By: Lincoln McKinnon, CPA
Our purpose as external auditors is generally reduced to the definition of assuring the accuracy of the Company’s financial statements for the shareholders and general public. However, I feel the true value of any bank auditor lies in their ability to facilitate a smooth examination process, which is accomplished by addressing any tough issues with management prior to the examiners walking through the door. While my role as auditor often has me on the other side of the table with the C-suite, this role is typically reversed during the examination process. With ever increasing regularity, we are fielding questions from our financial services clients about recommendations or requests made by the regulators which appear to contradict GAAP accounting.
When dealing with recommendations from regulators, we must understand that although their mission is also to act in the best interest of the general public, their primary concern is not the financial reporting implications of such recommendations. For example, we have an active client who was informed by their regulator that the value of a foreclosed property in the OREO account should be written up to the newly appraised value. However, the appraised value of the property itself was in excess of the book value of the loan at the time of foreclosure. I’m sure many of you are aware, as was our client, that this concept is not in agreement with the lower of cost or market rules governing OREO accounting. After a brief discussion with our client, they were able to discuss the issue with the regulators and settled the matter appropriately.
An even more prevalent situation in our financial institutions centers around the Allowance for Loan Losses and what is an acceptable percentage when compared to total loans. The allowance at your bank should be based on the risks present in your portfolio and the Bank’s operating environment. However, senior management at financial institutions with Allowance-to-Loan ratios below the peer group get an uneasy feeling prior to their examination due to an unspoken notion that any significant deviations will serve as a red flag and potentially be seen as a weakness in the allowance process or management itself. The key to remember when preparing for an examination is that only one portion (FAS 114) of your ALLL is driven by the known issues in the portfolio. The remaining portion (FAS 5) is governed by such qualitative factors as geographical, economic, and personnel risks. A financial institution should never increase (or decrease) their allowance in order to match their peers. Instead, sound logic and supportable evidence must drive any decision as significant to the financial health of the institution as the estimate of loan losses. Unfortunately, the recommendations from the regulators are sometimes interpreted as such. If you as CFO/CCO feel the allowance will draw undue scrutiny from the regulators, the most practical and supportable consideration is to take a good look at the qualitative factors driving your FAS 5 “general” reserves and determine if there are any areas where minor adjustments can be made. Often times a Bank will find they have several areas where they can increase the allocation for an already stated risk, or that previously unidentified risks are present which may need to be added to the calculation. Please remember that any adjustments should be documented to maintain the integrity of the calculation itself, as this will serve as your support when discussing the allowance with your examiner. Having a total allowance with a large disconnect between what is recorded on the general ledger or call reports, and what the underlying calculation states is sure to draw the same level of scrutiny from regulators and auditors as having a supportable calculation that is below the peer group.
These are just two examples of several issues brought to our attention during the last examination cycle. As I wrap-up this article, please know that we equally value being able to serve our financial institutions in the capacity as auditor and consultant. Should you come across a situation where the information or requests from the regulatory agency does not seem to agree with your understanding of GAAP, please reach out to us. You should not make changes to your accounting methodology, without contemplating the premise of the request, solely to appease your current examiner. Remember, the examiners are knowledgeable about GAAP, but are not bound to the requirements set forth in the framework. They do serve a very worthwhile purpose, but you are still the operators of your financial institution and the financial health of your institution is your job day in and day out. This includes managing the expectations of shareholders, auditors, and regulators. All three parties are here to serve the greater good of the public, but this does not alleviate situations as discussed above from arising; which may ultimately impact the level of service you are able to provide to your customers.