United States: Disclosures by U.S. Public Companies Regarding Provisions and Allowances for Loan Losses

Originally published September 1, 2009

Keywords: SEC, Division of Corporation Finance, Management's Discussion and Analysis of Financial Condition and Results of Operations, MD&A, financial institutions, corporate disclosure,

In August 2009, the staff of the Division of Corporation Finance of the Securities and Exchange Commission (the "Staff") sent a letter¹ to certain public companies describing a number of disclosure issues to be considered in preparing Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A").² The letter identifies a number of common MD&A disclosure suggestions that the Staff has provided to financial institutions regarding disclosure to consider providing with respect to provisions and allowances for loan losses. Public companies that did not receive such a comment letter should nevertheless consider the materiality of the issues raised by the Staff.

Staff Guidance

Higher-Risk Loans. Higher-risk loans, which include option adjustable rate mortgage, or ARM, products, junior lien mortgages, high loan-to-value ratio mortgages, interest-only loans, subprime loans and loans with initial teaser rates, can have a greater risk of non-collection than other loans. Therefore, additional disclosure may be necessary to allow a reader to understand the risks associated with a loan portfolio and to evaluate any known trends or uncertainties that could have a material impact on results of operations. The items to consider disclosing are:

• The carrying value of higher-risk loans by loan type;
• Current loan-to-value ratios by higher-risk loan type, including a discussion of how the ratios are calculated and the sources of the underlying data, further segregated by geographic location;
• The amount and percentage of refinanced or modified loans by higher-risk loan type;
• Asset quality information and measurements, such as delinquency statistics and charge-off ratios by higher-risk loan type;
• The policy for placing loans on non-accrual status when a loan's terms allow for a minimum monthly payment that is less than the interest accrued on the loan and how this policy impacts the non-performing loan statistics;
• The expected timing of adjustment of option ARM loans and the effect of the adjustment on future cash flows and liquidity, taking into consideration current trends of increased delinquency rates of ARM loans and reduced collateral values due to declining home prices; and
• The number and percentage of customers that are making the minimum payment on their option ARM loans.

Changes in Practices. Changes in practices used to determine the allowance for loan losses can impact the amount of the allowance and can also impact an understanding of the presented credit quality information. If a practice is changed, the company should discuss why the change was made and quantify the effect of the change, if possible. If a company does make a change in practice, the Staff guidance highlights the following items to consider disclosing:

• The historical loss data used as a starting point for estimating current losses;
• How economic factors affecting loan quality were incorporated into the allowance estimate;
• The level of specificity used to group loans for purposes of estimating losses;
• Non-accrual and charge-off policies;
• How loss factors were applied to graded loans; and
• Any other estimation methods and assumptions used.

Declines in Collateral Value. If a decline in the value of assets serving as collateral for loans may impact the ability to collect on those loans, the items to consider disclosing are:

• The approximate amount (or percentage) of residential mortgage loans, as of the end of the reporting period, with loan-to-value ratios above 100 percent;
• How housing price depreciation, and a homeowner's loss of equity in the collateral, is taken into consideration in the allowance for loan losses for residential mortgages; and
• The timing and frequency of appraisals and the sources of those appraisals for collateral-dependent loans.

Other. The Staff guidance highlights the following additional items to consider disclosing to the extent relevant and material:

• Any risk mitigation transactions, including insurance arrangements, participation in the U.S. Treasury Home Affordable Modification Program, credit default agreements and credit derivatives, used to reduce credit risk exposure and how these transactions impact the financial statements;
• The reasons why key ratios changed from period to period, and how this information and other relevant credit statistics were considered in determining whether the allowance for loan losses was appropriate; and
• How the accounting for an acquisition under FAS 141R³ or the accounting for loans under SOP 03-3⁴ affects trends in the allowance for loan losses, charge-off ratios and the allowance for loan loss to total loans.

Finally, the Staff guidance points out that it would be inconsistent with generally accepted accounting principles to delay recognizing credit losses that can be estimated based on current information and events.

Additional Considerations

In reviewing the Staff guidance set forth in the form letter, the following should also be considered:

• Even if you did not receive this letter from the Staff, you should consider its relevance to your company and, if relevant, you should consider the materiality of the suggested disclosures; and
• When the Staff reviews the filed reports of a public company, disclosures in this area will likely be subject to additional scrutiny and comment.

Footnotes

1. A form of the letter is available at http://www.sec.gov/divisions/corpfin/guidance/loanlossesltr0809.htm.

2. Item 303 of Regulation S-K.

3. Financial Accounting Standards Board Financial Accounting Standards Statement 141 (revised 2007), Business Combinations.

4. American Institute of Certified Public Accountants Statements of Position 03-3, Accounting for Certain Loans of Debt Securities Acquired in a Transfer.

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