New and Improved Disclosures for Credit Quality and Allowance for Credit Losses
By: Daniel St. Clair, CPA
Audit Principal

Significant disclosure changes related to “financing receivables”, previously referred to as loans and trade receivables, are on the horizon for fiscal year ends after December 15, 2011. They include increased detail related to several items:

  • Nonaccrual and past due financing receivables
  • Impaired loans
  • Credit quality and related credit risk
  • The allowance for loan and lease losses (ALLL), which is now referred to in the accounting guidance as “Allowance for Credit Losses.”

Information related to these items must now be disaggregated into “class of financing receivable” or “portfolio segment” as discussed further below.  Increased information will also be required in the “Summary of Accounting Policies and Procedures” footnote disclosure. 


Class of financing receivable: The guidance describes this as a group of financing receivables determined on the basis of all of the following:

  • Initial measurement attributes (such as amortized cost)
  • Risk characteristics
  • The entity’s method for monitoring and assessing credit risk

Early examples of disclosure requirements indicate classes should include commercial, commercial real estate, consumer, residential and financial leases.

Portfolio Segment: This is the level at which the entity develops and documents a systematic methodology to determine the allowance for credit losses.  We would expect the level of detail to correspond with the Call Report. Again, early examples indicate portfolio segments as commercial, commercial real estate, consumer, residential and financial leases. 

Correspondingly, an entity might have more than one class of financing receivables, and each class would be broken down into the portfolio segments, if applicable within the class. 

Accounting Policies

The disclosure for “Summary of Significant Accounting Policies” still requires the basis for accounting for financing receivables (also referred to as loans herein) and the method for recognizing interest income.  The statement must include the entity’s policy for treatment of related fees and costs, including the method for amortizing net deferred fees or costs.  The summary must also note the policies for a) placing a loan on nonaccrual status, b) recording payments received on nonaccrual loans, c) resuming accrual of interest, d) charging off uncollectible loans and e) determining past due or delinquency status.  Furthermore, there are additional requirements relating to accounting policies for credit losses and doubtful accounts.  While organizations must continue to disclose the methodology used to estimate their allowance for loan losses, the new accounting guidance indicates this description should identify risk characteristics and other factors that influenced management’s judgment. Examples include historical losses and existing economic conditions, and include risk elements relevant to particular categories of financial instruments. 

Nonaccrual and Past Due Loans

The accounting guidance now requires providing this information by class of financing receivable and should include an analysis of the time period that the investment is past due. The tabular disclosure would include columns for 30-59 days past due, 60-89 days past due, greater than 90 days past due, and a summary column for total past due.  A column for items greater than 90 days past due and still accruing interest is also required. 

Impaired Loans

This information must also be provided by class of financing receivable and must be separated into two groups, one with a related allowance for credit losses and the other with no related allowance for credit losses. The details should include a) recorded investment, b) unpaid principal balance and c) related allowance, if any. 

Credit Quality and Credit Risk

Qualitative and quantitative information is required by class of financing receivable.  This should include a description of the credit quality indicator used to monitor credit quality.  For each such credit quality indicator, the date or range of dates when the information was updated must be disclosed.  For internal risk ratings used as a credit quality indicator, a description of how the internal rating relates to the likelihood of loss.  Risk ratings generally used include pass, special mention and substandard.  A description of how these ratings are used, as well as the likelihood of loss, should be included. 

Allowance for Credit Losses

The allowance for credit losses and related activity may have the most significant changes, and will now need to be disclosed by portfolio segment and in total. Therefore, the Bank will need to track all elements, including provision, charge-offs and recoveries, by portfolio segment in order to properly document the roll-forward from beginning balance to ending balance.  Additionally, this section of the disclosure requires the disaggregated amount of the balance for credit losses for the end of the period, and the recorded investment in financing receivables related to each balance. Amounts relating to a) loss contingencies collectively evaluated for impairment b) individually evaluated for impairment and c) acquired loans having deteriorated credit quality should be shown separately. 

As you can see, the disclosures related to loans and credit quality have become much broader and deeper than previously required.  For non-public entities, this guidance is effective for fiscal years ending after December 15, 2011.  However, banks should proactively evaluate the processes necessary to properly collect and disclose the detailed activity prior to December 31, 2010.


Consumer Compliance Impacts of the Dodd-Frank Wall Street Reform and Consumer Protection Act
By: Randy Carey
Professional Consultant

While the impact of the consumer compliance amendments contained within the Dodd-Frank Wall Street Reform and Consumer Protection Act will not be known until the actual regulations are promulgated, financial institutions should be prepared for some major changes. While there will most likely be substantial lead time for many of these changes, implementation is projected to be costly.  Staff training and a revamp of disclosure software and processing systems will be required.  A brief recap of some of the major changes to look forward to is as follows:

  • Expedited Funds Availability Act – Requires that next-day availability of deposits be raised to $200 from $100 and that this amount be updated every five years based on the Consumer Price Index.


  • Fair Credit Reporting Act – Issues new regulations establishing guidelines for furnishing information to a consumer reporting agency regarding the accuracy and integrity of the information relating to consumers and requiring establishment of reasonable policies and procedures by financial institutions for implementing the guidelines.


  • Fair Credit Reporting Act – Expands to all consumer loan applications (currently only applies to transactions secured by 1-4 family dwellings) the disclosure of credit scores and key factors that adversely affected the      credit score of the consumer.


  • Home Mortgage Disclosure Act – Adds additional information gathering including: age of applicants, total points and fees, the rate spread on all loans, terms of any prepayment penalty, value of pledged property, term of any introductory interest rate, presence of negative amortization, the loan term, how the application was received (retail, broker, etc.), loan originator’s SAFE License number, a universal loan identification number, the parcel number of the property pledged, and the credit score of the applicants.  


  • Truth-in-Lending Act and the Real Estate Settlement Procedures Act – Develops a single, integrated disclosure for mortgage loan transactions (including real estate settlement cost statements) in conjunction with the disclosure requirements of the Truth in Lending Act that, taken together, may apply to a transaction that is subject to both or either provisions of law. The purpose of such model disclosure shall be to facilitate compliance with the disclosure requirements by utilizing readily understandable language to simplify the technical nature of the disclosures.


  • Truth-in-Lending Act –
    • Increases the coverage of the Truth-in-Lending Act (excluding real estate secured or private education loans, which currently have no dollar threshold limitation) to $50,000 and requires this amount to be updated annually based on the Consumer Price Index.
    • Expands required income and debt verification to all mortgage loans (currently limited to higher priced mortgage loans).
    • Establishes a requirement to send monthly statements on all mortgage loans.
    • Expands High-Cost Mortgage regulations to include Home Equity Lines of Credit, which are currently exempt.

Additionally, there are also numerous studies that are ordered within the new legislation with the subsequent outcome being additional new regulations.  Regardless, we can expect a very busy consumer compliance arena over the next several years.


FDIC- Assisted Transactions
Q&A with Frank Hall, CFO of First Financial Bancorp
By: Sally Luber, CPA, CIE, CFE
Business Advisory Services Manager

In response to our clients’ inquiries regarding FDIC-assisted transactions, we decided to speak with someone who has extensive first-hand knowledge of the process.  Frank Hall is the CFO of First Financial Bancorp. In the year 2009, there was significant growth and positive change for the Bank.  In less than 3 months, First Financial completed several significant transactions and doubled the size of the bank: 

  • June – purchased $145 mm in select performing loans from Irwin Bank
  • July – purchased 19 banking centers, $521 mm in deposits and $336 mm in loans from Peoples in FDIC-assisted transaction
  • August – purchased 3 banking centers, $85 mm in deposits and $41 mm in select performing loans from Irwin Bank
  • September – purchased 27 banking centers, $2.5 B in deposits and $1.8 B in loans from Irwin in FDIC-assisted transaction

For more information on the transactions, readers are encouraged to read the presentations found on the Investor Relations section of the First Financial website (

I was able to talk with Mr. Hall about his experiences with the FDIC. Below are excerpts from our conversation: 

Was the decision to acquire the two institutions part of the strategic plans of the bank? (Growth through acquisitions) Or did FFBC plan to grow organically?  

First Financial has had a formal acquisition strategy in place for the past 5 years.  As part of this strategy, we have defined the internal criteria used for analyzing a transaction.  In summary, we answer three key questions for each possible transaction: 

1. Is it strategic?

2. Can we manage the operational risk?

3. Is it financially compelling?

For both the People’s and Irwin transactions, the overall structure made them more financially compelling than de novo branches as they added market penetration that would have taken years to build.  

What was your “Day One” focus? What were the long-term priorities?Initially our main focus was to address the human resource and staffing issues, specifically with the acquired organizations.  These events are definitely emotionally challenging, so we wanted to make sure that employees were handled with respect. After the “people” component, we wanted to ensure a quick, smooth transition, making sure we took care of customer needs.  It was also important to change over all of the signage as soon as possible.   At that point, we could focus on the back office and integrating different products, processes and systems.  We knew that it was important to develop an integration path that was fast, while at the same time making sure that at the end of the process, we had an organization that still looked like First Financial.

 What surprised you the most about the process?

The FDIC was remarkably well-prepared and professional. Although it was hectic, the activities associated with the closing weekend were remarkably well-coordinated.  It was obvious throughout the process that they had developed a structured approach for each transaction.

What do you wish you would have known ahead of time?Honestly, going into the transactions, we had identified what the uncertainties were going to be. In essence, we “knew what we didn’t know.”  However, we were surprised at the collective lack of experience on the part of the professional services firms, specifically as it related to applying the current accounting rules for business combinations.  

What were the biggest challenges you and your team faced?

The financial reporting component and communicating this information to the market has definitely been the most challenging aspect of the transactions.  The new accounting rules are extremely complex and create noise in an organization’s numbers.  This has led to even more complexity in comparing seemingly comparable institutions. In addition, regulators have just recently formalized their views with regards to bargain purchase gains.  Overall, both the industry and the regulatory agencies are still in a learning phase.  

 In your opinion, what will 2010 be like for the banking industry with regards to M&A activity and bank closures?

I think the number of closures will be about the same as what we’ve seen over the past year, but the sum total assets will be lower.  Closures will involve the smaller institutions where it’s much harder to find an interested buyer.  The FDIC seems to have become more creative and patient when dealing with institutions, which is ultimately a good thing for the industry.

 Can you say anything about FFBC’s plans for the future?

 We are always looking for growth opportunities – organic and otherwise.

J. Franklin Hall
Executive Vice President
 Chief Financial Officer

 Mr. Hall joined First Financial in 1999 and was appointed to his current position in 2005.  Prior to joining the Company, he was with Firstar Bank (currently US Bancorp).  He is a Certified Public Accountant (inactive) and began his career with the public accounting firm Ernst & Young, LLP.

About First Financial Bancorp

First Financial Bancorp is a Cincinnati, Ohio based bank holding company. As of June 30, 2010, the Company had $6.6 billion in assets, $4.4 billion in loans, $5.2 billion in deposits and $707 million in shareholders’ equity. The Company’s subsidiary, First Financial Bank, N.A., founded in 1863, provides banking and financial services products through its three lines of business: Commercial, Retail and Wealth Resource Group. 

The Commercial and Retail units provide traditional banking services to business and consumer clients and the Wealth Resource Group provides financial planning, investment management, trust & estate, brokerage, insurance and retirement plan services and had approximately $2.2 billion in assets under management as of June 30, 2010. The Company’s strategic operating markets are located in Ohio, Indiana, Kentucky and Michigan where it operates 113 banking centers across 75 communities.


Documentation is Key
By: Daniel St. Clair, CPA
Audit Principal

Over the past few years it has become more evident that the regulatory agencies expect good, strong documentation and that issues not properly documented have not been adequately evaluated by management.  While this is most important in the area of credit quality and the allowance for credit risks, other areas requiring good documentation include the reporting of loan fees, evaluation of unrealized losses on securities and deferred tax assets. 

Since we noted the most significant area is on credit quality and the allowance for credit risks, we will start the discussion there.  By now, most banks have established a fairly detailed allowance methodology as required, which includes both quantitative and qualitative parameters.  Most have even included economic risks, geographic risks and other market risks directly affecting their financial institution.  The problem is that for many, once a good methodology has been established, the detailed documentation stops.  The allowance methodology should be discussed in detail at least quarterly and include all risk elements considered.  Are risk characteristics increasing or decreasing?  Are there new economic or market risks present which need to be included?  Like never before, this should be a living document that is ever-changing based on the risk elements within. 

Asset quality has come under fire the past two years at alarming rates.  What has the bank done to properly protect its capital from potential losses?  Not having proper documentation to support a credit, including recent financial statements as required by the loan agreement, is enough to have the credit downgraded to substandard during a regulatory exam.  Therefore, we recommend establishing a more aggressive documentation standard, including a “loan diary” for all significant credits.  This documentation should include the risk characteristics of the loan, the borrower’s ability to repay and the underlying collateral’s ability to sustain the loan if the borrower is unable to repay (establishing a backdoor or exit strategy).  This loan diary can be updated whenever needed, but a least annually, to note issues related to loan quality.  If the loan is on “watch” or having past due issues, the diary should be updated quarterly or monthly to document the state of the loan and management’s active oversight of the credit.  It is much easier to substantiate your internal credit rating for the loan with clear and up-to-date documentation. 

The diary system is also recommended for any other real estate owned (ORE).  If the loan diary is already in place, it is a simple update to document the conversion to ORE and include any impairments, write-downs or additional costs incurred due to the change in classification. This will help management better document the exit strategy for the asset and provide clear support for the estimates used for valuation purposes. 

The area of amortizing and recording loan fees has been somewhat under the radar for a while, but appears to be getting more attention during regulatory exams lately. While most banks understand they technically should amortize these over the life of the loan, it has often been considered to be an insignificant issue and the net amount would be immaterial for reporting.  Otherwise, banks will establish a policy whereby the first few thousand dollars are taken into income, to offset the estimated direct origination costs, and any amounts over the established threshold are then amortized over the life.  While this shortcut method works well in practice and has been widely used for years, it is technically incorrect.  The real problem is that this creates an assumption that all loans cost the same amount to originate.  ASC 310-20-30-2 states “Loan origination fees and related direct loan origination costs for a given loan shall be offset and only the net amount shall be deferred.”  We recommend the bank clearly document the estimated costs for loan originations by portfolio segment, and if significant, tiered by size.  This will better establish a base for calculating net fee income to be amortized on a loan by loan basis as required.  In this case, the best defense appears to be a good offense, and again, proper documentation is the key. 

The last area of note relates to deferred tax assets (DTA), especially if the bank is still new and has no history of income to utilize accumulated tax losses.  We have seen the FDIC disallow the entire balance of DTA because the bank has not established the ability to utilize the net operating losses from a tax standpoint.  It should be noted that all banks will have a deferred tax asset due to the tax treatment required for the allowance for credit risks. This is considered a temporary timing difference where the expense is reported for book purposes before being deductible for tax purposes.  Having clear documentation of what elements make up the DTA can help support the reporting of these items.  However, for banks that have not yet shown taxable income during any reporting period, we recommend a full valuation allowance on all deferred tax assets, not just the net operating losses, until such time as the bank can establish the ability to utilize the DTA in future periods.  Contact your CPA for further guidance related to documenting these, and other, accounting issues.


Concerns Continue with CRE Asset Quality
By: Bill Findlay
Senior Loan Review Specialist


Commercial Real Estate (CRE) remains a primary concern for examiners, given the historical rapid growth of these exposures and banks’ significant concentrations relative to their capital. Examiners most often cited the distressed real estate market and poor product performance as the reason for the tightening of underwriting standards. In an August 2010 report, examiners indicated that compared to the previous survey year, overall CRE credit risk increased at 92% of financial institutions. Driving the assessment of increased credit risk were external conditions, downward trends in collateral values, weakening debt service capacity and both current and expected levels of problem loans.  

The commercial real estate market is driven largely by employment. With high unemployment, CRE continues to face tough times. Experts predict that four property types – apartment, retail, office and warehouse – are going to have record-high vacancies. Declining retail sales figures in department and specialty stores are causing more vacancies and making the retail market the hardest-hit CRE sector. With the bankruptcy of larger anchor tenant stores such as Mervyns and Circuit City, remaining tenants within or near some shopping centers are seeing significant negative effects. Consequently, the surviving retailers are pressuring landlords for lower rent and lease expense. Vacancies are expected to increase while rents are expected to decrease for retail centers and “strip malls” through 2011. 

The top five markets in the U.S with excess retail space include Austin and San Antonio. However, there is good news for Texas – Houston, Dallas/Fort Worth, San Antonio and Austin are among the markets experiencing a more stable job market when compared to the rest of the country. This should help to lessen the negative impact on CRE properties in much of Texas. 

Shopping centers are not the only areas suffering in the current economic climate. Rising unemployment is causing a slump in the office and warehouse markets. Office vacancies will be at an all time high of 21% by the beginning of 2011. Net operating income is expected to decline most steeply in the coastal metro areas. Additionally, record-high vacancy rates in apartments are being caused by job losses and the oversupply of apartment units. This has been further exacerbated by the number of condo units being converted to rentals due to slow sales.  

Still another area of concern is in the Hotel/Motel Market. The revenue per available room (RevPAR) continues to decline. The falling room rates along with declining occupancies will cause the decline to continue through 2010. This will have implications on the ability of the owners to make mortgage payments.  Consequently, a significant number of hotel properties could become distressed during this downturn. 

Despite all of the negative news, there are certain safeguards that can be helpful both in protecting the CRE asset quality of your bank and during a regulatory exam. These items include: 

  • Being proactive in recognizing and identifying problems in the CRE portfolio and being aggressive in dealing with those problems by developing realistic workout plans.
  • Ensuring compliance with the nonaccrual policy on all problem loans.
  • Establishing a policy on the use of interest reserves and documenting the proper use.
  • Establishing and implementing a policy on the re-appraisal of collateral in a declining market and maintaining current values on problem properties for troubled borrowers.
  • Evaluating the adequacy of cash flow analysis on the repayment sources to ensure their accuracy and completeness.
  • Ensuring all loans are properly identified with the bank’s risk rating system and are included in the ALLL.

Implementing these best practices can go a long way with helping your financial institution’s asset quality and easing regulator concerns.

Fighting Fraud
By: Rebecca O’Malley, CPA
Senior Auditor

When we think of bank theft, most of us imagine an attention-grabbing headline about a person robbing a bank branch.  However, that is only one way to steal money from a bank.  Today’s reliance on information technology, coupled with the pressures of the recession, have contributed to the unprecedented growth in external frauds involving a range of individuals from industry professionals to organized crime groups with elaborate fraud schemes.  During the 1980’s and 1990’s, approximately 60% of the frauds reported by financial institutions were related to bank insiders.  Since that time, however, external fraud schemes have become one of the largest challenges faced by financial institutions today.  

The growth of such fraud schemes is the result of the pervasive nature of check fraud, counterfeit negotiable instruments, mortgage fraud, and the availability of personal information.  According to the Federal Bureau of Investigation (FBI), white collar crime is estimated to cost the United States more than $300 billion annually. 

For the period of April 1996 through September 2007, the FBI received over 846,000 Suspicious Activity Reports (SARs) for criminal activities related to check fraud, check kiting, counterfeit checks and negotiable instruments, and mortgage loan fraud. These frauds accounted for over $21.4 billion dollars in losses, as reported by the FBI and compiled from the SAR database maintained by the U.S. Treasury. 

These suspicious activities exclude robberies of financial institutions, which in addition to the $300 billion in annual white collar crimes, accounted for $45 million in 2009 and $62 million in 2008.  As the instances of financial institution fraud are increasing over the years, so too is the cost of insurance. By having a strong fraud prevention strategy, costs associated both with insurance and with fraud itself can be significantly reduced. So what can be done to mitigate the risks of being subject to a fraud scheme? 

Internal controls are only effective if properly designed and implemented.  Therefore, they should be designed with fraud schemes in mind.  Accountants and fraud specialists are a valuable resource for designing and testing the internal control systems and assessing the areas with greater risks of fraud in the control environment. 

Education and Training, both upon hiring and throughout a person’s career, are important for the prevention and detection of fraud schemes.  Orientation and training programs should be designed to educate employees on both common and emerging fraud schemes.  The FBI, the U.S. Treasury and other Federal organizations have published resources specifically designed for financial institution professionals to aid in identifying fraud trends, designing fraud prevention programs, and effectively implementing procedures to prevent and detect fraud. 

Specialists that are trained in designing controls to prevent and detect fraud, educate employees on fraud and investigate suspected frauds are one of the greatest resources a financial institution can utilize.  Having a strong fraud awareness, prevention and detection system can minimize the risks associated with one of the largest challenges faced by financial institutions today.  

Lastly, financial institutions should perform a Self-Assessment to determine where they stand in the fight against fraud.  

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