The Securities and Exchange Commission (the “SEC”) recently published guidance on the Management’s Discussion and Analysis of Financial Condition and the Results of Operations (“MD&A”) and accounting policy disclosures of smaller financial institutions. The guidance is intended to assist smaller financial institutions in improving certain disclosures in reports filed with the SEC. This bulletin provides a brief overview of the SEC’s recent guidance focusing on some of the most important disclosure issues, particularly accounting for the allowance for loan losses and descriptions of a registrant’s charge-off and non-accrual policies. Although the SEC’s guidance is targeted at smaller financial institutions, similar considerations may also be applicable to other financial institutions.
Allowance for loan losses
As a reflection of the challenging credit climate, a substantial part of the guidance addresses disclosures relating to asset quality and loan accounting. In particular, the allowance for loan losses is a major factor in evaluating a smaller financial institution’s ability to absorb credit losses, as well as the fairness and accuracy of its financial statements. Generally accepted accounting principles (GAAP) require a smaller financial institution to 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 statement. The allowance for loan losses must be supported by appropriate analyses, be well-documented and consistent from period to period.1 The SEC frequently asks smaller financial institutions to provide more information about the processes, methodologies and underlying assumptions of their allowance for loan losses. According to the guidance, a smaller financial institution should address:
- Why allowance ratios, such as 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 have fluctuated relating to total allowance; and
Details of any geographic or higher-risk loan type concentrations in the loan portfolio.
The SEC recommends that smaller financial institutions disclose, among other details, how historical loss rates are calculated, how they are applied, and the causes for any changes from previous periods. Smaller financial institutions may also need to “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.”
Charge-off and nonaccrual policies
The SEC, through its comment process, has asked smaller financial institutions to provide greater insight into management’s criteria for determining when certain loans should be charged-off or placed on non-accrual status. Registrants should clearly describe their non-accrual and charge-off policies. Simply stating that a smaller financial institution complies with applicable regulatory requirements is likely to trigger follow-up questions from the SEC. The SEC may request that a smaller financial institution:
- Disclose the relevant thresholds used to place loans on nonaccrual status or charge-off past due loans;
- Explain why a particular loan was not charged-off at a specific past-due threshold, including the specific factors considered in reaching that conclusion; and
- Discuss the reasons for any changes in charge-off policies.
Loans measured for impairment based on collateral value
If a smaller financial institution’s loan portfolio has a significant number of loans for which impairment is based on collateral value, the SEC recommends that the smaller financial institution disclose in detail the policies and procedures for obtaining third-party appraisals, and any situations when their methodology does not require the of use third-party appraisals. Smaller financial institutions may also need to disclose the typical timing of classifying such loans as nonaccrual, recording any provision for loan loss, or recognizing a charge-off, including the amount of any charge-off.
Troubled Debt Restructuring (TDRs) and modifications
In recent years, many smaller financial institutions have seen an increase in the number of loan modifications. The SEC has requested that smaller financial institutions provide greater insight into how they determine whether a loan modification is a TDR,2 and, if the amount of TDRs is material, may ask them to quantify the total amount of modified loans and detail their loan modification policies and programs. A smaller financial institution should also be prepared to discuss why some modified loans are not considered TDRs or why certain loans were removed from their TDR disclosures.
Other topics in the SEC’s guidance
The SEC also provided guidance regarding other asset quality and loan accounting disclosures including commercial real estate, credit risk concentration and other real estate owned. In addition, the SEC discusses information that should be disclosed relating to FDIC assisted transactions and the realization of tax deferred assets. For more information, the SEC’s full CF Disclosure Guidance can be found at http://www.sec.gov/divisions/corpfin/guidance/cfguidance-topic5.htm.
For further information please contact Ryan J. York or Christina Y. Chan.
1 See Accounting Standards Codification (“ASC”) 310-10-35-4(c)
2 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. ASC 310-40-15-5.