Effective December 15, 2025, FASB released Accounting Standards Update (ASU) 2025-08 as an update to Accounting Standards Codification (ASC) 326, Financial Instruments—Credit Losses, for the purpose of expanding on the accounting treatment of purchased loans. As a result of this update, an institution completing an acquisition will need to change how it classifies the Day 1 allowance for credit losses in its Tier 2 capital calculation (for those institutions that have not elected to utilize the Community Bank Leverage Ratio). While ASU 2025-08 changes U.S. GAAP accounting for acquired loans, it does not amend federal banking regulations governing regulatory capital, including the definition of adjusted allowances for credit losses (AACL).
Background
Prior guidance distinguished between purchased credit-deteriorated (PCD) assets and non-PCD assets. ASU 2025-08 effectively eliminates this distinction by introducing purchased seasoned loans (PSLs) and expanding the gross-up accounting model to most acquired loans. The allowance for credit loss balance related to these PCD assets previously had not been included in the AACL, an addition to the acquiring institution’s Tier 2 capital, as the AACL includes only those allowance balances that originated via earnings or retained earnings.
Therefore, the only AACL to be added by an acquiring institution would be the allowance for credit loss related to the non-PCD assets, if applicable. With ASU 2025-08 effectively removing this distinction and eliminating the Day 1 credit loss expense on PSLs, the related allowance for credit losses may be excluded from the AACL and, therefore, from Tier 2 capital, based on existing regulatory definitions and historical interpretation.
What Is Tier 2 Capital?
The supplementary layer of an institution’s capital, Tier 2 capital, is considered by regulators to be a less loss-absorbing form of capital. It is thought to be less secure than Tier 1 as it is more challenging to liquidate. Some of the most common examples of Tier 2 capital will include an institution’s balance of:
- AACL
- Allocated transfer risk reserves
- Subordinated instruments
Tier 1 represents the core capital held by an institution and typically comprises common stock, retained earnings, and accumulated other comprehensive income (loss). Altogether, an institution must maintain a capital ratio (total capital divided by total risk-based assets) of at least 8% and a minimum of 6% provided by Tier 1 capital. Failure to meet these requirements would classify an institution as “undercapitalized” and would immediately require a restoration plan. An institution would then be subject to limitations, including restrictions on asset growth, limits on capital distributions, and reductions in management fees paid to holding companies.
The most common component of Tier 2 capital, noted above, is the AACL, which is embedded in regulatory capital calculations through the call report Schedule RC-R, Part I, line 42. The total amount reportable as AACL on this line of the call report is capped at 1.25% of the bank’s total risk-weighted assets. AACL is to include allowances that have been established through a charge against earnings or retained earnings, which has not changed through the update to ASC 326. The change from this update comes in the form of those allowances that are created through an offset to goodwill rather than earnings via an acquisition.
This interpretation would result in the allowance for credit losses established at acquisition through gross-up accounting being excluded from Tier 2 capital reported on Schedule RC-R, Part I, line 42. In light of the Federal Reserve’s increased emphasis on material financial risk and reliance on internal governance, institutions should make sure their regulatory capital interpretation is supported by clear internal documentation and review.
Key Items to Consider for Institutions
Entities will need to consider the newly updated credit loss regulation and how this will impact financial reporting. When making considerations about acquiring an institution, management should keep these changes in mind and how Tier 2 capital is calculated. Failure to maintain an appropriate level of capital will provide complications for an institution and ASU 2025-08 could have an effect. In addition, any acquiring institution will need to consider these changes in regard to their reporting on the call report to make sure that the acquiree’s allowance for credit losses is properly addressed in capital calculations.
How Forvis Mazars Can Help
The experienced professionals at Forvis Mazars can assist you in strategically planning your prospective acquisitions. We frequently communicate with federal and state regulators so we can bring their perspectives on the banking industry to our clients. If you have any questions regarding this matter, please contact a professional at Forvis Mazars.