PHOENIX-Credit unions are being urged to implement a four-step process that will help avoid conflicts with examiners when it comes to allowance for loan and lease losses.
Bart Ferrin, a CPA with Ferrin & Co. in Salt Lake City told the CUNA CFO Council conference here the ALLL estimate should be based on comprehensive, well-documented and consistently applied analysis of the loan portfolio. He added the estimate should take into account all available information existing as of the financial statement date, including environmental factors such as industry, geographical, economic and political factors.
"Management is responsible for developing the process," Ferrin said. "This means having an effective loan classification or credit grading system that can identify, monitor and address asset quality problems in an accurate and timely manner. One of the most important things to do is to evaluate loss estimation models before they are employed. The validation of ALLL methodology does not have to be done by one person, it can be divided among independent parties."
A Four Step Process
Ferrin outlined a four-step process for building an "acceptable" ALLL:
- Establish an appropriate pooling process.
- Establish an appropriate individual identification process.
- Establish an appropriate qualitative and environmental analysis process.
- Prepare a final management and discussion analysis (MD&A).
"By doing this process, credit unions can narrow the playing field and cut the examiner off at the pass," he said. "The goal is to fund one year of losses in the loan portfolio."
Pooling, the process of creating groups of homogenous loan types, is a "good start, but only a start," said Ferrin, cautioning that not all loans can be pooled, meaning they must be able to identify problem loans.
For Step Three, the larger the CU, the more diverse the loan portfolio, and therefore the more detailed the Q&E analysis should be. Ferrin warned if all portions are not recorded in writing, examiners will doubt if analysis is really being done.
"They want to know what you are thinking and why you are thinking it."
Pulling Everything Together
As for Step Four, he said the MD&A "pulls everything together."
"Make sure what is in the final document stands on its own," he said. "This process is a lot of work, but formalization of the process ensures understanding of all the factors affecting this most significant statement. A complete methodology will yield an appropriate estimate, regardless of a good or bad economy, because all factors will be considered each time the estimate is prepared."
Ferrin noted FASB has proposed credit loss accounting standards update, although it probably will take a couple of years to go into effect.
Getting partciular scrutiny due to the profound effect on ALLL is the expected loss model. If approved, the new standard would prohibit estimating credit losses solely on the basis of most likely outcome-the possibilities of credit loss and no credit loss must be considered.
