FINANCIAL INSTITUTION UPDATE
Newsletter by Hawkins Ash CPAs
In this edition
May 15, 2018

Calculating Allowance for Loan Loss: Plan for Environmental and Economic Factors

Accounting Standards Update (ASU) 2016-01 Effect on Call Report

Avoid Litigation With Attention to Common Red Flags

Current Expected Credit Losses (CECL) – The Vintage Analysis Method

Calculating Allowance for Loan Loss: Plan for Environmental and Economic Factors
The environmental and economic factor is often an important piece to the allowance for loan loss (ALL calculation) that is often neglected. A common refrain for omitting this factor is not knowing what to include in the analysis. It is an answer that is unique to each financial institution. In order to reasonably determine a necessary environmental and economic factor, it helps to step back and ask one question: What factors will affect my charge-offs going forward that aren’t reflected in my historical data? This question is also the crux of the new CECL model, since too often financial institutions simply looked back at the historical data instead of looking forward to what was coming. However, until 2020, when CECL is effective for all entities, it is a good idea to strengthen the current economic and environmental factors. Some common factors that should be considered include the following:

  • Changes in underwriting standards as well as changes to lending policies, procedures and practices
  • Experience, ability and depth of lending management and other relevant staff
  • Levels of and trends in delinquencies and impaired loans
  • National/local economic trends and conditions
  • Industry conditions

When reviewing these factors, it is important to note how each compares to your historical data. For example, if local unemployment rates had consistently been around 5 percent during the historical data period, than a current unemployment rate of 5 percent would presumably have no effect on expected future charge-offs. An adjustment to the allowance might not be warranted in this circumstance. However, if the most recent unemployment rate increased to 5.5 percent, it might be likely that increased delinquencies and charge-offs will be seen in the near future. In this scenario, it would be reasonable to expect an increase to the ALL to account for the increase in unemployment rates.

Now that you’ve determined what economic and environmental factors apply to your financial institution, you need to quantify the affect, if any, each factor will have on your charge-offs. When possible, it is best to support your conclusion with data. For example, given the scenario in the previous paragraph, it might be possible to look back at prior years when the unemployment rate was 5.5 percent to see charge-off ratios from that period. Those ratios could then be compared to the current charge-off ratios in order to estimate the increase in charge-off rates the financial institution might expect to see in the near future. Note that it might not be possible to look at previous results; for example, a change in underwriting standards probably has no historical period to look back to. These situations will require a “best guess” assumption that may need to be revisited as actual results start to hit the historical data.

With any analysis or calculation that incorporates assumptions it is important to document the reasoning behind the estimates/assumptions that were used to support your conclusion.

Potential data sources:
Contact: Jeff Danen, CPA, CVA
Direct: 920.337.4546
Email: jdanen@hawkinsashcpas.com
Accounting Standards Update (ASU) 2016-01 Effect on Call Report
In January 2016, the FASB issued ASU 2016-01, Financial Instruments-Overall (Topic 825): Recognition and Measurement of Financial Assets and Financial Liabilities, effective for annual reporting periods beginning after December 15, 2018. Early adoption is permitted. The new guidance requires entities to measure equity investments that do not result in consolidation or are under the equity method to be reported at fair value. Changes in fair value are to be recognized in net income. The ASU indicates the change is to be recorded as a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. As such, any balance reported in an unrealized gain/loss account at year end would be transferred to the undivided earnings account as of the beginning of the year the change is adopted.  

So What Does This Mean?  
From a financial statement standpoint, any balance in unrealized gain/loss accounts will be consolidated into the undivided earnings account. Going forward, any changes to the fair value will be run through the income statement. For Call Report purposes, this brings up two questions. First, do I need to do anything special to report the cumulative-effect adjustment? Second, where are changes to fair value reported going forward? Per correspondence with the Region 1 office of the NCUA, the answer to the first question is there is no additional reporting necessary on the Call Report to show the cumulative-effect adjustment. The answer to the second question isn’t as obvious. On the Call Report, the Statement of Income and Expense page includes a separate line for gain/loss on investments. However, this section specifically excludes trading securities. As a result, any changes in fair value of these investments would be reported as gains/losses on line 4 (Trading profits and losses) on the Statement of Income and Expenses. 
Avoid Litigation With Attention to Common Red Flags
Any size retirement plan can run into serious trouble when sponsors aren’t careful. With some planning, though, your qualified retirement plan doesn’t have to be the target of ERISA litigation. A reminder of the most common red flags leading to litigation might be helpful.

Reasonable Expenses
Of course, you can’t assure consistently strong investment performance. But plan sponsors can — and must — ensure that expenses are reasonable.

When your plan’s investment portfolios are performing well, it’s easy to pay less attention to the recordkeeping costs and investment management fees. But when performance is subpar, out-of-line expenses stick out like the proverbial sore thumb. Make sure you schedule regular, independent reviews of your plan expenses and fees every three to five years as part of your due diligence.

Opaque Fee Structures
In the past, complex and opaque fee structures such as revenue-sharing arrangements between asset managers and third-party administrators made it harder to get a handle on cost. But with the U.S. Department of Labor’s fee disclosure regulations now in their fourth year, pleading ignorance is no excuse. In fact, it never really was.

Mutual fund shares with built-in revenue sharing features still exist but, with required disclosure statements, it’s easier for you (and plan participants) to understand what they are. Although these built-in revenue sharing features aren’t inherently bad, they tend to be associated with funds that have higher expense charges.

Try not to incorporate such funds into your plan — absent a good reason that you can explain to participants. In some plan fee litigation, courts have deemed fee-sharing arrangements a payoff to an administrator to recommend those funds, subordinating its assessment of the funds’ merits as sound investments.

Bundled Services
Another expense-related red flag that could trigger litigation is exclusive use of a bundled plan provider’s investment funds. This also can raise questions about the effort that you put into investment performance evaluation.

So if you use only a bundled provider’s funds, you could give the appearance of not performing your fiduciary duty to seek out the most appropriate and competitively priced funds. And in fact, the odds are slim that one bundled provider has best-of-class funds in all of your desired investment strategy categories and asset classes. When retaining a bundled provider, question whether the recommendation of primarily proprietary funds could result in a conflict of interest if better performing and lower cost funds are available on their platform.

Share Classes
Even when your plan’s investment lineup features funds from multiple asset management companies, you could be inadvertently flying a red flag if the funds in your investment menu are in an expensive share class. Individual investors, unless they have very deep pockets, generally have access to only retail-priced share classes. In contrast, retirement plans, even small ones, typically can use more competitively priced institutional share classes. The failure to use institutionally priced share classes has been at the heart of many class actions against plan sponsors.

Different share classes of the same mutual fund have different ticker symbols; that’s one easy way to determine what’s in the portfolio. Fund companies that offer shares with sales loads typically offer more variations, with “A,” “B” and “C” categories of retail shares, and an institutionally priced “I” share class without embedded sales charges.

Having some high-cost investments in your fund lineup isn’t in itself a reason that you’ll be deemed to have breached your fiduciary duties. There may indeed be good reasons to include them, notwithstanding the higher costs.

Investment Policy Statements
The concept of “procedural prudence” is embedded in ERISA and case law. This means plan sponsors must establish — and follow — policies and procedures to safeguard participants’ interests and set the criteria used to evaluate vendors, including asset managers.

Create an investment policy statement (IPS) to articulate your vision for plan investments overall, and the investment options you want to make available to participants. The IPS should clearly state:

  • What kind of assets you’ll include in investment options
  • The degree of investment risk and volatility that’s acceptable
  • How you’ll assess investment performance
  • When you’ll change managers

Although having an IPS isn’t obligatory, doing so can show that you’re exercising procedural prudence — provided you can document your compliance with it. Merely signaling prudence won’t get you off the hook; following carefully crafted procedures and policies will go a long way toward preventing missteps that could lead to litigation in the first place. If you already have an IPS, be sure to follow it.

Next steps
Avoiding ERISA litigation is on every plan sponsor’s wish list. Reviewing expenses, fee structures and bundled services, and creating and following an IPS, can help you achieve this. Start by making periodic review of these areas the norm, in good times and bad.
Contact: Erica Knerzer, CPA
Direct: 608.793.3113
Email: eknerzer@hawkinsashcpas.com
Current Expected Credit Losses (CECL) – The Vintage Analysis Method
The allowance for loan losses is headed for a major overhaul within the next few years. Instead of basing the allowance on the losses experienced in the past, the current expected credit loss will be based on the cash flow you expect over the life of the loan. There are a variety of methods that can be used for the CECL calculation, and the accounting standards do not dictate the method used for the estimate. As a reminder, CECL will be effective for credit unions for fiscal years beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022.

Some of the common methods used for the CECL calculation are the vintage analysis, static pool analysis, or migration analysis methods. Following is a description and example of the vintage analysis method; future articles will provide details of other methods.

Vintage Analysis
When using a vintage analysis, segments of loans are tracked on the basis of the year of origination. By analyzing the loss experience for the group of loans originated in each year, a pattern may be developed to estimate the losses expected in the future. The following example illustrates how a vintage analysis might be used to estimate the expected credit loss at March 31, 2017.

Credit Union A tracks used auto loans on the basis of the calendar year of origination, and also tracks the credit losses associated with these loans. Due to a merger in 2013, Credit Union A does not have complete information for loans originated prior to 2013. Credit Union A changed its used auto lending policy in 2016 to increase risk slightly and grow the portfolio. For purposes of this example we will assume the credit quality related to these loans has been consistent through 2015.

Used Auto Loans at Origination
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Used Auto Current Balances
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Used Auto Net Losses
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Calculated Historical Losses
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Conclusions

  • For loans issued prior to 2013, we used a reserve rate of 1.3%, which represents the loss rate of 2013 because we believe it more closely reflects the discount for cash flows in the previous periods.

  • For loans issued in 2014 and 2015 we maintained the 1.3% discount rate because the credit quality of loans and lending policies in place for these periods was consistent with 2013.

  • For 2016 and 2017 we increased the discount rate on the loan pools because of a change in loan policy with the intent of increasing risk and growing the used auto portfolio.

  • The Allowance for Loan Loss related to used auto loans as of March 31, 2017 for Credit Union A is $5,470,671, and the allowance should be adjusted accordingly.

  • Environmental factors should be applied to the Actual Reserve rate based on particular circumstances.

At the time CECL is implemented, you will record a one-time adjustment to your allowance based on the new calculation. You are not allowed to boost up your allowance in preparation for CECL. 

Please watch for future articles related to CECL implementation. For more information, please contact Jeff Danen or Dan Lightfuss in our Green Bay office at 920-336-9850.
Contact: Dan Lightfuss, CPA
Direct: 920.337.4552
Email: dlightfuss@hawkinsashcpas.com
More Resources from CPA-HQ
Quarterly Charge-Off Report
Wisconsin Credit Union
Charge Off Ratios ending December 31, 2017

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Hawkins Ash CPAs
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