Dear CFO: Watch Your Loan Loss Reserves

The SEC issues a new letter aimed at financial institution CFOs, emphasizing the need to "reassess" loan loss reserves in light of the economic slump.

The latest “Dear CFO” letter from the Securities and Exchange Commission focuses on how to account for loan loss reserves, a thorny issue the regulator is spending more time reviewing.

The letter, which was publicly released this month, was generic in nature in that it was not addressed to a specific company; rather, it went out to all CFOs of public companies that may have questions on the topic. In this case, the SEC emphasizes that the letter does not change accounting rules or provide new guidance: it is a reminder that companies — primarily banks and financial institutions — may want to “reassess” their valuation of loan loss reserves in light of the “current economic environment.”

Setting loan loss reserves has been a hot topic for the SEC during the past several years. Since 2006 the commission and companies have written 814 comment letters and responses, respectively, on the subject of loan loss valuation, according to data provided by research firm Audit Analytics, which tracks public financial data on the 5,600 largest companies registered with the SEC. The total rises to 850 when letters that mention loan loss accounting rules — specifically the disclosure provisions in FAS 141R and SOP 03-03 —are included in the count.

In that bevy of company-specific comment letters, banks such as Wells Fargo, Wachovia, and Suntrust have received missives on the topic from the SEC, while other financial institutions, such as GMAC, e-Trade, Countrywide Financial, and Bear Stearns, have also exchanged comment letters with the commission on accounting for loan losses.

Estimating the value of loan losses so corporate reserves can be established has been a controversial issue since the subprime crisis blindsided investors, as many financially troubled banks and financial institutions were caught with inadequate reserves to keep up with the pace of defaults.

Regulators and standard-setters have been trying to figure out a fix to the problem of inadequate reserves, and to that end, the SEC’s chief accountant James Kroeker told an audience at an industry conference sponsored by Baruch College in April that the accounting treatment for loan loss reserves, as well as for off-balance-sheet items, would become a major area of focus for the regulator in the coming months.

At the same conference, Robert Herz, chairman of the Financial Accounting Standards Board, said new loan loss accounting guidance would likely require companies to disclose the economics of the transaction and record the early capture of losses.

Also, the Financial Crisis Advisory Group, an advisory group to FASB and the International Accounting Standards Board, believes the two standard-setters should seek ways to use more forward-looking information for calculating bad debts with respect to loan loss reserves, and find ways to rein in so-called cookie-jar reserves that can be used to manage earnings.

What’s more, during the past year, the Public Company Accounting Oversight Board found several accounting firms lacking in their reviews of clients’ loan loss reserves. In its annual inspection reports, the PCAOB criticized, among other firms, Deloitte, KPMG, and McGladrey & Pullen for not doing adequate testing on their clients’ reserves.

The August “Dear CFO” letter notes that additional information about “high-risk loans” — such as junior lien mortgages, interest-only loans, subprime loans, and loans with initial teaser rates — may be useful to investors, and should be disclosed in the management’s discussion and analysis sections of corporate annual reports. The letter also warns companies that if they change their practices with regard to how they calculate loan loss reserves, then that change, as well as changes in collateral value and key ratios, must be disclosed, too.

The SEC posts “Dear CFO” letters from time to time to help companies better comply with disclosure requirements, and to provide “real-time” guidance. “In light of the issues facing financial institutions related to the prolonged problems in the lending markets, we want to make sure that lenders were focused on good disclosure practices regarding loan loss reserves in drafting their upcoming MD&As,” the SEC told CFO.com.

 

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