SEC's 'Dear CFO' Letter on MD&A Disclosure of Loan Loss Provisions, ALLL

On Aug. 18, the SEC posted a new "Dear CFO" letter - more formally called a "Sample Letter Sent to Public Companies" - a communication vehicle the Commission uses from time to time to spread the word through direct mail of a standard letter to a group of company exec's (e.g. CEOs and/or CFOs of all public co's, co's in a particular industry, or certain public co's).

By posting a copy of the letter on the SEC website for illustrative purposes, the SEC is able to communicate with a large number of constituents (issuers, investors, analysts and others) as to the specific or general disclosures which the Commission is encouraging companies to provide, such as by suggesting specific or general disclosures that companies "may" wish to consider. (The SEC telling you that you "may" wish to consider disclosing something is somewhat akin to a policeman telling you that you "may" wish to follow the posted speed limit.)

The Dear CFO letter posted by the SEC on Aug. 18, entitled: "Sample Letter Sent to Public Companies on MD&A Disclosure Regarding Provisions and Allowances for Loan Losses, was sent by the SEC's Division of Corp Fin to "certain public companies" in August, 2009, with the objective of "identifying a number of disclosure issues they may wish to consider in preparing Management's Discussion & Analysis." General highlights from the letter include:

• Clear and transparent disclosure about how you account for your provision and allowance for loan losses has always been critically important to an investor’s understanding of your financial statements.
• While generally accepted accounting principles regarding how to account for these items have not changed in recent years, the current economic environment may require you to reassess whether the information upon which you base your accounting decisions remains accurate, reconfirm or reevaluate your accounting for these items, and reevaluate your Management’s Discussion and Analysis disclosure.
• Item 303 of Regulation S-K requires you to discuss, in your Management’s Discussion and Analysis, any known trends, demands, commitments, events or uncertainties you reasonably expect to have a material favorable or unfavorable impact on your results of operations, liquidity, and capital resources.

Specific disclosures which the SEC suggests "you should consider" providing in MD&A - "if they are relevant and material to you" - are enumerated in some detail under the following categories in the letter:

• Higher-Risk Loans
• Changes in Practices
• Declines in Collateral Value
• Other (including risk mitigation strategies, key ratios, and certain trend reporting)

The final paragraph of the letter - signed "Sincerely, Associate Chief Accountant"- states:

"[A]lthough determining your allowance for loan losses requires you to exercise judgment, it would be inconsistent with generally accepted accounting principles if you were to delay recognizing credit losses that you can estimate based on current information and events. Where we believe a financial institution’s financial statements are inconsistent with GAAP, we will take appropriate action."

My Two Cents
(I remind you of the disclaimer on the side of this blog.) I may be trying to read too much into this, but I'm trying to figure out if that last paragraph in the Dear CFO letter is meant to:

• insure a status quo approach, which I believe many if not most people believe to be the "incurred loss" model, which many view as the approach that has received SEC's direct or indirect approval over the past decade or so, or
• send a signal that the SEC is going to allow more conservative loan loss provisions for "expected" losses - e.g. based on current projections of future events, or under certain stress test or sensitivity analysis scenarios - rather than strictly permitting provisioning aimed at "incurred" losses.

For a general discussion of pros and cons of the "incurred loss" model vs. "expected loss" model, see, the Final Report of the FASB-IASB Financial Crisis Advisory Group (FCAG), printed pg. 4 (pdf pg 11) which states:

Whatever the final outcome of the debate over fair value accounting, it is unlikely that, on balance, accounting standards led to an understatement of the value of financial assets. While the crisis may have led to some understatement of the value of mark-to-market assets, it is important to recognize that, in most countries, a majority of bank assets are still valued at historic cost using the amortized cost basis. Those assets are not marked to market and are not adjusted for market liquidity. By now it seems clear that the overall value of these assets has not been understated – but overstated. The incurred loss model for loan loss provisioning and difficulties in applying the model – in particular, identifying appropriate trigger points for loss recognition – in many instances has delayed the recognition of losses on loan portfolios. (The results of the US stress tests seem to bear this out.) Moreover, the off-balance sheet standards, and the way they were applied, may have obscured losses associated with securitizations and other complex structured products. Thus, the overall effect of the current mixed attribute model by which assets of financial institutions have been measured, coupled with the obscurity of off-balance sheet exposures, has probably been to understate the losses that were embedded in the system.

And see printed pg 7 (pdf pg 14) of the FCAG Final Report, which states:

[B]oth accounting standard setters and prudential regulators now are inclined to agree that the incurred loss model and/or its application may delay recognition of losses.

Some had viewed SEC's policy over at least the past decade or so as effectively prohibiting the booking of "expected" losses, under the theory that "expected" losses appeared to fall under the same bucket as 'cookie jar reserves' criticized in then-SEC Chairman Arthur Levitt's seminal speech in the SEC's anti-earnings management campaign - a speech entitled "The Numbers Game," delivered at NYU law school on Sept. 28, 1998. (In fact, loan losses are expressly referenced briefly under the subsection of that speech, in a section entitled "Miscellaneous Cookie Jar Reserves.")

However, analysis of the fallout from the credit crisis over the past couple of years has led some to consider whether loan loss provisioning methodology under GAAP (including the implicit if not explicit support of the SEC) should move from an incurred to an expected loss model. There is also a particular version of provisioning which has received a fair amount of attention over the past year, called 'dynamic provisioning,' which is said to offer the benefit of being counter-cyclical, by essentially putting away reserves for a rainy day, precisely what some may view as 'cookie jar reserves.'

In fact, FCAG's Recommendations 1.3 and 1.4 in its Final Report state:

1.3. In the financial instruments project, the Boards should explore alternatives to the incurred loss model for loan loss provisioning that use more forward-looking information. These alternatives include an expected loss model and a fair value model.

1.4. If the Boards pursue an expected loss model, care must be taken to avoid fostering “earnings management,” which would decrease transparency.

For related discussion, see also our blog post earlier summarizing some highlights from the U.K.'s Turner Review.

Tea Leaves, Anyone?
On the one hand, the SEC states early on in the Dear CFO letter that "GAAP regarding how to account for these items hasn't changed in recent years." On the other hand, the SEC states later in the letter that "it would be inconsistent with generally accepted accounting principles if you were to delay recognizing credit losses that you can estimate based on current information and events."

I would take the SEC at its word that in its view, GAAP in this area hasn't changed. But, is current GAAP a strict incurred loss view, or is the SEC saying there's room for interpretation under current GAAP to allow an expected loss view, as long as it is "based on current information and events."

And, look again at the FCAG report cited above, whose authors maintained that: "The incurred loss model for loan loss provisioning and difficulties in applying the model – in particular, identifying appropriate trigger points for loss recognition – in many instances has delayed the recognition of losses on loan portfolios."

Yet another possibility - although this may not be the driving force behind the last paragraph in the letter - is that the SEC may subconsciously if not consciously be laying the groundwork for FASB's upcoming proposal that would require all financial instruments - including loans - to be carried at fair value.

Still another possibility is that the SEC is signaling a willingness to move to an expected loss model for loan loss provisioning as a potential alternative to fair valuing or 'marking to market' loans - particularly in light of recent experience with challenges experienced by issuers, auditors, and others in trying to arrive at a proxy for 'market value' for illiquid financial instruments.

I invite all tea leaf readers and experts who subscribe to this blog to share their two cents (or whatever your home currency may be) in the comment section of our blog.

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