# Presentation: 675219

## Minority Depository InstitutionsConference Call Accounting IssuesDecember 9, 2008

- Robert Storch
- Chief Accountant
- Division of Supervision and Consumer Protection
- Federal Deposit Insurance Corporation
- Washington, DC

## Topics

- Allowance for Loan and Lease Losses (ALLL)
- Deferred Tax Asset Limits
- Other-than-Temporary Impairment of Investment Securities

## Allowance for Loan and Lease Losses

- ALLL is one of the most significant estimates in an institution’s financial statements and regulatory reports
- Each institution is responsible for developing, maintaining, and documenting a comprehensive, systematic, and consistently applied process for determining the ALLL and provision expense
- Each institution should ensure controls are in place to consistently determine the ALLL in accordance with GAAP, its stated policies and procedures, management’s best judgment, and relevant supervisory guidance

## Allowance for Loan and Lease Losses

- Principal GAAP guidance
- FASB Statement 5, *Accounting for Contingencies*
- http://www.fasb.org/pdf/aop_FAS5.pdf
- FASB Statement 114, *Accounting by Creditors for Impairment of a Loan*
- http://www.fasb.org/pdf/aop_FAS114.pdf
- FASB Emerging Issues Task Force (EITF) Topic D-80 on application of FAS 5 and FAS 114
- Incurred loss model, not expected loss model

## Allowance for Loan and Lease Losses

- Relevant supervisory guidance
- December 2006 *Interagency Policy Statement on the Allowance for Loan and Lease Losses*
- http://www.fdic.gov/regulations/laws/rules/5000-4700.html#5000interagencypso
- July 2001 *Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions*
- http://www.fdic.gov/regulations/laws/rules/5000-4650.html#5000psalll

## Allowance for Loan and Lease Losses

- Each institution must analyze the collectability of its loan portfolio each quarter and maintain an ALLL at a level that is appropriate and determined in accordance with GAAP
- Arriving at an appropriate allowance involves a high degree of management judgment and results in a range of estimated losses
- Prudent, conservative, but not excessive, loan loss allowances that fall within an acceptable range of estimated losses are appropriate

## Allowance for Loan and Lease Losses

- Determining an appropriate ALLL level should be based on management’s current judgments about the credit quality of the loan portfolio
- Consider all significant qualitative or environment factors that affect collectability as of the balance sheet date, such as
- Changes in lending policies and underwriting standards
- Changes in economic and business conditions
- Changes in collateral values
- Changes in the volume and severity of past due and adversely classified loans and in nonaccrual volume

## Allowance for Loan and Lease Losses

- When collectability factors provide evidence of declining credit quality trends relevant to the types of loans in an institution’s portfolio, management should generally increase the ALLL as a percentage of the portfolio
- This reflects the concept of directional consistency for the ALLL
- Corollary is that when improving credit quality trends are evident, the ALLL level as a percentage of the portfolio should generally decrease

## Allowance for Loan and Lease Losses

- Appropriate ALLL consists only of
- FAS 114 component for loans individually evaluated and found to be impaired
- FAS 5 component for groups of loans with similar risk characteristics
- An “unallocated” allowance is appropriate when it reflects estimated credit losses, determined under GAAP, and is properly supported

## Allowance for Loan and Lease Losses

- FAS 114
- Apply normal loan review procedures to identify loans to be individually evaluated for impairment
- Does not apply to large groups of smaller balance homogeneous loans collectively evaluated for impairment
- However, a loan that undergoes a modification of terms that represents a troubled debt restructuring is an impaired loan to which FAS 114 must be applied

## Allowance for Loan and Lease Losses

- FAS 114
- A loan is impaired when, based on current information and events, it is probable that the creditor will be unable to collect all amounts due (principal and interest) according to loan’s contractual terms
- A judgment about performance, not collateral protection
- If an individually evaluated loan is determined to be impaired, measure impairment (i.e., the loan’s FAS 114 allowance) based on one of three methods

## Allowance for Loan and Lease Losses

- FAS 114
- FAS 114 measurement methods
- Present value of expected future cash flows discounted at loan’s effective interest rate
- Fair value of collateral if loan is collateral dependent (required for such a loan), i.e., if repayment is expected to be provided solely by underlying collateral
- Loan’s observable market price
- If individually evaluated loan is not impaired, include in a group of loans evaluated under FAS 5

## Allowance for Loan and Lease Losses

- FAS 5
- Starting point is to determine historical loss rate (or range of loss rates) for each group of loans with similar risk characteristics based on institution’s own loss experience for that group
- Historical net charge-off rates generally used
- Next, consider qualitative or environmental factors likely to cause estimated credit losses to differ from historical loss experience

## Allowance for Loan and Lease Losses

- FAS 5
- Reflect overall effect of qualitative factors on a loan group as an adjustment that increases or decreases group’s historical loss rate
- Evaluating overall effect requires significant judgment because data to determine precise impact of factors may not be reasonably available or directly applicable
- Maintain documentation to support historical loss rates and qualitative adjustments

## Deferred Tax Asset Limits

- Principal GAAP guidance is FASB Statement No. 109, *Accounting for Income Taxes*
- http://www.fasb.org/pdf/aop_FAS109.pdf
- Temporary differences arise when events are recognized in one period on a bank's books but are recognized in another period on its tax return
- Result in reporting of income or expense in different periods in income statement and tax returns
- Deductible temporary differences reduce taxable income in future periods and create deferred tax assets
- Net operating loss carryforwards also create deferred tax assets

## Deferred Tax Asset Limits

- Taxable temporary differences result in additional taxable income in future periods and create deferred tax liabilities
- Calculate deferred tax assets and liabilities by multiplying applicable tax rate times amount of the temporary difference or carryforward
- The realizability of all deferred tax assets must be evaluated each period
- A valuation allowance must be recorded, if needed, to reduce deferred tax assets to an amount that is more likely than not (greater than 50 percent likelihood) to be realized

## Deferred Tax Asset Limits

- Consider all available evidence, both positive and negative, in assessing the need for a valuation allowance
- Realization of deferred tax assets depends on the existence of sufficient taxable income of the appropriate character in either the carryback or carryforward period
- On the balance sheet, report net amount of deferred tax assets (less any valuation allowance) and deferred tax liabilities separately for each tax jurisdiction (e.g., federal, state, and local)

## Deferred Tax Asset Limits

- Regulatory capital standards limit the amount of deferred tax assets that can be included in Tier 1 capital
- Limit applies to deferred tax assets that, to be realized, are dependent on future taxable income, i.e.,
- Deferred tax assets arising from deductible temporary differences that exceed taxes previously paid that could be recovered through loss carrybacks if all temporary differences (both deductible and taxable) fully reverse at the report date and
- Deferred tax assets arising from operating loss and tax credit carryforwards

## Deferred Tax Asset Limits

- For regulatory capital purposes, deduct from Tier 1 capital the amount by which deferred tax assets dependent on future taxable income exceed the lesser of
- Amount of such deferred tax assets the bank expects to realize within one year based on projected future taxable income for that year or
- 10% of the bank's Tier 1 capital
- Bank should calculate one overall limit on deferred tax assets that covers all tax jurisdictions rather than a separate limit for each tax jurisdiction
- See Call Report Schedule RC-R, item 9.b

## Other-Than-Temporary Impairment

- Principal GAAP guidance
- FASB Statement No. 115, *Accounting for Certain Investments in Debt and Equity Securities*
- http://www.fasb.org/pdf/aop_FAS115.pdf
- FASB Staff Position FAS 115-1 and FAS 124-1, *The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments*
- http://www.fasb.org/pdf/fsp_fas115-1&fas124-1.pdf

## Other-Than-Temporary Impairment

- EITF 99-20, *Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets*
- http://www.fasb.org/pdf/abs99-20.pdf
- Applies to available-for-sale (AFS) and held-to-maturity (HTM) securities
- Under FAS 115, an AFS or HTM security whose fair value is less than its cost basis is “impaired”

## Other-Than-Temporary Impairment

- Evaluate each impaired security each quarter to determine whether impairment is temporary or other than temporary, considering such factors as
- Probability of collecting all amounts due according to contractual terms of a debt security
- Duration and severity of the impairment
- Issuer’s financial condition and near-term prospects
- Intent and ability to hold security until anticipated recovery in fair value (for a debt security, this may be maturity)

## Other-Than-Temporary Impairment

- For an impaired beneficial interest in securitized financial assets that is not of “high credit quality,” i.e., rated below AA at acquisition, also apply EITF 99-20
- If there has been an adverse change in estimated cash flows based on bank’s best estimate of cash flows that a market participant would use in determining the current fair value of the beneficial interest, other-than-temporary impairment is considered to have occurred
- Discount cash flows at current yield used to accrete discount on beneficial interest

## Other-Than-Temporary Impairment

- If impairment is determined to be other than temporary, cost basis of individual security must be written down to fair value through earnings, establishing a new cost basis for the security
- Given current market conditions, the longer a security remains impaired and recovery of fair value remains uncertain, particularly for equity securities (which have no maturity), the more evidence is needed to support a conclusion that the impairment continues to be only temporary and no write-down is needed

## Other-Than-Temporary Impairment

- Banks should have policies and procedures in place for the quarterly evaluation of impaired securities and the determination of whether impairment is temporary or not
- Evaluations should be made case-by-case based on individual facts and circumstances, which requires judgment, and should be documented
- Policies and procedures that are inadequate, nonexistent, or not followed are subject to examiner criticism

## Other-Than-Temporary Impairment

- Ensure that investments in “preferred” stocks with readily determinable fair values are properly reported
- Preferred stocks with a stated maturity date or that can be redeemed at the option of the investor are debt securities under FAS 115
- Report in Call Report Schedule RC-B, item 6
- Perpetual preferred stocks (even if they can be redeemed at the option of the issuer) are equity securities under FAS 115 and cannot be HTM
- Report in Call Report Schedule RC-B, item 7
- All Fannie Mae and Freddie Mac preferreds currently outstanding are perpetual

## Other-Than-Temporary Impairment

- Based on placement of Fannie Mae and Freddie Mac into conservatorship on 9/7/08, other factors relating to these actions, and additional significant decline in market price of their perpetual preferred and common stock, these securities are presumed to have other-than-temporary impairment losses if their cost basis is well in excess of current market prices
- These losses are considered realized and must be recognized in earnings in the 9/30/08 Call Report
- Losses are capital losses for tax purposes as of 9/30/08

## Other-Than-Temporary Impairment

- Section 301 of Emergency Economic Stabilization Act of 2008 changes losses on sales of Fannie Mae and Freddie Mac preferred stock on or after 1/1/08 to ordinary losses for tax purposes for banks
- IRS Revenue Procedure 2008-64 issued 10/29/08 extends this tax treatment to certain indirect investments in Fannie Mae and Freddie Mac preferred stock
- Change in tax treatment cannot be recognized in Call Report balance sheets and income statements until quarter ending 12/31/08 because law and Revenue Procedure not enacted until fourth quarter

## Other-Than-Temporary Impairment

- For regulatory capital purposes, agencies allowed institutions to recognize change in the tax treatment of these losses in 9/30/08 regulatory reports
- http://www.fdic.gov/news/news/press/2008/pr08102.html
- http://www.fdic.gov/news/news/press/2008/pr08108.html
- http://www.fdic.gov/news/news/financial/2008/fil08112.html

## Questions?