to accrual status until the obligation is brought current and has performed in accordance with the contractual terms for a reasonable period of time, and the ultimate collectability of the total contractual principal and interest is no longer in doubt.

Similar to practice under legacy GAAP, the ACL on the loan portfolio is a valuation allowance deducted from the recorded balance in loans. However, under CECL the ACL represents principal which is not expected to be collected over the contractual life of the loans, adjusted for expected prepayment, whereas under legacy GAAP the allowance represented only losses already incurred as of the balance sheet date. The ACL is increased by a provision for credit losses charged to expense, and by principal recovered on charged-off balances. It is reduced by principal charge-offs. The amount of the allowance is based on management’s evaluation of the collectability of the loan and lease portfolio, using information from internal and external sources, relating to past events, current conditions and reasonable and supportable forecasts. Adjustments are also made for changes in risk profile, credit concentrations, historical trends, and other economic conditions.

The ACL for loans and leases is separated between a collective reserve evaluation, for loans where similar risk characteristics exist and an individual reserve evaluation for loans without similar risk characteristics. The collective evaluation of loans is performed at the portfolio segment level, using call code as the primary segmentation key but also considering similarity in quantitative reserve methodology. The Company’s ACL is categorized according to the following portfolio segments: 1-4 Family Real Estate, Commercial Real Estate, Farmland & Agricultural Production, Commercial & Industrial, Mortgage Warehouse, and Consumer. Management utilizes a discounted cash flow methodology to estimate the quantitative portion of collectively evaluated reserves for the 1-4 Family Real Estate, Commercial Real Estate, Commercial & Industrial and Mortgage Warehouse portfolio segments. Management utilizes a Remaining Life Quantitative Reserve Methodology for the Farmland & Agricultural Production, and Consumer portfolio segments. Within the portfolio segments utilizing the DCF quantitative reserve methodology, management has made the election to adjust the effective interest rate to consider the impact of expected prepayments.

Loans where similar risk characteristics exist are evaluated for the ACL in the collective reserve evaluation. The Company’s policy is that loans designated as nonaccrual no longer share risk characteristics similar to other loans evaluated collectively and as such, all nonaccrual loans are individually evaluated for reserves. As of September 30, 2022 the Bank’s nonaccrual loans comprised the entire population of loans individually evaluated. The Company’s policy is that nonaccrual loans also represent the subset of loans where borrowers are experiencing financial difficulty where an evaluation of the source of repayment is required to determine if the nonaccrual loan should be categorized as collateral dependent. It is the Company’s policy that the only loans and leases where the credit quality has deteriorated to the point where foreclosure is probable are the Company’s nonaccrual loans.

The implementation of CECL also impacted the Company’s ACL on unfunded loan commitments, as this ACL now represents expected credit losses over the contractual life of commitments not identified as unconditionally cancellable by the Company. The Reserve for Unfunded Commitments is estimated using the same reserve or coverage rates

calculated on collectively evaluated loans following the application of a funding rate to the amount of the unfunded commitment. The funding rate represents management’s estimate of the amount of the current unfunded commitment that will be funded over the remaining contractual life of the commitment and is based on historical data. Under CECL the ACL on unfunded loan commitments remains in Other Liabilities while any related provision expense has been moved to provision for credit loss expense from its prior presentation in noninterest expense. Prior period expense has been reclassified for comparative purposes.

For available-for-sale debt securities in an unrealized loss position for which management has an intent to sell the security or considers it more likely-than-not that the security in question will be sold prior to a recovery of its amortized cost basis, the security will be written down to fair value through a direct charge to income. For the remainder of available sale debt securities in an unrealized loss position, which don’t meet the previously outlined criteria, management evaluates whether the decline in fair value is a reflection of credit deterioration or other factors. In performing this evaluation, management considers the extent which fair value has fallen below amortized cost, changes in ratings by rating agencies, and other information indicating a deterioration in repayment capacity of either the underlying issuer or the borrowers providing repayment capacity in a securitization. If management’s evaluation indicates that a credit loss exists then a present value of the expected cash flows is calculated and compared to the amortized cost basis of the security in question and to the degree that the amortized cost basis exceeds the present value an allowance for credit loss (“ACL”) is established, with the caveat that the maximum amount of the reserve on any individual security is the difference between the fair value and amortized cost balance of the security in question. Any unrealized loss that has not been recorded through an ACL is recognized in other comprehensive income.

On April 1, 2022 the Company transferred $162.1 million of Agency, Mortgaged-Backed and Municipal securities from available-for-sale to held-to maturity.  Because of the implicit and explicit guarantees of the Federal Government on the Agency and Mortgage-Backed securities there is no expectation of future losses on any of these securities.  The Bank’s municipal bonds moved to the held-to-maturity designation all have credit ratings considered investment grade or equivalent.  A discounted-cash-flow reserve calculation was performed upon the transfer of these securities into the held-to-maturity designation and a reserve of $0.02 million was calculated and charged to provision expense.