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The Allowance for
Loan Losses:
Critical Issues for
Credit Union Leaders
Michael J. Sacher, CPASacher Consulting
Foreword by Dr. Harold M. SollenbergerProfessor Emeritus of Accounting and Information Systems
Michigan State University
ideas grow here
PO Box 2998
Madison, WI 53701-2998
Phone (608) 231-8550
www.filene.org PUBLICATION #243 (7/11)
The Allowance for
Loan Losses:
Critical Issues for
Credit Union Leaders
Michael J. Sacher, CPASacher Consulting
Foreword by Dr. Harold M. SollenbergerProfessor Emeritus of Accounting and Information Systems
Michigan State University
Copyright © 2011 by Filene Research Institute. All rights reserved.Printed in U.S.A.
Deeply embedded in the credit union tradition is an ongoing
search for better ways to understand and serve credit union
members. Open inquiry, the free flow of ideas, and debate are
essential parts of the true democratic process.
The Filene Research Institute is a 501(c)(3) not-for-profit
research organization dedicated to scientific and thoughtful
analysis about issues affecting the future of consumer finance.
Through independent research and innovation programs the
Institute examines issues vital to the future of credit unions.
Ideas grow through thoughtful and scientific analysis of top-
priority consumer, public policy, and credit union competitive
issues. Researchers are given considerable latitude in their
exploration and studies of these high-priority issues.
The Institute is governed by an Administrative Board made
up of the credit union industry’s top leaders. Research topics
and priorities are set by the Research Council, a select group
of credit union CEOs, and the Filene Research Fellows, a blue
ribbon panel of academic experts. Innovation programs are
developed in part by Filene i3, an assembly of credit union
executives screened for entrepreneurial competencies.
The name of the Institute honors Edward A. Filene, the “father
of the U.S. credit union movement.” Filene was an innova-
tive leader who relied on insightful research and analysis when
encouraging credit union development.
Since its founding in 1989, the Institute has worked with over
one hundred academic institutions and published hundreds of
research studies. The entire research library is available online
at www.filene.org.
Progress is the constant replacing of the best there
is with something still better!
— Edward A. Filene
iii
Filene Research Institute
iv
The author would like to thank Bill Eckhardt, Daniel McCue, and
Norm West of Alaska USA Federal Credit Union for their encour-
agement and incisive feedback in the preparing of this report. In
addition to his generous foreword, Professor Harold Sollenberger
provided initial guidance and a welcome final review.
Filene would also like to acknowledge members of the Filene
Research Council and their staffs for their timely and helpful advice.
These members include:
• Gerry Agnes—Elevations Credit Union, Boulder, Colorado.
• Patricia Campbell—Christian Financial Credit Union, Roseville,
Michigan.
• Teresa Freeborn—Xceed Financial Federal Credit Union,
El Segundo, California.
• Laida Garcia—Florida Central Credit Union, Tampa.
• Steve Post—VSECU, Montpelier, Vermont.
Acknowledgments
v
Foreword vi
Executive Summary and Commentary vii
About the Author ix
Chapter 1 Introduction 2
Chapter 2 Relevant ALL Accounting Standards
and Principles 7
Chapter 3 A Sound ALL Approach for Credit Unions 17
Chapter 4 Q&E and TDR Factors 24
Chapter 5 Common ALL Mistakes: A Great Recession
Post-Mortem 29
Chapter 6 Final ALL Considerations 33
Endnotes 39
Table of Contents
vi
The seriousness of valuating loan portfolios cannot be overstated at
any time, much less during the recent past, present, and coming time
periods. Probably no other element in credit union financial report-
ing has as great an impact on a credit union’s reported earnings and
financial position. Equity levels that were once very strong have been
significantly impacted by loan losses and allowance account balances.
These losses have come from loans charged off as uncollectible, debt
restructurings, and foreclosures and from numerous other causes that
have reached levels unheard of over the lifetimes of every current
credit union manager.
Accounting for expected and even unexpected losses during this
unusual period has required careful application of both old account-
ing practices and newly instituted accounting rules and regulations.
Historic methods have had difficulties handling current loss volumes
while trying to fairly reflect a credit union’s true financial position.
Also, new directives from accounting authorities have, at times,
become moving targets. There is mounting uncertainty regarding the
adequacy of allowance for loan loss accounts and methodologies used
for calculating loan loss provisions, determining loan portfolio fair
values, and ensuring that the matching principle is actually working
properly.
This research report addresses a broad set of issues related to loan loss
accounting and reporting. The most troublesome issues surround
estimates of loan loss—how to make estimates, how to apply man-
agement judgment as to the probability of losses, how to determine
the adequacy of allowances, and how to account for these estimates.
With examples, actual experiences of the author, references to appro-
priate accounting regulations and standards, and a straightforward
attack on loan loss accounting and management, this report is an
excellent primer for credit union managers.
The author, Michael J. Sacher, is highly qualified to discuss these
critical financial and accounting issues. His prior experience includes
many years as an auditor of credit unions and a partner in a major
CPA firm. As a consultant, he has focused much of his work on
credit unions and on loan valuation problems. His knowledge
of accounting theory, the history and current status of financial
accounting reporting standards, credit union regulators’ needs,
and the CPA profession’s best practices for auditing and reporting
combine in a unique way to give insight into actual problems arising
from the financial crises of the past four years. Here, he combines the
theory, reporting requirements, financial market information needs,
and common sense into a clear picture of how credit union loan
valuation reporting should be handled.
Foreword
by Dr. Harold M. Sollenberger,
Professor Emeritus of Accounting and Information Systems
Michigan State University
vii
by Ben Rogers,
Research DirectorThe Washington Mutual (WaMu) collapse of 2009 stands as the
nation’s largest- ever bank failure. Economic, strategic, and market
challenges all coalesced against the thrift at the end, but the more
immediate cause of its failure was an insurmountable mismatch on
its balance sheet: bad loans overwhelmed the bank’s ability to stay
solvent. WaMu’s allowance for loan losses (ALL) was not big enough.
Today’s financial landscape is littered with the bones of banks and
credit unions alike done in by bad loans. But credit losses are a story
as old as banking itself: Financial institutions suffer, and some col-
lapse, when borrowers cannot (or will not) repay their loans. Regula-
tions and accounting standards are enacted with the best intent to
control and measure credit losses. But marketplace volatility exhib-
ited by devaluation of collateral and negative earnings has focused
increased scrutiny of the ALL. Add to the mix complex accounting
requirements heretofore not applicable to most credit unions and
the result has been confusion, disagreement, and contention over
the ALL.
What Is the Research About?The Allowance for Loan Losses: Critical Issues for Credit Union Lead-
ers illuminates the ground on which credit unions calculate their
particular allowance. Respected CPA and industry veteran Michael
Sacher unpacks the various accounting standards at play and matches
them with the expectations of CFOs and credit union examiners
alike. The result is a useful document that can be used as both a tem-
plate and a reference for finance managers, supervisory committee
members, and boards of directors walking the fine line between “too
much” and “not enough” ALL. In some cases the fate of the credit
union depends on that line.
The report breaks down into four parts:
• An introduction to the current ALL trends among US credit
unions.
• An examination of the relevant accounting standards and inter-
pretations, including credit union–specific guidance around
FASB and NCUA requirements.
• A model ALL approach for credit unions, with specific guidance
and suggestions for qualitative and environmental (Q&E) factors.
• Common ALL mistakes, a Great Recession post- mortem that
identifies specific areas for review for those involved in day-to- day
management or long- term supervision of the allowance.
Executive Summary and Commentary
viii
What Are the Credit Union Implications?This analysis of credit unions’ ALL deals directly with a pressing cur-
rent problem: What is the right way to reserve for credit losses? The
issue is made more challenging because it is not just a management
issue but a regulatory issue in which reasonable people with differing
perspectives often disagree. And for CFOs to disagree with examin-
ers, even respectfully, requires a firm basis in the relevant accounting
principles.
Several points in the report are particularly salient for credit unions
today:
• What goes up must come down. Loan loss and allowance trends
are at least stable and, in many cases, declining for a majority of
credit unions. This calls for a measured reanalysis of the ALL, and
credit unions should consider carefully the author’s suggestions
on how to formulate sound Q&E positions.
• Learn how to properly account for troubled- debt restructure
(TDR) loans and properly consider impairment for all loans that
do not meet the homogenous definition.
• History can be misleading. An overreliance on historical trends
and ratios accounted for some of credit unions’ ALL confusion at
the beginning of the crisis. Conversely, credit unions should not
dwell too much on midcrisis trends in building today’s allowance.
The turmoil of the last three years calls for a thorough review of
every credit union’s ALL policy.
• Track with the right tools. Included is a helpful list of analytical
tools and the factors boards of directors and supervisory commit-
tees should consider based on the metrics presented by financial
managers. It also provides a useful list of available ratios for
improved supervisory tracking.
The ALL is just one of many accounting variables that a credit union
should manage well. But its importance has been reinforced during
the Great Recession. This timely, tactical report will help your credit
union manage it better.
ix
Michael J. Sacher
Mike Sacher is a CPA with over 30 years’ experience providing ser-
vices to credit unions. Mike has earned a national reputation for his
expertise in areas such as accounting and finance, internal control,
asset liability management, and governance issues of importance to
credit unions. In 2008, Mike launched his own consulting prac-
tice, Sacher Consulting, with the goal of assisting credit unions as a
trusted business advisor and partner.
From 2001 to 2008, Mike was the partner in charge of the Los
Angeles office of McGladrey & Pullen’s National Credit Union Divi-
sion, where he oversaw the delivery of audit and consulting services
to over 150 credit unions annually ranging in size from $5 million
to $7 billion in assets. Mike was also the assurance leader of the
division, where he helped to resolve complex accounting and audit-
ing matters, and he led the firm’s efforts to customize the approach
to credit union audits. Prior to joining McGladrey & Pullen, Mike
was a senior partner in the O’Rourke Sacher & Moulton CPA firm,
which was acquired by McGladrey & Pullen in 2001.
In 2008, Mike became a member of the board of directors of Kaiser
Federal Bank, and he also serves as chairman of the Audit Com-
mittee. Mike is a member of the American Institute of Certified
Public Accountants and the California Society of Certified Public
Accountants.
Mike has a bachelor’s in Business Administration (Accounting Con-
centration) from California State University, San Francisco. He has
been a certified public accountant since 1978.
About the Author
CHAPTER 1Introduction
The objectives of this report are to clarify the accounting theory surrounding the allowance for loan losses, to discuss specific areas where errors have been common in credit unions, to provide best practices for consideration of management, and to discuss internal controls that are critical to the allowance for loan losses process.
3
The allowance for loan losses (ALL) is arguably the most important
accounting estimate in a credit union’s financial reporting structure.
Unlike many accounting applications that are precise and highly
objective by their very nature, determining the appropriate balance
of the ALL requires significant judgment by management. The severe
recession over the past few years, with its record levels of unemploy-
ment, housing value declines, skyrocketing delinquencies and charge-
offs, restructuring of troubled loans, and high level of foreclosures in
many areas of the United States, has significantly impacted manage-
ment of the ALL.
Many credit unions have struggled with the accounting principles
that define an appropriate ALL balance as well as practical meth-
ods for determining the balance on an ongoing basis. Accounting
standard setters and regulators—the Financial Accounting Standards
Board (FASB), the Securities and Exchange Commission (SEC),
the American Institute of Certified Public Accountants (AICPA),
the National Credit Union Administration (NCUA), and state
regulators—have been concerned about the ability of financial
institution management to manage earnings vis-à-vis building ALL
balances during periods of strong earnings and high credit quality
and depleting the ALL (and bypassing expense recognition) during
periods of declining earnings and weakened credit quality. Auditors
and regulators have challenged many credit unions on their approach
and have demanded significant upward adjustments to the ALL,
resulting in significant operating losses and reduced capital levels.
The objectives of this report are to clarify the accounting theory sur-
rounding the ALL, to discuss specific areas where errors have been
common in credit unions, to provide best practices for consideration
by management, and to discuss internal controls that are critical to
the ALL process.
4
Current ALL Trends Tell a StoryIn order to understand the impact of the deteriorating economy on
credit unions over the past few years, consider the following statistics
as portrayed in the accompanying figures.
The delinquency ratio (loans over 60 days delinquent divided by
total loans) has increased substantially over the past few years, with
credit unions in the “sand states” (California, Nevada, Arizona, and
Florida) significantly exceeding the national peer group averages (see
Figure 1). However, it appears that delinquencies have reached a
plateau, and hopefully a downward trend is developing.
In response to rising delinquency, the ALL as a percentage of loans
outstanding has significantly increased over the past few years, espe-
cially in the sand states (see Figure 2).
With rapidly increasing charge-offs, the ALL became inadequate to
absorb one year’s worth of net charge-offs for many credit unions,
a tell-tale signal of ALL understatement (see Figure 3). However, it
appears that as credit unions stepped up ALL funding in 2009–2010,
the current ALL balances were much more adequate.
The Great Recession led to a remarkable increase in provision for
loan loss (PLL) expense, which has significantly eroded earnings over
the past few years (see Figure 4). Note that PLL averaged less than
0.5% of average assets prior to the current economic cycle.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Q1 Q2
20062005
Delin
quen
cy ra
tio (p
erce
nt)
Q4 Q3 Q4 Q1 Q2 Q3 Q1Q4 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2007 2008 2009 2010
Sand statesUS overall
Figure 1: Delinquent Loans as a Percentage of Total Credit Union Loans
Source: NCUA, Callahan & Associates.
5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Q1 Q2
20062005
Q4 Q3 Q4 Q1 Q2 Q3 Q1Q4 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2007 2008 2009 2010
ALL
(per
cent
age
of to
tal l
oans
)
Sand statesUS overall
Figure 2: ALL as a Percentage of Total Loans
Source: NCUA, Callahan & Associates.
Sand statesUS overall
0
50
100
150
200
250
Q1 Q2
20062005
Q4 Q3 Q4 Q1 Q2 Q3 Q1Q4 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2007 2008 2009 2010
Net c
harg
e-of
fs (p
erce
ntag
e of
prio
r-ye
ar A
LL)
Figure 3: Net Charge-Offs as a Percentage of Prior-Year ALL
Source: NCUA, Callahan & Associates.
6
The level of PLL quadrupled to 2% for the sand states and doubled
to over 1% for all credit unions in the United States. Consider that
total net income during the “best of years” for the industry was in
the range of 1% of average assets (1% return on assets).
0.0
0.5
1.0
1.5
2.0
2.5
Q1 Q2
20062005
PLL
(per
cent
age
of a
vera
ge a
sset
s)
Q4 Q3 Q4 Q1 Q2 Q3 Q1Q4 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2007 2008 2009 2010
Sand statesUS overall
Figure 4: PLL as a Percentage of Average Assets
Source: NCUA, Callahan & Associates.
Credit unions are required to adhere to gener-ally accepted accounting principles (GAAP). This chapter reviews and clarifies those that are most relevant and most likely to affect a credit union’s allowance practices.
CHAPTER 2Relevant ALL Accounting Standards and Principles
8
About Accounting Standards ReferencesAt the end of 2009, the FASB implemented the Accounting Stan-
dards Codification (ASC), which supersedes the prior accounting
standards set by FASB and other accounting standard setters (SEC,
AICPA, etc.). Those previous standards that were still effective upon
adoption of the ASC were combined into the new ASC and were
given new topical references. This report makes references to the new
ASC, and in some cases also references the original FASB opinion
number to facilitate a reference that might be known to the reader by
the original FASB reference.
What Is the ALL?The ALL represents an estimate of losses that have been incurred on
loans in the portfolio that are considered to be “impaired” as of the
balance sheet date, based in part on review of individual loans and
in part on high- level analytics of groups of loans sharing common
risk characteristics. Credit unions are also familiar with the allowance
for loan and lease losses (ALLL) designation, but because leases are
usually a minimal slice of credit union portfolios, we use the simpler
terminology throughout this report. It should be noted that the ALL
is also referred to as the allowance for credit losses, since the same
accounting requirements apply to other receivables in addition to
loans to borrowers made by financial institutions.
The following overview of the ALL is given in the ASC:
The allowance for credit losses shall be established at a level that is
adequate but not excessive to cover probable credit losses related to
specifically identified loans as well as probable credit losses inherent
in the remainder of the loan portfolio that have been incurred as of
the balance- sheet date. Impairment shall not be recognized before
9
it is probable that impairment has occurred, even though it may be
probable that impairment will occur in the future. The measurement
of credit losses in a portfolio of loans and receivables consists of two
parts: reviewing specifically identified loans and estimating credit
losses in the remaining portfolio.1 [Underlining added for emphasis.]
There are several critical points (underlined by the author in the
above paragraph) that are worthy of further comment.
Adequate but Not ExcessiveAn inadequate ALL results in overstated assets, overstated earnings,
and overstated capital. An excessive ALL results in understated assets,
understated earnings, and understated capital. In either case, the
financial statements are misstated. The goal is to get a reasonable
ALL properly supported by appropriate analytics. Due to the great
degree of subjectivity in many of the factors used in the determina-
tion of the ALL, management must exercise due care not to manage
earnings by either understating or overstating the ALL. Earnings
management is not acceptable and can result in harsh criticism of
those charged with corporate governance.
Probable Credit LossesThe term “probable” is not defined by mathematical percentages.
However, the accounting standards define a range of outcomes,
including remote, reasonably possible, and probable. This range of
probability was originally defined in SFAS Statement 5, “Accounting
for Contingencies” (March 1975). The ALL is not meant to measure
loans that have less than a probable chance of not paying interest and
principal according to their contractual terms. Great care must be
taken by preparers of financial statements to ensure that ALL calcula-
tion methods properly meet the “probable” threshold.
Incurred As of the Balance-Sheet DateNot only must the loss rise to a level of probable, but the underly-
ing event that gave rise to the loss must have occurred prior to the
balance- sheet date. This is a critical concept misunderstood by many.
Currently, GAAP in the United States operate under what is referred
to as an incurred loss model. Before an ALL is recognized, the cir-
cumstances giving rise to a loss must have already occurred (and be
estimable). Consideration is being given to adopting an expected loss
model, wherein losses would be recognized based on expectations of
probable future events that will have a direct impact on the collect-
ibility of principal and interest amounts contractually due. There is
10
strong opposition in the financial services industry to the expected
loss model, which is being considered due to the convergence of US
GAAP with international standards. However, regulators may in fact
prefer the expected loss model, as it is believed to be more forward-
looking and may eliminate some volatility created by the current
accounting guidance.
Reviewing Specifically Identifiable LoansIt is critical to recognize that retail financial institutions such as
credit unions have hundreds or perhaps many thousands of loans to
individual consumers. It would be virtually impossible to evaluate
each loan for impairment on a regular basis. However, certain loans
must be individually evaluated once they no longer fit within other
homogenous loan categories. The following types of loans are typi-
cally evaluated on an individual basis:
• Individually significant loans, including member business loans
that do not have homogeneous risk characteristics.
• Loans that have already been identified as having credit problems,
such as TDRs, loans delinquent over a predetermined period such
as 60 days, bankruptcies and other collection accounts, loans in
process of foreclosure, and loans where borrowers have requested
short sales.
• Other loans that are no longer accruing interest.
This ALL component is commonly referred to as the specific valua-
tion reserve (SVR).
Estimating Credit Losses in the Remaining PortfolioOnce those loans that are individually evaluated for impairment are
identified, the remaining portfolio is typically evaluated based on
both analytical and qualitative considerations of each major loan cat-
egory. Consideration is given to levels of past charge-offs by category,
current economic trends, quality of and changes in underwriting,
value of underlying collateral, and other related factors.
This ALL component is commonly referred to as the general valua-
tion reserve (GVR). It is critical to understand that the GVR is still a
measure of probable losses as of the balance- sheet date. However, the
manner of estimating those losses is much less precise than the SVR
estimation, since various categories of loans are being pooled and
impairment assessed using high- level analytical techniques.
11
The Evolution of an Impaired LoanTo set the stage for the technical matters, let’s consider the various
phases of a “bad” consumer loan from origination to charge-off.
Upon origination of a consumer loan (auto, mortgage, unsecured,
etc.), the credit union’s underwriting process considers the borrower’s
ability and willingness to repay by evaluating income levels, employ-
ment status, credit score, collateral value, and other appropriate
underwriting metrics. As evidenced by historical industry charge-off
rates, underwriting processes usually result in loans to borrowers
who make principal and interest payments throughout the term of
the loan according to the contractual provisions, and no credit losses
are sustained.2 Occasionally, however, despite the best underwriting
efforts, a loan loss is incurred and a charge-off is recorded.
Typically, there is a loss event3 leading to a loan loss that can be iden-
tified with 20/20 hindsight. The borrower may have lost their job,
the borrower or a close family member may have had a serious illness
or died, or a natural disaster such as an earthquake, fire, or flood may
have occurred. Once the loss event occurs, the potential credit prob-
lems typically become known to management because a payment is
missed and the loan becomes delinquent (a loss event indicator). Or,
in today’s environment, a borrower who is not even delinquent may
contact the credit union and advise of their inability (or unwilling-
ness) to continue making payments on their loan. Ultimately, a loss
is confirmed once the delinquency exceeds a set period of time or
other conditions (such as a short sale or foreclosure) are initiated.
This is referred to as loss confirmation.
To illustrate the impact on the ALL, consider a hypothetical situa-
tion in which we have one loan in our entire loan portfolio. Every
month, we review this loan for the purpose of identifying whether a
loss event has occurred. Six months after the origination of the loan,
we identify that the borrower lost their job. Even though the loan is
not yet delinquent at the end of month six, we are in a position to
assess the likelihood of this event impairing the borrower’s intent or
ability to repay principal and interest according to the contractual
terms of the loan. We can certainly conclude that the risk of loss is
higher upon the loss of employment than it was prior to this event
having occurred. Depending on other factors, such as the borrower’s
willingness and ability to continue making loan payments, we might
conclude that the risk of loss is still remote, or reasonably possible,
or probable. If our conclusion is that a loss is probable, we establish
12
an ALL in month six, even though the loan is not yet delinquent. If
we conclude that the risk of loss is less than probable, we continue to
monitor the loan, and if the risk of loss rises to a level of probable, at
that time an ALL for that loan is established. Importantly, the loss of
employment in this example prompts a greater need to evaluate the
risk of loss and to document the rationale for conclusions regarding
impairment.
This hypothetical example is illustrative of the complexity involved
in ALL theory. First, we need to determine whether a loss event
has occurred. Then, we must assess whether the impact of the loss
event will result in the inability of the borrower to repay principal
and interest according to the contractual terms of the loan. Lastly,
once the likelihood rises to a level of probable, we must estimate the
amount of the inherent loss arising from the loss event. Now imag-
ine the additional complexity of extrapolating this thought process
to various loan segments within the credit union, where each loan
segment might contain thousands of individual loans originated over
the course of several years.
The critical points illustrated by this example are:
• The ALL is a measure of expected losses incurred for loans that
have experienced a loan loss event, the event rendering it prob-
able that principal and interest will not be collected based on the
contractual terms of the loan.
• Although delinquency is an early indicator that a loan loss event
has occurred, delinquency alone is not a loss event and cannot be
solely relied upon to drive the ALL calculation.
• The likelihood scenario required before a loan loss provision is
recorded must be probable as compared to remote or reason-
ably possible as these outcomes are defined in the accounting
standards.
Is the ALL a Fair Value Adjustment?The ALL is not a fair value adjustment. Imagine having a seasoned
portfolio of consumer auto loans totaling $100 million (M). Some
loans in the portfolio were originated very recently. Other loans
have various origination dates, and the average remaining life of the
portfolio is approximately two years. The credit union has histori-
cally incurred losses of approximately 1% per year. For discussion
purposes, let’s assume the economy has been stable over the past few
years (we wish!). For ALL purposes, the credit union has an ALL bal-
ance approximating the one-year loss ratio ($1M), and therefore the
portfolio’s net book value is $99M.
13
Now, imagine the variables that would enter into estimating the fair
value of this portfolio. Said differently, how much would a willing
buyer pay to acquire the portfolio? Would the buyer offer book value
($99M)? Not likely. The buyer would most likely consider the fol-
lowing factors:
• How much in cumulative credit losses will be incurred over the
life of the portfolio and what will the timing of such losses be? The
fair value assessment would extend way beyond the parameters
embedded in the ALL calculation. The buyer is not concerned
with whether the losses meet the “probable” accounting defini-
tion or whether the loss events have already occurred. These are
concepts invented by accountants, and they have little bearing on
the determination of fair value in a free market.
• What is the average life of the portfolio, and what is the rate of
prepayments that should be assumed in order to discount future
cash flows? A portfolio with an average weighted life of 2 years
has much different fair value characteristics than a portfolio of
loans with an average weighted life of 10 years.
• What is the average interest rate in the portfolio, and how does
that rate compare to current market rates of debt instruments
with similar risk and duration?
The above points clearly differentiate the factors that would be
considered for fair value treatment as compared to the ALL model
currently required by US GAAP.
Directional Consistency: An Important ConceptAccountants often use the term “directional consistency” when
describing one of the objectives of the ALL. The term was made
well known in a proposed Statement of Position (SOP) issued by the
AICPA in 2003. Although this SOP was never finalized, the concept
of directional consistency clearly articulates an important ALL con-
cept. The following paragraph from the SOP explains the concept.
The measurement of a component of collective loan impairment
should be based on the relevant observable data relating to existing
conditions and should not project changes in the observable data that
may occur in the future. The measurement will rarely be a math-
ematical function of the observable data; rather, significant judgment
will usually be needed to develop an estimate. However, a credi-
tor should consider the directional consistency of the measurement
with changes in the related observable data from period to period.
For example, if the change in the observable data indicates a dete-
rioration in the credit quality of a pool of loans, an increase in the
14
component of collective loan impairment related to that pool of loans
(as a percentage of the pool of loans under assessment) would be direc-
tionally consistent with the change in the observable data. Conversely,
if the change in the observable data indicates an improvement in the
credit quality of a pool of loans, a decrease in the component of collec-
tive loan impairment related to that pool of loans (as a percentage of
the pool of loans under assessment) would be directionally consistent
with the change in the observable data. In applying this principle,
creditors should take into account the interaction of components of
collective loan impairment over time. For example, in applying this
principle to a component established in a previous period to adjust
the creditor’s historical charge-off experience component for conditions
not reflected in the historical experience, the creditor should take into
account the extent to which those conditions are currently reflected in
the creditor’s historical charge-off experience component. Further, the
extent to which such directional changes should affect the amount of
the allowance for credit losses is a matter of significant judgment and
expertise.4
In other words, during periods of strong economic trends and strong
loan quality, there is an expectation of relatively smaller ALL bal-
ances and lower provision for loan loss expense. During periods of
worsening economic conditions, there is the opposite expectation.
This concept is in strong opposition to a practice followed by many
financial institutions in past years of building reserves during the
good times to avoid the impact of negative earnings during the chal-
lenging times.
A Walk Through the Accounting StandardsMany important aspects of the relevant accounting standards have
been discussed above and are elaborated upon further in the remain-
der of this report. However, it is often necessary to refer back to the
specific accounting standards for purposes of responding to auditor/
examiner concerns and addressing practical issues by those charged
with governance in credit unions. And because of the newly imple-
mented ASC, it is sometimes difficult, especially for those who are
familiar with the original FASB standards, to identify the most cur-
rent accounting reference materials.
There are two primary topics under the ASC that address the ALL.
Key concepts extracted from Topics 450 and 310 of the ASC are
summarized below. In the opinion of the author, it is critical for
15
credit unions to understand these in order to properly comply with
GAAP.
• Topic 450, Subtopic 20, “Loss Contingencies,” addresses account-
ing for loss contingencies. Much of this topic is derived from
Statement of Financial Accounting Standards (SFAS) State-
ment 5, “Accounting for Contingencies,” which was issued
in 1975 and to this day represents one of the foundations of
accounting theory. Topic 450 specifically references Topic 310,
noting that the ALL is a subset of loss contingencies.
• Topic 310, “Receivables,” addresses various issues related to
accounting issues subsequent to the origination or acquisition of
receivables, such as impairment. Former accounting standards
SFAS 5, SFAS 15, and SFAS 114 provide much of the content for
this section, which addresses the following:
■ The general concept that impairment of receivables is rec-
ognized when, based on all available information, it is prob-
able that a loss has been incurred based on past events and
conditions existing at the date of the financial statements.
This general concept applies to large groups of smaller-
balance homogenous loans and to loans that are individu-
ally considered to be impaired, including TDRs.
■ A loss arises when the creditor will not be able to collect
principal and interest according to the contractual terms of
the loan.
■ Losses must be probable before loss accrual.
■ Probable means the future event is likely to occur (that is,
it is likely that principal and interest will not be collected
according to the contractual terms of the loan).
■ Appropriate analytics must support the ALL.
■ An insignificant delay in collection of principal and interest
does not require ALL recognition.
■ If a loan is individually impaired, the amount of the loss
provided in the ALL should be based on the present value
of the expected future cash flows discounted at the loan’s
contractual interest rate that existed prior to any restruc-
tured terms.
■ As a practical expedient, impairment for a collateral-
dependent loan can be measured based on the fair value of
the collateral (less costs to sell).
16
■ Collateral-dependent is defined as a loan for which the
repayment is expected to be provided solely by the underly-
ing collateral. Based on this definition, it is unlikely that
most TDR loans would be defined as collateral-dependent.
■ If a loan is specifically identified as impaired and is mea-
sured for impairment, care should be taken to not double-
count the loan in the general valuation component.
■ It is possible for an impaired loan to have no ALL require-
ment. For example, if the underlying collateral value of an
impaired real estate loan exceeded the loan balance, no ALL
would be needed.
Because every portfolio is different, some of a credit union’s ALL decision making must be subjective. But most credit unions are similar enough that the template in this chapter forms a stable foundation on which to build an ALL approach.
CHAPTER 3A Sound ALL Approach
for Credit Unions
18
There are many methods a credit union can utilize to determine its
ALL balance in accordance with GAAP. The approach used should
be based on the facts and circumstances encountered at that particu-
lar credit union, it should be documented in policy, and it should be
consistently applied and tested for reasonableness based on com-
monsense expectations. The internal controls surrounding the ALL
should be tested for appropriateness of design and operating effec-
tiveness. Appropriate qualitative and environmental (Q&E) factors
should be considered, and accounting for TDRs should be addressed
for propriety.
The “Sample ALL Calculation” section below contains an example
of an ALL calculation with explanations of each reserve component.
The major categories include:
• Specific identification and ALL reserves for all loans that have
already been identified as being specifically impaired, which
include, but are not limited to, TDRs, loans over a set period of
delinquency, bankruptcies, and foreclosures in process.
• A GVR component for all loans that have not been specifically
identified as already impaired.
• Appropriate consideration of Q&E factors.
• Proper accounting for TDR loans.
• Proper consideration of impairment for all loans that do not
meet the homogenous definition, which in credit unions consist
primarily of member business loans.
Sample ALL CalculationFigure 5 summarizes a sample ALL calculation for a credit union
with a diversified loan portfolio totaling $400M. The methodology
presented is consistent with the vast majority of credit unions the
author has seen over the years.
19
The ALL calculation reflects the following components with further
explanations provided below:
• Loans that have been identified as requiring an SVR total
$5,232,000 with a related ALL of $2,016,000. The SVR com-
ponent includes TDR loans (see the previous section) as well as
other loans that no longer fit the homogenous definition due to
delinquency status or other loss events having been identified.
• The remaining portion of the loan portfolio totals $394,768,000
and has a GVR totaling $7,998,372. It is important to note the
GVR is a result of utilization of both historical loss ratios and
appropriate Q&E factors.
• Careful consideration must be given to determining the need for
and approach taken to determine the Q&E component of the
ALL. At the beginning stages of an economic downturn, historical
Figure 5: Sample ALL Calculation
ABC Federal Credit Union
Allowance calculation
As of December 31, 2010
Loan category
(1) (2) (3) (4)
Balance of
specifically
identified
impaired loans
Remaining
(unimpaired)
loan balance
Total loan
balance SVR
Non-real-estate loans
Share-secured loans $0 $10,000,000 $10,000,000 $0
Credit card loans $300,000 $39,700,000 $40,000,000 $300,000
New autos—direct $84,000 $39,916,000 $40,000,000 $42,000
New autos—indirect $150,000 $59,850,000 $60,000,000 $75,000
Used autos—direct $24,000 $39,976,000 $40,000,000 $12,000
Used autos—indirect $74,000 $24,926,000 $25,000,000 $37,000
Subprime indirect auto $100,000 $9,900,000 $10,000,000 $50,000
Total non-real-estate loans
Real estate loans
First trust deed $1,500,000 $98,500,000 $100,000,000 $400,000
Second trust deed including
HELOC
$1,000,000 $39,000,000 $40,000,000 $800,000
Business loans—
participation purchased
$1,000,000 $19,000,000 $20,000,000 $200,000
TDR loans $1,000,000 $14,000,000 $15,000,000 $100,000
Total real estate loans
Total loans $5,232,000 $394,768,000 $400,000,000 $2,016,000
(continued on next page)
20
loss ratios understate impairment, and “unfavorable” Q&E
adjustments are likely appropriate. As the cycle matures, the his-
torical loss ratio will likely overstate impairment (last year’s losses
will exceed current impairment), and a “favorable” Q&E adjust-
ment will likely be appropriate. At the time of writing this report,
the author believes that we are generally shifting to improving
economic conditions and that neutral or perhaps favorable Q&E
adjustments are appropriate for many credit unions.
The following explanations provide further insight into the ALL
methodology reflected in Figure 5.
Share-Secured LoansThere is no ALL component provided for share- secured loans, since
ABC has never had a loss on this loan type and all of these loans are
100% securitized by the borrower’s share balance.
Figure 5: Sample ALL Calculation (Continued)
ABC Federal Credit Union
Allowance calculation
As of December 31, 2010
Loan category
(5) (6) (7) (8) (9)
5 × 2 6 + 7 4 + 8
GVR
One-year
historical loss
ratio
Historical loss
component
Q&E
adjustment Total GVR
Total valuation
reserve
Non-real-estate loans
Share-secured loans 0.0% $0 n/a $0 $0
Credit card loans 2.2% $873,400 –$100,000 $773,400 $1,073,400
New autos—direct 1.6% $638,656 –$50,000 $588,656 $630,656
New autos—indirect 2.4% $1,436,400 $140,000 $1,576,400 $1,651,400
Used autos—direct 1.3% $519,688 $0 $519,688 $531,688
Used autos—indirect 2.8% $697,928 $50,000 $747,928 $784,928
Subprime indirect auto 4.2% $415,800 $0 $415,800 $465,800
Total non-real-estate loans
Real estate loans
First trust deed 2.1% $2,068,500 –$200,000 $1,868,500 $2,268,500
Second trust deed including
HELOC
3.0% $1,170,000 $100,000 $1,270,000 $2,070,000
Business loans—part.
purchased
0.2% $38,000 $200,000 $238,000 $438,000
TDR loans n/a n/a n/a n/a $100,000
Total real estate loans
Total loans n/a $7,858,372 $140,000 $7,998,372 $10,014,372
Note: For illustration purposes, the loan portfolio is segmented by collateral type. Consideration should also be given to segmenting the portfolio by credit risk,
geographic concentrations, and other distinguishing characteristics.
21
Credit Card LoansAs of December 31, 2010, ABC had specifically identified loans
totaling $300,000 that were pending charge-off in January 2011.
Therefore, an SVR has been established for the losses on these loans,
which represent 100% of the loan balances.
Additionally, the one-year loss ratio results in a GVR of approxi-
mately $873,000. However, in recognition of an improving economy
over the past 18 months, including more aggressive collections and
stronger underwriting, a favorable Q&E adjustment of $100,000
is established. It should be noted that based on the best data and
most up-to-date analysis, ABC expects unsecured loan charge-offs to
approximate $50,000 per month, which provides further support for
the favorable Q&E adjustment.
Auto Loans (All Categories)Each of these categories reflects the amounts of pending charge-offs
that will occur in January 2011 for the SVR. Q&E factors reflect
differing results for each component based on current conditions.
Consideration is given to declining early- stage delinquency trends,
improving economic conditions, and other relevant factors. In all
cases, the resulting GVR exceeds the expected charge-offs for the
next 12 months by a margin of approximately 20%.
First and Second Trust Deed Loans (Including HELOC)As of December 31, 2010, loans totaling $1.5M have come to
management’s attention that represent probable loss. Loans in this
category are primarily comprised of loans over 60 days delinquent
for which collection efforts are approaching exhaustion and foreclo-
sure proceedings will begin shortly. There is also a loan in this group
where the borrower has approached the credit union for a short sale
due to significant collateral value slippage. Estimated losses for these
specifically identifiable loans total $400,000.
In addition to the amounts resulting from the historical loss ratio,
management has obtained updated combined loan-to-value (CLTV)
data for all real estate loans through the use of third- party automated
valuation models and combined the CLTV data with updated credit
score metrics. Management has made estimates for impairment for
all real estate loans based on bandwidth of CLTV and credit scores,
with emphasis on loans with CLTV ratios above 125%.
Business LoansBusiness loans typically do not meet the definition of a homogenous
loan pool and must be evaluated on an individual basis for impair-
ment characteristics. This process often involves an annual (or more
frequent, as appropriate) review of each loan, using a grading system
22
that quantifies impairment and results in specific loss estimates
after consideration of current collateral value. When these member
business loans consist of participations purchased from other credit
unions, great care should be taken by the investor credit union to
ensure that the servicing credit union is taking appropriate steps to
monitor deteriorating credit characteristics and to maximize collec-
tion efforts. Many credit unions have relied on the servicing credit
union to identify and quantify impairment on participation loans
without the commensurate level of due diligence taken by the inves-
tor credit union.
Sample Calculation of SVR on a TDR LoanIn order to illustrate how to calculate the SVR on a TDR loan, assume
the loan in Figure 6 was modified and is considered to be a TDR.
Net investment in the loan at the date of restructure (including
loan balance, accrued interest, deferred origination costs, etc.) as
compared to the present value of the future expected cash flows
discounted at the loan’s original contractual rate. Therefore, we need
to determine the future expected cash flows on this loan and then
discount those cash flows to their present value at the original 6%
interest rate.
There are many tools available for determining the present value.
As noted in Figure 6, the present value is $172,560 as compared to
the loan balance of $186,376. Therefore, an initial SVR of $13,816
(assuming no re-default) is required at the onset of this modification.
Figure 6: Sample TDR Loan
Original loan balance $200,000
Original term 30 years (360 months)
Original rate 6%
Net investment in loan at date of
restructure
$186,376
Remaining term 300 months
Revisions to original contractual terms Rate changed from 6% to 3% for 3 years (36
months), reverts to 6% fully-amortizing loan
for remaining 264-month (22-year) term
Re-default assumption For illustration purposes, assume no re-default
risk
Original loan payment (P&I) $1,199
Revised loan payment for next 36 months $884
Revised loan payment for months 37 to 300 $1,166
Present value of next 300 payments
discounted at 6% interest rate
$172,560
23
What about re-default? One way of understanding why this is an
important question is to consider the impact on expected cash flows
if a re-default occurs that results in the need to foreclose on the
property securing this loan. If a foreclosure occurred, only one pay-
ment would be received subsequent to the re-default, which would
approximate the collateral value net of selling expenses.
There is no precise way of predicting re-default. However, empirical
evidence clearly indicates that the greater the gap between property
value and loan balances (first and second loan balances combined),
the greater the risk of re-default. In the example given in Figure 6,
if the property were located in the sand states and its value had
declined 50%, there would be a greater risk of re-default than if the
property value were closer to the current loan balance.
One final issue needs to be addressed that often raises questions.
What if the revised rate offered to the borrower (3% in the example)
approximates a market rate for a new loan? If the borrower could
refinance their loan at the same rate as other borrowers in an arms-
length transaction, this modification probably would not be consid-
ered a TDR. However, the borrower would have to be able to execute
such a transaction given their current credit status (credit score,
employment status, debt coverage, etc.) and also given the property’s
current market value. These considerations result in the vast majority
of loan modifications being considered TDRs.
There are several critical takeaways from the example in Figure 6:
• The credit union’s loan- tracking system needs to flag this credit
as a TDR and apply special impairment testing and regulatory
reporting on a go- forward basis.
• The present value of the future cash flows will change through-
out the remaining term of the loan subsequent to the modifica-
tion. Therefore, all TDR loans will need to have the present
value recalculated over their remaining term; at a minimum, this
should be performed quarterly for call reporting purposes.
• Re-default risk is directly related to the loan-to- value ratio (LTV).
Therefore, the credit union needs to obtain updated LTV infor-
mation and carefully document the assumptions used for estimat-
ing re-default risk.
• The absence of delinquency status does not alleviate the need for
the present value calculations and for classification as a TDR loan
over the remaining loan life.
Sometimes historical loss ratios are not enough. This chapter illuminates timely Q&E fac-tors that may apply to your credit union. It also examines the increasingly common TDR arrangements and how to properly account for them.
CHAPTER 4Q&E and TDR Factors
25
What Are Q&E Factors?As noted earlier, historical loss ratios alone are not adequate to
measure impairment on pools of loans, especially during periods of
economic volatility. Said differently, the fact that losses last year were
x% does not necessarily mean this year’s losses will also be x%. The
historical loss ratio is a starting point used to measure impairment;
it needs to be adjusted up or down depending on other appropriate
factors, such as the following, to properly measure impairment in
the GVR:
• A significant downturn in the general economy exhibited by
increasing inflation, rising unemployment, or a declining housing
market.
• A significant deterioration in the quality of the underwriting pro-
cess, exhibited by increasing delinquency and charge-off trends.
• The occurrence of a natural disaster, such as an earthquake or
flood.
• Economic turmoil in the field of membership, such as a major
strike, layoffs, or a merger.
• Experience, ability, and depth of lending management.
• Changes in lending policies and procedures, including changes in
underwriting standards and collection, charge-off, and recovery
practices not considered elsewhere in estimating credit losses.
• Changes in international, national, regional, and local economic
and business conditions and developments that affect the col-
lectibility of the portfolio, including the condition of various
segments.
• Changes in the nature and volume of the portfolio and in the
terms of the loans.
• Changes in the volume and severity of past-due loans, the volume
of non- accrual loans, and the volume and severity of adversely
classified or graded loans.
26
• Most recent charge-off trends (e.g., three-month and six-month
annual charge-off trends are higher/lower than amounts reflected
in one-year historical loss ratio).
• Changes in the quality of the credit union’s loan review system.
• The existence and the effect of any concentrations of credit, or
changes in the level of such concentrations.
• The effect of other external factors, such as competition and legal
and regulatory requirements, on the level of estimated credit
losses in the credit union’s existing portfolio.
Q&E Factors for Residential Real Estate Loans Can’t Be IgnoredFor credit unions facing significant deterioration of collateral value
on real estate loans, unique issues arise that impact the ALL. A real
estate loan with significant collateral devaluation may be impaired
even if it is not yet delinquent. Conversely, real estate loans with sig-
nificant collateral devaluation may not be impaired. The ALL process
must appropriately assess the impact of declining real estate value,
and this process needs to be carefully documented and updated
regularly.
LessonIn order to develop appropriate ALL analytics for real estate loans
in geographic areas facing declining values, credit unions need to
obtain updated fair value analytics on the collateral, often done by
utilization of automated valuation models (AVMs) provided by third
parties. The updated AVM data, combined with updated credit score
data on the borrowers, will identify the real estate loans with the
highest LTV ratios are those with the highest risk and therefore the
greatest likelihood of impairment.
Finally, consider that just as historical loss ratios alone may have
resulted in ALL understatement at the beginning of the declining
economic cycle, historical loss ratios alone will likely result in ALL
overstatement as the economy recovers.
Q&E Ideas for Your ConsiderationAs the term implies, there is a lot of subjectivity that enters into the
methodology and quantification of Q&E factors. Following are six
methods that the author has seen successfully employed by credit
unions.
• For residential real estate loans, create a matrix of each major
portfolio by CLTV and credit score. Those loans with high CLTV
27
and low credit score are at greatest risk of impairment and might
not be properly quantified by loss ratios alone. Estimate the
amount of such impairment by regression analysis, sampling of
loan files, use of industry standards, or other appropriate analyti-
cal methods.
• Consideration should be given to segmenting the portfolio by
year of origination, especially when timing of origination is reflec-
tive of loss exposure.
• Evaluate trends in early-stage delinquency, which are obviously an
indicator of future impairment trends. As early-stage delinquency
trends begin to decline, favorable adjustment of historical loss
ratios should be considered (and vice versa).
• Compare the calculated ALL balance to the amount of expected
charge-offs for the next 12 months. As the ALL balance begins to
represent an amount exceeding 150% of expected charge-offs, a
favorable Q&E adjustment should be evaluated.
• Determine the historical correlation between local area unem-
ployment and increased levels of charge-offs. As unemploy-
ment rises or falls, impound an appropriate factor into the ALL
analysis.
• Compute an annualized loss ratio based on the past three months
and the past six months. If there is a significant difference
between these look-back periods compared to the one-year loss
ratio, determine which look-back period is most reflective of cur-
rent conditions.
• Calculate a loss ratio based on net charge-offs as compared to
delinquent loan balances by loan category. If delinquency is fall-
ing rapidly, this loss ratio might provide a good perspective for a
reduction in the ALL as compared to the conventional approach.
Remember, as the economy stabilizes, unemployment rates fall,
and real estate values firm up, the historical loss ratios of the past
few years could result in an overstated ALL balance. Therefore, the
appropriate Q&E factors should be identified and quantified to
supplement these loss ratios.
What Is a TDR and How Is a TDR Accounted For?A TDR occurs when a creditor, for economic or legal reasons related
to the debtor’s financial difficulties, grants a concession to the
debtor that it would not otherwise consider. That concession either
stems from an agreement between the creditor and the debtor or is
imposed by law or a court. If a loan is restructured in a manner that
would make it difficult or impossible to receive equally favorable
28
terms from another financial institution, there is a good chance the
loan meets the definition of a TDR, and further analysis would be
required. It should be noted that a rate concession to an equivalent
market rate may likely be considered a TDR if the borrower would
not otherwise qualify for the market rate due to impaired collateral
value or inadequate credit standing.
Each real estate TDR must be separately evaluated to determine
the amount of impairment that is derived based on discounting
expected future cash flows at the loan’s original interest rate. There-
fore, assumptions must be made as to the amount of the future cash
flows, which will take into consideration not only the borrower’s
willingness and ability to make the payments during a short-term
rate reduction period, but also their willingness and ability to return
to full payments at the end of the rate reduction period. This is com-
monly referred to as re-default risk. Depending on the amount and
number of restructured consumer loans, similar treatment m ay need
to be considered for such loans. An example of how to calculate the
SVR on a TDR loan is provided in Chapter 3.
My clients often ask why they have to take an accounting loss on
a TDR loan simply because the interest rate has been reduced to
enable the borrower to make payments and avoid default. Said dif-
ferently, why not just recognize prospective interest income at the
reduced rate reflected in the loan modification? One way to answer
this question is to consider what the impact would be if the entire
loan portfolio interest rate were reduced, say from a 6% contrac-
tual rate to a 3% temporary rate for the next three years. The result
would be to impound a significant reduction of earnings into the
future, without any recognition of this economic event in the current
period’s income statement or allowance valuation reserve. When
this impact is considered at the entire portfolio level, it is clear that
some kind of loss recognition is appropriate. The discounted present
value approach enacted by FASB is, in the opinion of the author, a
reasonable way to measure the financial loss resulting from the loan
modification.
LessonRe-default risk is difficult to assess. However, there is an expecta-
tion that the risk of re-default increases as the LTV ratio rises. Since
re-default risk impacts future cash flows in a significant manner,
credit unions must employ appropriate analytical techniques to
measure LTV metrics within the TDR portfolio and make reasonable
assumptions about the re-default risk of such loans.
With the benefit of 20/20 hindsight, it is clear to this author that mistakes have been made by many charged with governance over the ALL. This chapter outlines some of the most common mistakes seen during the Great Recession and offers lessons on how they can be prevented from happening again.
CHAPTER 5Common ALL Mistakes: A Great
Recession Post-Mortem
30
The incredible economic cycle of 2007–2010 provides the perfect
laboratory for assessing how credit unions have accounted for the
ALL. During the period of 2007–2009, annual charge-offs for credit
unions significantly exceeded the prior year-end balance of the ALL,
an indicator of ALL understatement. This was especially evident in
the sand states of Arizona, California, Florida, and Nevada.
Based on a combination of publicly available financial data, as well as
empirical data observed in my consulting practice, the following les-
sons help to explain this condition and are critical for those charged
with governance in credit unions to understand.
Overreliance on Historical Loss Ratios, Failure to Consider Q&E FactorsMany credit unions relied too heavily on historical loss ratios for
the GVR component of the ALL. Since loss ratios by definition
are retrospective, the quickly changing environmental conditions
that gave rise to impairment (rising unemployment combined with
rapidly declining real estate values) were not reflected in the loan loss
analytics.
LessonHistorical loss ratios alone are a poor indicator of impairment during
periods of economic volatility and can lead to ALL understatement
during deteriorating cycles, as well as overstatement during improved
cycles. Credit unions must consider appropriate Q&E factors (see fur-
ther discussion below) to supplement the historical loss ratios. Credit
unions with large residential real estate portfolios, especially in the
sand states, must understand the relationship between current loan
balance and underlying collateral value in order to properly assess
portfolio impairment. Also, it is critical to select a look-back period
(one year, three years, etc.) that is reflective of current economic
conditions. Generally, a one-year look-back period supplemented
by appropriate Q&E factors is common (and appropriate) for credit
unions.
31
Failure to Properly Account for TDRsWhen a borrower is unable to make their contractual loan payments,
lenders often reduce the interest rate or forgive some portion of the
loan in order to lower the amount of the monthly payment. When
this occurs, the loan is classified as a TDR and requires specialized
accounting. This is one of the more complex areas of credit union
accounting, and it requires an understanding of estimating and
discounting future cash flows on an ongoing basis (see further discus-
sion below).
LessonMany credit unions didn’t have adequate controls in place to prop-
erly identify TDR loans, and they also didn’t understand the proper
accounting for such loans. This breakdown of internal controls in
many cases led to an overstatement of earnings and net worth. Also,
many credit unions lack automated systems to properly identify and
prospectively account for TDR loans.
Failure to Properly Account for Business Loans on an Individual Loan BasisMany credit unions originate and hold member business loans,
which typically have large balances and do not meet the homogenous
portfolio definition. Such loans need to be evaluated for impairment
on a loan-by-loan basis, with consideration given to impairment
characteristics such as current collateral value, current borrower
financial condition, and underlying business cash flow assessments.
Often, member business loans have deteriorating characteristics that
would require an ALL reserve component well in advance of such
loans becoming reportably delinquent.
LessonMany credit unions have not implemented adequate monitoring and
assessment methods to properly evaluate impairment on member
business loans. Further, these loans are often serviced by third par-
ties, and credit unions often fail to determine the reliability of the
servicers and the timely receipt of impairment data.
Outdated ALL PoliciesAlthough GAAP for recognition of loan losses have not really
changed, many credit unions didn’t understand how a severe eco-
nomic downturn could impact the ALL, and their allowance policies
and procedures were reflective of ongoing strong economic cycles.
32
Members of the board and supervisory committee often lacked the
technical insights required to monitor the reasonableness of the ALL,
and therefore auditors and examiners were often the first to question
the resulting understated balances.
LessonOngoing efforts should be made to update all critical accounting
policies. The board of directors should ensure not only that these
policies are updated regularly, but also that there is an ongoing edu-
cational process in place to ensure compliance with accounting and
regulatory reporting standards.
No report can address every facet of ALL regu-lation and management. This final chapter offers guidance on some of the most com-mon challenges in today’s confounding ALL environment.
CHAPTER 6Final ALL Considerations
34
A Word About Timing of Charge-OffsCare should be taken to ensure that loans are charged off when
routine collections efforts have been exhausted and the loan is
deemed to be uncollectible, and when the credit union has properly
acquired title to the collateral, if any, securing the loan balance. It
would be improper to delay a charge-off until the last possible dollar
of expected payments had been received. A loan should be charged
off if the asset (or portion thereof ) is considered uncollectible and of
such little value that its continuance on the books is not warranted.
Failure to charge off loans in a timely manner often results in signifi-
cant understatement of the ALL balance, since historical loss ratios
will be understated, and often the loans in question are not properly
identified in the SVR calculation.
One of the outcomes of the Great Recession is the significant delay
experienced by many credit unions throughout the country in being
able to execute a foreclosure on residential properties. The delays are
often the result of backed-up judicial processes, as well as the large
volume of real estate loans pending foreclosure, especially in the sand
states. During this period of delay, delinquent real estate loans con-
tinue to escalate, even though the loss exposure on these loans should
be fully reserved in the SVR component of the ALL.
A question often arises as to when the loan can be charged off,
thereby reducing the delinquency ratio. If the credit union is in phys-
ical possession of the property, the credit union should charge off the
estimated loss portion of the loan and transfer the remaining balance
(fair value less costs to sell) to “other real estate owned” (OREO). It
should be noted that if a residential property has been abandoned by
the borrower, the credit union is likely considered to have physical
possession. However, if the property has not been abandoned, the
balance of the loan should not be transferred to OREO.
35
What Do NCUA Regulations Say About the ALL?NCUA Rules and Regulations Part 702.402(b) states in part, “The
financial statements of a federally- insured credit union shall pro-
vide for full and fair disclosure of all assets, liabilities, and members’
equity, including such valuation (allowance) accounts as may be
necessary to present fairly the financial condition.” Part 702.402(d)(2)
further clarifies this requirement by stating, “The allowance for loan
and lease losses established for loans must fairly present the probable
losses for all categories of loans and the proper valuation of loans.
The valuation allowance must encompass specifically identified
loans, as well as estimated losses inherent in the loan portfolio, such
as loans and pools of loans for which losses have been incurred but
are not identifiable on a specific loan-by- loan basis.”
The NCUA’s position on the ALL is summarized in Interpretive
Ruling and Policy Statement 02-3, issued in May 2002 (www.ncua.
gov/Resources/RegulationsOpinionsLaws/IRPS/2002/IRPS02-3.
html), and Accounting Bulletin 06-1, issued in 2006 (www.ncua.
gov/GenInfo/GuidesManuals/accounting_bulletins/2006/06-01ALLL.
pdf). This regulatory guidance addresses key issues of importance
to credit union management and officials, and should be reviewed
regularly for compliance.
One last regulatory point of confusion regarding TDR accounting:
For call reporting purposes, a restructured loan must continue to
be reported as delinquent (based on the original contractual terms)
until six months of timely contractual payments under the restruc-
tured terms have been received by the credit union. Thereafter, the
TDR loan is no longer reported as delinquent unless another pay-
ment is missed, in which case the delinquency reporting would be
based on the restructured terms. Many credit unions have confused
the delinquency reporting requirements with the TDR accounting
requirements, which, as noted earlier, are based on the present value
of future cash flows.
LessonThe absence of TDR delinquency status does not alleviate the need
for the discounting of future cash flows over the remaining term of
the restructured loan and for classification of the loan as a TDR.
36
Why Do Internal Controls Impact the Determination of the ALL?An appropriate system of internal controls is critical to properly
evaluating the reasonableness of the ALL. The accuracy of the aging
of delinquent loans, the timely foreclosure and repossession of col-
lateral, and the timeliness of charge-offs are but a few examples of
critical internal controls that management must be able to place reli-
ance upon. Management must be able to demonstrate and represent
to the board of directors that such controls are operating effectively,
or the board may face harsh criticism over potential and material
misstatement of financial statement accuracy.
The following is a partial listing of key internal controls that are
appropriate for most credit unions. The supervisory/audit committee
of every credit union should satisfy themselves that the credit union
has identified the appropriate controls surrounding the ALL and that
such controls are operating effectively.
• Delinquency reports are generated from each major loan system
at month’s end and are considered in the determination of the
ALL balance.
• There is an effective loan review system in place to ensure that
loans originated are in compliance with underwriting policies.
• Controls are in place to identify problem loans in a timely
manner.
• The CFO performs a formal review of ALL analytics on at least
a quarterly basis. This review is documented and signed-off on
by others with oversight responsibility, including the CEO, chief
lending officer, and COO.
• A review of the ALL methodology and its application is per-
formed by a party that is independent from the ALL estimation
process on at least an annual basis.
• There is a process to ensure the timely charge-off of uncollectible
loans.
• The board of directors and supervisory committee meet with
management on at least an annual basis to review ALL methodol-
ogy and key analytical trends.
• For commercial loans, if any, there is an appropriate loan grading
system that is updated at least annually, and loans whose credit
quality has deteriorated are individually reviewed for impairment
on at least a quarterly basis.
• Loans recommended for charge-off are approved by the board of
directors.
37
• Actual charge-offs are reconciled to authorized charge-offs.
• The credit union’s internal audit staff reviews the effectiveness
of the above controls on at least an annual basis and reports the
results of this review to management and the board of directors
and supervisory committee.
ALL Analytical ExpectationsThose charged with governance in credit unions should develop
expectations of reasonable ALL analytics and should regularly com-
pare those expectations with actual ALL metrics. The following chart
provides an example of expectations that should be considered by
all credit unions; this example should be customized and updated as
appropriate.
Figure 7: Analytical Expectations
Analytic tool Expectations/Concerns
1. A comparison of current-year charge-offs
to the prior year-end ALL balance. This is
sometimes referred to as a look-back test.
Generally, current-year charge-offs are less than the prior year-end balance of the ALL. When
current-year charge-offs exceed the prior year-end balance, this indicates a possibility that the
ALL methodology is not adequate, and the ALL could be understated and earnings overstated
in the current period.
Reality Test: How does the current balance of the ALL compare to expected charge-offs for
the next 12 months? If expected charge-offs exceed the current ALL balance, this may be
an indicator of an inadequate ALL. If the current balance of the ALL significantly exceeds the
12-month expectation, the ALL may be overstated.
2. A review of delinquent loan and charge-off
trends.
Note: Consideration should be given to
calculating both the delinquent and charge-
off ratio using total loans and also stripping
away real estate loans from the numerator and
denominator of both fractions to calculate a
“consumer only” delinquent and charge-off ratio.
• Generally, rising delinquent loan balances are indicative of the need to increase the balance
of the ALL.
• Rising delinquencies may be indicative of untimely charge-offs.
• An increase in charged-off loans could indicate the credit union should be using a shorter-
term loss ratio (for example, a one-year loss ratio as opposed to a three-year loss ratio).
3. A review of the trend in the severity of
delinquency (for example, if there is a
higher amount and/or percentage of loans
that are over six months delinquent this
year versus last year).
• If delinquent loans are increasing in severity of delinquency, it could be indicative of a
higher required ALL balance.
• Increasing severity of delinquency could also be indicative of the credit union not charging
loans off in a timely manner.
4. A review of the balance of delinquent loans
as a percentage of the ALL balance.
As delinquent loan balances become a larger percentage of the ALL balance, the possibility
exists that the ALL is inadequate to absorb losses on loans that might not yet be in the
reportable delinquent stage.
5. A review of the balance of the ALL as a
percentage of loans outstanding.
Changes to this percentage should be consistent with recent loan trends. For example, if
the ALL balance is a significantly lower percentage of loans this year versus past years, the
expectation is that there has been an improvement in loan quality.
6. An assessment of the impact that
overdrawn share-draft accounts could
have on the ALL.
For ALL purposes, an overdrawn share account is considered the equivalent of a loan to a
member. Therefore, the balance of overdrawn accounts must be reviewed for collectibility.
38
Putting It All Together: Five Questions to Help Manage the ALLDuring periods of economic stability, determining the reasonableness
of the ALL is comparatively easy and the risk of material financial
statement error is minimal. However, during highly volatile eco-
nomic times such as we’ve encountered over the past few years,
oversight of the ALL becomes a critical concern to credit union man-
agement and officials. The following list is provided to help those
charged with governance ensure an appropriate ALL balance:
1. Is there a process for reviewing and updating the ALL policy on an
annual basis, and is the updated policy appropriately documented,
consistently applied, and approved by the board of directors?
2. Is there an annual assessment of the adequacy of internal controls
surrounding the ALL? Is the operating effectiveness of critical
controls tested on a regular basis, and are the results of those tests
monitored by the supervisory committee and reported to the
board of directors?
3. Has the credit union developed reasonable ALL expectations, and
are actual results compared to these expectations each period in
order to identify developing trends in a timely manner?
4. Is the calculation of the GVR based on appropriate segmentation
of the loan portfolio by loans with common risk characteristics?
• Is the historical loss ratio look-back period (e.g., one-year
loss ratio) appropriate and reflective of current economic
conditions?
• Does the GVR component properly consider appropriate Q&E
factors as a means of supplementing the historical loss ratios?
• Does the credit union appropriately consider the decline in
residential real estate values as part of the Q&E evaluation?
• Are uncollectible loans charged off in a timely manner?
5. Does the calculation of the SVR consider the following?
• Is the present value of future cash flows discounted at the
loan’s original interest rate for loans specifically identified as
impaired as of the measurement date?
• Are appropriate assumptions regarding re-default risk and
prepayments made for TDR loans?
• Do re-default assumptions provide for higher loss estimates
for loans with comparatively high LTV ratios?
• Are the present value calculations updated on a regular basis?
• Is there a reliable process for identifying other known losses,
such as pending short sale loans, bankruptcies, and fore-
closures, and are these known losses accounted for at their
estimated value less selling costs?
39
1. FASB ASC, 310-10.
2. Historically, loan charge-offs in credit unions have averaged
0.5% of average loans outstanding. During the Great Reces-
sion, charge-offs increased to approximately 1.1% of average
loans. Despite the increased level of charge-offs, the vast major-
ity of loans originated by credit unions pay all principal and
interest due according to the contractual provisions of the loan
agreement.
3. The terms “loss event,” “loss event indicator,” and “loss confir-
mation” are all noted in the accounting standards and are very
descriptive of the sequence of events applicable to ALL theory.
4. AICPA Proposed Statement of Position (SOP), “Allowance for
Credit Losses,” 2003, Par. 25.
Endnotes
The Allowance for
Loan Losses:
Critical Issues for
Credit Union Leaders
Michael J. Sacher, CPASacher Consulting
Foreword by Dr. Harold M. SollenbergerProfessor Emeritus of Accounting and Information Systems
Michigan State University
ideas grow here
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Madison, WI 53701-2998
Phone (608) 231-8550
www.filene.org PUBLICATION #243 (7/11)
