Division of Corporation Finance
Securities and Exchange Commission
CF Disclosure Guidance: Topic No. 5
Staff Observations Regarding Disclosures of Smaller Financial Institutions
Date: April 20, 2012
Summary: This guidance summarizes a number of the Division of Corporation Finance's observations on Management’s Discussion and Analysis and accounting policy disclosures of smaller financial institutions.
Supplementary Information: The statements in this CF Disclosure Guidance represent the views of the Division of Corporation Finance. This guidance is not a rule, regulation or statement of the Securities and Exchange Commission. Further, the Commission has neither approved nor disapproved its content.
In our review of the filings of smaller financial institutions, we frequently issue comments on several topics that impact Management’s Discussion and Analysis (MD&A)1 and accounting policy disclosures. We are issuing this guidance to summarize our observations on such matters in order to assist smaller financial institutions in enhancing the disclosure they provide investors in the reports they file with the Commission.
The topics discussed in this guidance may not be material for all registrants. Likewise, these observations may not encompass an individual registrant’s particular facts and circumstances and may not address all of the material disclosure issues applicable to each registrant’s circumstances. Each registrant should consider its own facts and circumstances when preparing its filings.
These observations summarize and discuss certain U.S. generally accepted accounting principles (“GAAP”) and certain rules and regulations that the Commission has adopted. However, these observations are not a substitute for the Accounting Standards Codification (“ASC”) or the rules and regulations of the Commission. Only the ASC and the rules and regulations themselves can provide registrants with the complete and definitive requirements applicable to their circumstances.
Asset Quality / Loan Accounting Issues
Allowance for Loan Losses
The allowance for loan losses is a material item for financial institutions. GAAP requires that a registrant establish an allowance through the recognition of a provision for loan losses when, based on all available information, it is probable that a loss has been incurred based on past events or conditions existing at the date of the financial statements. GAAP does not permit a registrant to establish allowances it cannot support with appropriate analyses, and the approach for determining the allowance should be well documented and applied consistently from period to period.2 A registrant’s allowance for loan losses generally consists of two components. The first component is allocated to individually evaluated loans found to be impaired and is calculated in accordance with ASC 310.3 The second component is allocated to all other loans that are not individually identified as impaired pursuant to ASC 310-10 (“non-impaired loans”). This component is calculated for all non-impaired loans on a collective basis in accordance with ASC 450.4 Industry Guide 3 (“Guide 3”)5 includes a requirement to disclose the detail of the allowance for loan losses allocated by type of loan. In some instances, a registrant may disclose that a portion of the allowance calculated in accordance with ASC 450 is unallocated.
We frequently ask registrants to provide more disclosure about how they calculate the allowance and its components. Depending on its circumstances, we may ask a registrant to explain:
- Why its allowance ratios, such as its allowance to total loans or allowance to total nonperforming loans, have fluctuated;
- The basis for any large unallocated allowance;
- The rationale for changes in methodologies for determining the allowance;
- Why the components of the allowance (i.e., calculated in accordance with ASC 310 or 450) have fluctuated relative to the total allowance; and
- The details of any geographic or higher-risk loan type concentrations in the loan portfolio.
A widely-used method of calculating the allowance for non-impaired loans is based on historical loss rates. A registrant may also make adjustments to the allowance for non-impaired loans due to the effects of qualitative or environmental factors for groups of loans with similar risk characteristics. The allowance for non-impaired loans is frequently a significant component of the allowance for loan losses, and we have asked registrants to:
- Describe how they calculate and apply historical loss rates, and how they group loans for purposes of deriving historical loss rates;
- Disclose the periods they use to determine historical loss rates, including both the number of periods and the length of time;
- Explain the causes for any changes to historical loss rates calculated and applied during the current period;
- Discuss how qualitative and environmental factors are considered in their methodologies (e.g. as an adjustment to historical loss rates or as a separate adjustment to the allowance, etc.) and how such factors are reflected in the allowance; and
- Quantify any portion of the allowance for non-impaired loans that they do not calculate by applying historical or adjusted historical loss rates, describe how they calculate the associated allowance, including why they do not use historical or adjusted historical loss rates, and explain the reasons for any changes in the calculation during the period.
Charge-off and Nonaccrual Policies
Registrants have policies for placing loans on nonaccrual status or charging them off when certain events occur (e.g., the loans become a certain number of days past due). When a registrant appears to have a material amount of loans on nonaccrual status or charged off in a period, we may ask the registrant to describe its nonaccrual and charge-off policies, particularly when its disclosure simply states that the policies comply with bank regulatory requirements. For example, we may request that registrants:
- Disclose the relevant thresholds they use to place loans on nonaccrual status or charge off past due loans;
- Explain why a loan was not charged off at a specific past-due threshold, including the specific factors they considered in reaching that conclusion; and
- Discuss the reasons for changes in charge-off policies.
Registrants also have policies for characterizing loans as nonperforming. We may request that registrants disclose their policies for identifying nonperforming loans.
We have issued comments seeking disclosure that describes how charge-offs for credit losses impact the coverage ratio (i.e., the allowance to total nonperforming loans). For example, we may ask registrants to provide an analysis of:
- The ratio of the recorded investment in nonperforming loans for which they have charged off the credit loss to the recorded investment in total loans;
- The ratio of the recorded investment in nonperforming loans for which they have charged off the credit loss to the recorded investment in total nonperforming loans;
- The charge-off rate for nonperforming loans for which they have charged off the credit loss; and
- The coverage ratio, exclusive of nonperforming loans for which they have charged off the credit loss (i.e., the ratio of the allowance to nonperforming loans on which no charge-offs have been taken).
We also may ask registrants to explain the reasons for any trends related to these ratios.
Commercial Real Estate (CRE)
CRE loans may have unique characteristics. When we note that a registrant has a significant portion of its portfolio in CRE loans, we may ask it to explain:
- Why there are large fluctuations in charge-offs or nonperforming CRE loans;
- The workout strategies it uses to address collectability concerns and the dollar amount of loans modified under each strategy; and
- How guarantees or other collateral impact its conclusion regarding whether a CRE loan whose term has been extended at or near the loan’s original maturity is impaired.
When we note that a registrant has experienced significant increases in CRE charge-offs, or changes in the trend of charge-offs, we may ask it to describe:
- The triggering events or other circumstances that impact the timing of when it records a charge-off; and
- How it considers the increase or change in the trend of charge-offs when determining each component of the allowance.
Similarly, when we note that a registrant has significant increases in nonperforming CRE loans or changes in the trend of nonperforming CRE loans, we may ask it to explain:
- Whether the increase or change in the trend is due to a few large loans or a large number of smaller loans;
- Why the allowance has not proportionally followed the levels of nonperforming loans, if applicable;
- Any steps it has taken to monitor and evaluate collateral values as part of its credit risk management policies, how such monitoring is considered in its allowance methodology, and whether updates to collateral values result in charge-offs; and
- The reasons for any trends in collateral values in recent periods.
Many registrants use workout strategies such as restructuring an existing loan into multiple restructured loans to address collectability issues on CRE loans. When the impact of such workout programs appears material, we request that registrants describe:
- The amounts of loans they have restructured in each period presented;
- The quantitative impact workout strategies have on interest income, credit classification, and other financial metrics;
- The general terms of the new loans, including whether the new loans are underwritten in accordance with their customary underwriting standards and at current market rates, and how the new loans differ from one another;
- Their charge-off and nonaccrual policies for multiple loan structures and multiple loan restructurings;
- Whether the new loans are included in their impaired loans disclosures; and
- Where the new loans are classified in Guide 3 disclosures (e.g., as a troubled debt restructuring).
Loans Measured for Impairment Based on Collateral Value
GAAP requires creditors to measure a loan for impairment based on the fair value of the collateral when the creditor determines that foreclosure is probable.6 In addition, GAAP allows a creditor to measure an impaired loan on which the repayment of the loan is expected to be provided solely by the underlying collateral (i.e., a collateral-dependent loan) based on the fair value of the collateral.7 For registrants with significant loan portfolios that they measure for impairment based on the collateral value, we may ask them to describe:
- How and when they obtain third-party appraisals, and how the appraisals impact the amount and timing of any provision or charge-off;
- The types of appraisals they obtain, such as “retail” value or “as-is” value;
- What procedures they perform between receiving updated appraisals to ensure that they appropriately measure loan impairments;
- If applicable, the reasons they do not obtain appraisals in a timely manner;
- The typical timing of classifying loans as nonaccrual, recording any provision for loan loss, or recognizing a charge-off;
- How they determine the amount to charge off;
- How they classify and account for partially charged off loans after receiving an updated appraisal. For example, we may ask a registrant to explain whether the loans are returned to performing status or whether the loans remain in nonperforming status;
- The reasons they make any adjustments to appraised values when calculating impairment; and
- What procedures they perform to estimate the fair value of the collateral when they do not use external appraisals or have not obtained updated appraisals.
Credit Risk Concentrations
GAAP requires disclosure of all significant concentrations of credit risk arising from financial instruments, whether from an individual counterparty or groups of counterparties.8 Some registrants have a small number of loans making up a significant portion of their recorded investment in nonaccrual loans. We may ask those registrants to discuss:
- The types of concentrations that exist, such as geographies, industries, collateral types, product types, or borrower types (e.g., commercial developers, residential land developers, commercial businesses, etc.);
- The types of collateral securing the loans;
- The amount of total credit exposure;
- The allowance for the impaired loans;
- Whether the loans are guaranteed and what procedures they perform to evaluate the guarantors’ ability and willingness to repay the balance owed; and
- Any special circumstances surrounding the loans, such as whether the loans relate to properties out of the registrant’s normal market area and whether the loans are related to the registrant’s participation in a larger loan underwritten by another financial institution.
Troubled Debt Restructurings (TDRs) and Modifications
GAAP defines a TDR as the restructuring of debt when the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor it would not otherwise consider providing.9 Guide 3 requires separate disclosure of TDRs that are not included within a registrant’s Guide 3 disclosure of non-accrual loans or loans 90 days past due. When a registrant appears to have a material amount of TDRs, we may ask it to quantify the total amount of modified loans and discuss:
- The types of programs it uses to modify loans;
- Its policy for measuring impairment;
- Why any modified loans are not accounted for as TDRs;
- Its nonaccrual policy for restructured loans; and
- The effects of TDRs on its past-due statistics.
Some registrants remove loans from their TDR Guide 3 disclosures under certain circumstances. We may ask them to:
- Discuss the circumstances under which they would remove loans from their TDR disclosures;
- Quantify the amount of loans removed; and
- Provide a roll-forward of TDRs, if necessary to provide a transparent analysis of TDR activity.
Registrants may also have significant amounts of TDRs that continue to accrue interest. In such circumstances, we may ask registrants to discuss:
- All of the factors they considered when they determined the TDRs should continue to accrue interest; and
- Whether they have determined that they are reasonably assured of repayment and, if so, how they made that determination.
Not all loan modifications will meet the definition of a TDR under GAAP. Where a registrant has significant amounts of loan modifications that it does not account for as TDRs, we may ask it to quantify the amount of loans it modified (by loan type and workout strategy) in each period presented and to explain:
- The triggers or factors it reviews to identify the loans for modification, and the reasons why it does not account for modified loans as TDRs;
- The key features of its modification programs, including the usual type and length of modified terms;
- The success rates of its modification programs (i.e. the percentage of modified loans that have not defaulted);
- The accounting basis for its conclusion that the modifications should not be classified as TDRs;
- How the modified loans are classified (performing vs. nonperforming) and whether the modified loans continue to accrue interest; and
- The impact of modifications on past-due statistics.
Other Real Estate Owned (OREO)
Registrants record OREO in their financial statements when they acquire property for debts previously contracted, including through foreclosure or repossession. GAAP provides guidance on the accounting for and the reporting of foreclosed assets in ASC 310-40. OREO is generally presented on a registrant’s balance sheet as assets held for sale, and GAAP indicates an asset held for sale should be measured initially at the fair value less costs to sell and subsequently at the lower of its carrying amount or fair value less cost to sell.10 We often ask registrants with significant amounts of OREO to:
- Disclose the balance of OREO by type of asset;
- Provide a roll-forward of OREO with the beginning balance, additions, capitalized improvements, valuation adjustments, dispositions, and the ending balance;
- Discuss the actual OREO sales prices versus the amounts they recorded in the financial statements;
- Identify where in the income statement they recognize gains and losses upon the disposition of OREO; and
- Explain their typical foreclosure decision-making processes, including how and when they decide to foreclose, the impact of individual state laws deferring foreclosure, etc.
Although deferred taxes is a topic that impacts a wide range of registrants, in recent years, many smaller financial institutions experienced significant operating losses for one or more years, which may have given rise to material deferred tax assets related to net operating loss carry-forwards. GAAP requires that deferred tax assets be reduced, if necessary through recognition of a valuation allowance, by the amount of any tax benefits that are not more likely than not to be realized.11 GAAP indicates that, while there are no bright-lines, cumulative losses in recent years represent a significant piece of objective negative evidence that is difficult to overcome when determining whether or not a valuation allowance is required.12 When a registrant that has experienced cumulative losses in recent years appears to have a material deferred tax asset for which a valuation allowance has not been recorded we may ask it to explain:
- The positive and negative evidence it assessed in determining the extent of any valuation allowance and how it weighed such evidence;
- Why it believes projections of future income are sufficient to overcome the significant negative evidence of cumulative losses in recent years;
- Why it believes it is appropriate to exclude items such as loan loss provisions when it evaluates whether it has experienced cumulative losses in recent years;
- Why it believes deferred tax liabilities or tax planning strategies are sufficient to realize all or a portion of its deferred tax asset; and
- The tax planning strategies it expects to utilize.
Federal Deposit Insurance Corporation (FDIC)-Assisted Transactions
Many institutions that were placed into receivership by the FDIC have been reorganized, sold, or transferred by the FDIC to other financial institutions. A number of registrants have acquired or are contemplating the acquisition of troubled financial institutions or specific portions of troubled financial institutions, and the FDIC may provide significant assistance to registrants in the form of loss-sharing agreements or other discounts. If registrants acquire in FDIC-assisted transactions assets that appear to be material, we may ask them to:
- Disclose whether they accounted for any acquired loans not within the scope of ASC 310-30 by analogy to ASC 310-30 and, if so, how they determined that there was a discount due at least in part to credit quality on those loans;
- Describe if they have aggregated acquired loans into loan pools, and, if so, how they determined the pools, including the common risk characteristics they used, for the purposes of applying the recognition, measurement and disclosure provisions of ASC 310-3013;
- Explain disclosures that imply that they are using an automatic one-year window to finalize the purchase accounting amounts for the acquired loans (instead of following guidance in ASC 805-10-2514); and
- Disclose their accounting policies for any indemnification assets arising from loss-sharing agreements when changes to expected cash flows occur.
Loss-sharing agreements that arise in FDIC-assisted transactions often shift a material amount of the economic risk of loss associated with an acquired portfolio of loans from the acquiring financial institution to the FDIC. Where the impacts of loss-sharing agreements appear to be material, we may ask registrants to:
- Disclose how changes in expected cash flows on the loans subject to the loss-sharing agreement are presented in the income statement in relation to the provision for loan losses, interest income, and non-interest income; and
- Include the assets subject to the loss-sharing agreement in their Guide 3 disclosures, with separate footnotes highlighting the special nature of the assets. Alternatively, these assets could be presented separately within the Guide 3 disclosures.
1 See Item 303 of Regulation S-K; and Form 20-F, Item 5.
2 See ASC 310-10-35-4(c).
3 See ASC 310-10-35.
4 See ASC 450-20-60-3, which references ASC 310-10-35-7 through 11.
5 Industry Guide 3 outlines statistical disclosures required for bank holding companies.
6 See ASC 310-10-35-32.
7 See ASC 310-10-35-22.
8 See ASC 825-10-50-20.
9 See ASC 310-40-15-5.
10 See ASC 360-10-35-43.
11 See ASC 740-10-30-2(b) and 740-10-30-5(e).
12 See ASC 740-10-30-21.
13 ASC 310-30-15-6 explains the criteria to be considered when determining loan pools.
14 ASC 805-10-25-13 through 19 clarifies the information to be considered during the measurement period for a specific business combination.