ACUIAMay 16, 2011
Risky Business: Risk Assessment at the Audit Level
Bryan W. Mogensen, CPA, Partner
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About Clifton Gunderson
• One of the nation’s largest certified public accounting firms
• Founded in 1960• More than 1,900 professionals
serving clients from 46 offices across the country
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Credit Union Expertise
• Nationwide leader in providing auditing, consulting, tax, and valuation services for credit unions.
• Fifty-year track recorded of client success.
• Depth of experience – Credit Union clients range in asset size from $10 million to more than $20 billion.
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Our Presenter
• Bryan has more than 15 years experience auditing credit unions and he has undertaken considerable continuing education related to these areas.
• In addition, he has experience in auditing credit unions and credit union related organizations, community banks, not-for-profit organizations and other small business’.
• On these engagements he is responsible for planning, supervising the audit staff, reviewing the work performed, and attending client and exit conferences.
• He also makes several presentations and attends various national credit union conferences and League annual meetings throughout the year.
Bryan W. Mogensen, CPA, Assurance Partner
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Agenda
• Why are some credit unions in trouble today?– What were the common themes– What to expect from examiners going forward
• Enterprise Risk Assessment – the process • Enterprise Risk Assessment at the
Individual Audit Level, including:– Loan review– Regulatory compliance– Internal audit– IT security matters– Industry– Recent Accounting Matters
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Why are some credit unions in trouble?
• Some common themes we have experienced:– Trends seem to be fairly consistent for many
troubled credit unions:• Concentration in other commercial real estate and
acquisition, development and construction loans• Concentration in indirect auto lending with high loan
to values (i.e. in excess of 125% upon issuance)• Concentration in residential real estate lending in
areas that experienced large increases then decreases in values coupled with economy
• Many experienced a period of tremendous growth fueled with non-core funding sources
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• Weak lending and credit administration practices regarding MBLs:– High level of technical exceptions in
commercial and CRE portfolios– Policy exceptions – policies were adequate they
just didn’t follow them – overrides mainly for growth
– Lack of adequate documented site inspections
Why are some credit unions in trouble?
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– Weak credit administration practices• Inadequate appraisals:
– Use of “as completed” vs “as is” appraisals • Inadequate analysis of borrower cash flows including
failure to properly calculate global debt service ratios– Placed too much reliance on net worth of guarantors– Net worth doesn’t make loan payments, cash does!
– Poorly designed incentive compensation systems.
Why are some credit unions in trouble?
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• Weak lending and credit administration practices regarding auto or real estate lending:– Policy exceptions – policies were adequate they
just didn’t follow them – overrides mainly for growth
– Lack of or not following concentrations of portfolios based on net worth or loan portfolio
– Significant reliance on members ability to pay and/or collateral• Economy, gas prices, too much reliance on overtime
pay• Collateral value declines well beyond expectations
– Poorly designed incentive compensation systems.
Why are some credit unions in trouble?
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– Board failed to provide adequate oversight to institution
– Ineffective risk management programs:• Loan review function failed to identify
deficiencies in the institution’s underwriting policies and procedures and individual credits until it was too late
– Inadequate asset liability/concentration policies and procedures
Why are some credit unions in trouble?
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– Institutions failed to prepare allowance for loan losses calculation in accordance with GAAP and regulatory guidelines
Why are some credit unions in trouble?
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What to Expect From Examiners Going Forward
• Expect examiners to be more critical!– Loans acquired through participation:
• Need to perform your own independent site inspection and analysis of borrower / guarantor cash flows
• Need to verify major assets and liabilities of guarantors
– Asset liability policy must include or require:• Monthly preparation of cash flow projections
analyzing inflows and outflows of cash at various intervals (suggest looking at 30, 60, 90 and 180 time periods)
– Projections should also include schedule of contingent funding sources (available balances under lines of credit, FHLB Advances, and federal funds).
• Quarterly preparation of sensitivity analysis on cash flow projections
– Look at four to five scenarios ranging from best to worst case
• Contingency funding plan with information on what triggers liquidity problems
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What to Expect From Examiners Going Forward
– Need to provide segmentation information on any concentration in your loan portfolio (> 250% to 300% of the credit union’s total net worth): • For example, assume you have a concentration in
CRE loans:– Break out total of loans first by collateral type (i.e.
apartment complex, office building owner occupied, office building held for rental property, etc.) and then by loan to value ratio or seasoning of the loans
– You may need 2 to 3 subcategories for each collateral type
– Will require more capital if you have concentration in CRE loans above 250% to 300% of net worth:• Meeting the definition for a well capitalized credit
union may not be sufficient in the future
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What to Expect From Examiners Going Forward
– Regulators focused on loans modified because the member is having financial difficulties (troubled debt restructuring or TDRs)• Need to calculate the net present value of future cash
flows• Need to consider re-default risk in FAS #5
calculations• If TDR becomes re-delinquent need to evaluate based
on collateral value
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What to Expect From Examiners Going Forward
• Examiners have received a lot of criticism for not taking stringent enough action after identifying weaknesses.– Repeat violations, if significant, will almost
certainly lead to a 3 or 4 management rating– Expect more DOR, LUA, Orders to be issued
• NCUA may take preemptive action even if your credit union has enough capital to be considered “adequately capitalized”
• NCUA has also required net worth ratio to be higher than 7% (i.e. 8%) if deemed higher risk
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What to Expect From Examiners Going Forward
– Also expect examiners to require credit unions who receive a 3 or 4 management rating be required to:• Prepare a formal assessment of the number of,
compensation paid to, and qualifications of the institution’s management team and/ or executive officers
• The examiners have assessed monetary penalties against the board of director members of failed banks– In one bank, each board member was
assessed a penalty equal to 20 percent of their calculated net worth
– Haven’t seen this in credit unions yet but it could happen?
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What to Expect From Examiners Going Forward
• More closely, looking at the independence and quality of your risk management programs– They expect the board of directors to be very
involved in this process• Credit Unions falling under the Prompt
Corrective Action (PCA) regulations will be more closely monitored
• Plan should include detailed action items addressing how you will shrink the credit union, reduce overhead, improve net interest margins and improve risk management functions going forward
• Too many credit unions waste time fighting examiners vs. working with them to go forward
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Enterprise Risk Management
• Comprehensive analysis of the risk profile of a Credit Union– Should include a narrative explaining how
transactions are processed; who does it, what approvals are needed, what controls are in place, etc.
– An analysis of the risks or the “what could go wrong” question
– Description of the internal audit procedures to be applied to monitor and evaluate the significant internal controls
– Evaluation of the risks of the area and assignment of an overall risk rating to the area, which in turn is used to determine the frequency of testing to be applied to the area
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Business Risk Assessment Summary
Risk Rating
H=High65-100
M=Mod35-64
L = Low<35
Risk Factors >>> Stra
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Lines of Business
Investment Securitites Mod Low Mod Low Low Low High Mod Mod Low Mod
Lending High Low High Mod Mod Mod Mod Mod Mod Mod High
Other Financial Services - insurance and brokerage Mod Mod Mod Mod High Low Mod Mod Mod Low Mod
Branch, Teller and Customer Service Operations Mod Low Mod Mod High Low Mod Mod Low Mod Mod
Business Support Functions
Accounting and Financial Reporting Low Mod High Low Mod Low High Mod Mod Mod Mod
ACH & Wire Transfers Low Mod High Low Low Mod Mod Low Low Mod Mod
ATM & Debit Card Operations Low Mod Low Low Mod Low Mod Mod Low Mod Low
Deposit Operations Low Low Mod Low Mod Low Mod Low Low Low Low
Human Resources Low Low Mod Mod High Low Mod Low Low Low Mod
Information Technology Security Matters Mod Mod Mod Mod Mod Mod Mod Low Mod Low Mod
Item Processing Low Mod Mod Low Low Low Mod Mod Mod Mod Mod
Asset Liability Management High Low Mod Low Low Mod Mod Low Mod Low Mod
Loan Operations Low Low Mod Mod Mod Low Mod Mod Mod Mod Mod
Safe Deposit Boxes, Money Orders, Travelers Checks and Other Products & Services
Low Low Low Low Mod Mod Mod Low Mod Mod Mod
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Three Year Internal Audit Plan
Description Overall Risk Assessment
2010 2011 2012
Accounting and Financial Reporting Moderate X X ACH and Wire Transfers Moderate (1) X X Other Financial Services including insurance and brokerage
Moderate X X
ATM and Debit Card Operations Low X Investment Securities Moderate X X Branch, Teller and CSR Operations Moderate (2) X X X Deposit Operations Low X Lending High X X X Lending Operations Moderate X Safe Deposit Boxes, Money Orders, Traveler Checks, and Other Products and Services
Low X
Human Resources Moderate X X Information Technology Security Matters Moderate (3) X X X Item Processing Moderate X Asset Liability Management Moderate X X Marketing Low X Regulatory Compliance Matters Moderate (4) X X X
1) As required for the credit union to continue to offer ACH services, the ACH procedures set forth by the National Automated Clearing House Association will be performed on an annual basis.
2) The main location of the credit union will be tested every other year while at least two other branch locations will be subject to testing on an annual basis. During the three year cycle all branch locations should be subject to testing at least once.
3) To comply with industry best practices and comply with Federal Financial Institution Examination Council recommendations a general controls review and intrusion test on the credit union’s Internet connection will be performed on an annual basis and a network penetration test once every three years or any time there is a major change in the credit union’s local area network configuration.
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Effective Loan Review Program
• Loan review function must be independent of the lending function:– Loan review staff should not report to the
senior lending officer if this individual is also responsible for managing a portfolio of their own (i.e. loan quality control)
– Most credit unions have loan review staff report to the board, supervisory/audit committee, internal auditor, and/or the credit union’s chief lending officer or president
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Effective Loan Review Program
• Select a sample of loans to determine whether:– Sample should be in proportion to number and
balance of loans granted along with related risk• Annually should review at least 35% to 50% of the
total dollar amount of higher risk commercial and CRE loans
• Annually should review a sample of consumer loans (i.e. 50 to 100 loans)
– The related loan files contain the documentation required by credit union policy
– The loan documentation and note comply with credit union laws and regulations
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Effective Loan Review Program
– The loan is being administrated in accordance with the credit union’s loan policy and standard industry practices, for example:• Loans granted do not exceed policy concentrations• Site inspections and review of personal tax
returns/financial statements are performed on an annual basis as required by credit union policy for MBLs
– The risk rating assigned to the relationship is appropriate (MBL)• The review of consumer loans is focused on whether
the documentation in the loan file and the terms of the loan comply with the credit union’s loan policy.
– If evident, determine if the credit union’s underwriting policies and procedures are appropriate for risk
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Indirect Lending
• Risks– Controls over auto system approvals
• Are parameters set too low and allow for ease of approvals by unqualified borrowers
• Income verification requirements• No or limited credit score data
– Controls over override controls• What is percentage of booked loans approved
by management• Is management approving all/most initial loan
cautions/denials – growth goals• Do you require dual approvals
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Indirect Lending
• Risks– Concentrations
• With one/few dealers – kick-backs?• Approvals by one/few employees (over-rides)
– Qualifications for membership• Do these people qualify as members
– 100%+ financing and impact on equity• Do policies set limits for exposure on equity or
percentage of loans/assets
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Indirect Lending• Impact on audit plan
– Do not test just for compliance with policies and procedures
– Concentrate on system or override flaws– Review charge-off/repossession files
• Evidence of power-booking– Are all items on invoice actually on auto
• Evidence of stated income over-statement– Test for compliance for:
• Concentrations• Qualifications• Exposures
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Member Business Loans
Fundamentals are similar to other types of lending but:–More difficult financial analysis–More documentation is required–Higher risks to lender–Higher rewards to lender –Significant regulatory requirements
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Member Business Loans
What Makes Business/Commercial Lending Different?– Underwriting/Loan officer knowledge
• The business is the applicant• The loan officer must understand the business
– Understanding source of repayment– Trend analysis, cash-flow projections, etc– Credit Risk much greater– Documentation requirements vastly
different– Follow-up and tracking– Regulations– Marketing
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Member Business Loans
Is management monitoring the business lending program adequately? Key considerations: – Is the monitoring of the business lending
program formalized?• Written policy/procedures for performing the
oversight of the business lending program– Do the employees assigned to the
business lending program meet NCUA requirements with regard to skill and knowledge?
– What business lending reports are being monitored and by whom?
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Member Business Loans
Key considerations: – Has a “watch list” process been
established?• Is it a formalized watch list program? • How were the watch list criteria determined?• Who is performing and who is monitoring and
challenging– Ongoing review and analysis of the
financial condition of the businesses for business loans• How is this being monitored?
– Audit work papers: Do they cover all pertinent audit criteria? (NCUA Examiners Guide)
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Loan Participations
• Most loan participations are business loans
• Management should be monitoring these loans in similar fashion as their own business loans
• Many do not monitor as they should
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Loan Participations
• Risks–Same risks typically like business
loans–Must monitor and document same
as business loans• Watch list
– Do not rely just on servicer as must do own independent analysis
• Financial analysis– Either do internally or evaluate servicers
analysis
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Allowance For Loan Losses Calculation
• The credit union’s methodology for calculating the allowance for loan losses is in accordance with GAAP, is appropriate, considers all required elements, and follows policies and procedures
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Allowance For Loan Losses Calculation
• We normally expect to see FAS 5 reserves for:– CRE loans - 1% to 3%– Residential RE loans – 0.5 to 2%– Adjust upwards or downwards (i.e. +/– 50 basis
points) for economic trends:• Quality of underwriting standards• Experience of lending staff• Local economic and real estate market conditions• Local unemployment• Etc
– Indirect auto loan portfolio to have higher loss ratio than direct auto programs
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Allowance For Loan Losses Calculation
• For FAS 114 reserves we expect to see:– Specific reserves for all MBLs rated at
substandard or below– Residential RE loans specifically identified
• Delinquent• Modified• Those where LTV significantly above 100% and
borrowers credit score significantly dropped– Troubled debt restructured loans (TDRs)
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ALLL
• Fundamental computation issues–Timeliness of loan charge-offs–Additional segmentation may be
needed–Need for consideration and
documentation of Q&E factors–Reserving for TDRs–Business loan risk rating
downgrades
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Recent Issues w/ALLL
• Consumer loans–Still using short-term historical loss
rate• i.e. 12 months is standard• Consideration for some to go to 6 or 9
month based on recent trends– Be cautious
–No economic factor(s) addressed with rising loan delinquencies and/or charge-offs• Should have this documented to show
why you have or do not have present
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Recent Issues w/ALLL
• Real estate loans–Examiners want to see maximum
exposure in your portfolio• However cannot allow for all of this
exposure–Consider identifying where risk is in
portfolio and providing for those with high risk (i.e. LTV > 125%, current credit score declines by 100 or more, etc)
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Recent Issues w/ALLL
• Member business loans–No general reserves for performing
portfolio• Banks generally have 2-5%
– Inappropriate risk ratings• Expectation are to downgrade faster• Evaluate global debt service ratio• Evaluate expiring and remaining lease
terms/vacancy• Annual inspections
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Recent Issues w/ALLL
• Don’t forgot to prepare separate calculation for troubled debt restructured (TDR) loans:– Applies to all loans modified because the
borrower is experiencing financial hardship versus loans modified for competitive reasons
– Prepare a calculation of the net present value of the future cash flows due on the loans discounted using the loans original interest rate• Compare this net present value calculated amount to
the current unpaid balance of the loan to determine whether a TDR adjustment is needed
• Need to also apply an additional reserve to these TDR loans to account for risk that the borrower will default on the modified loan in the future
– Most common missed element of the allowance for loan losses calculation
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Troubled Debt Restructurings (TDR)
• In April 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-02, Receivables (Topic 310): A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring
• The ASU is effective for nonpublic entities, (including credit unions) for annual periods ending on or after December 15, 2012, and should be applied retrospectively to the beginning of the annual period of adoption
• The ASU was issued to help clarify what constitutes a concession and financial difficulty, in determining whether a restructuring is considered to be a Troubled Debt Restructuring (TDR)
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Troubled Debt Restructurings (TDR)
• Clarification of Concessions:• Indicators that CU granted
concession:–Borrower does not otherwise have
access to funds at a market rate for debt with similar risk characteristics as the restructured debt
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Troubled Debt Restructurings (TDR)
–More than insignificant payment delays, insignificant payment delays that do not constitute a TDR:• Amount of the restructured payments
subject to the delay is insignificant relative to the unpaid principal or collateral value of the debt and will result in an insignificant shortfall in the contractual amount due
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Troubled Debt Restructurings (TDR)
• Delay of restructured payment period is insignificant relative to any one of the following:
– Frequency of payments due under the debt– Debt's original contractual maturity– Debt's original expected duration
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Troubled Debt Restructurings (TDR)
• Clarification of Financial Difficulty:• Indications of borrower financial difficulty:
– Borrower may have financial difficulty even though not currently in payment default with the CU
– Borrower is currently delinquent on any of its debt (with or outside of the CU)
– Borrower has declared/declaring bankruptcy– Substantial doubt as to whether the borrower
will continue to be a going concern (MBL)– CU forecasts cash flows will be insufficient to
service existing debt for foreseeable future
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Troubled Debt Restructurings (TDR)
– Without modification, borrower cannot obtain funds from other sources at the same rate as a non-troubled borrower
• ASU also clarifies that a CU can no longer use the effective interest rate test as defined in Accounting Standards Codification (ASC) 470-60-55-10 in determining whether a restructuring constitutes a TDR
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Troubled Debt Restructurings (TDR)
• All loans that are part of a TDR are considered “impaired loans”– It is probable that the CU will be unable
to collect all principal and interest payments as scheduled in the original contractual terms
• Therefore to be allowed for under FAS 114
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Troubled Debt Restructurings (TDR)
• Regulatory Reporting on TDR– Delinquency on TDRs will normally be
reported on the Call Report consistent with the original loan contract terms
– Return the restructured debt to full payment status after 6-month period of demonstrated ability to repay consistent with the restructured terms
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Troubled Debt Restructurings (TDR)
• Risks– Lending and accounting do not talk
therefore could have many TDRs not identified
– TDRs not reserved for properly• Reserve for difference between cash flows
based on discounted present value of original vs modified terms
• Additional reserves for re-default• Collateral based loans reserve for difference
between estimated value of collateral less costs to sell compared to the loan balance
– Not reported properly as delinquent loans
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Regulatory Compliance Matters
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Compliance Hot Topics
• Fair and Accurate Credit Transactions Act (FACTA) – Red Flag Rules
• Credit Card Act Changes• Reg E – Opt-In Rules for Overdrafts• Courtesy Pay Programs• Reg Z - Open End Lending Rules• BSA/OFAC/AML• Secondary Mortgagee HUD Audit
Requirements
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Thoughts on Internal Audit
• Ensure that tickler system is used to track resolution of findings and recommendations:– Did management implement the
recommendations by the dates they committed to?
– The board of directors should review all reports issued by internal audit and the tickler report (at least quarterly for the tickler report)
– Ensure that your internal auditor is looking at both the design of the control is adequate and whether the control in place is operating as intended• Is there an alternative control which would be more
effective (more likely to detect the error) or more efficient (less costly)
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Thoughts on Internal Audit
– Internal audit should also periodically perform studies to look for profit improvement opportunities for the institution (i.e. staffing levels, the process used to price products and services, and performing a comparison of the credit union’s interest rates and fees to its competitors and peer group)• Effective internal audit programs can and should
bring value to you credit union!
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IT Risk Assessment
• High Risk – Remote Deposit Capture– ACH– Social Media Sites– Insider Threats
• Medium Risk– Vendor Management, Network Support– Email/Internet
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Examiner Hot Buttons
• Weak IT Audit Schedule– IT policies not tied to IT risk assessment
• Facebook/LinkedIn• Remote Deposit Capture
– Benefit to member but higher risk if controls not in place
• Vendor Controls• Not Enough BCP Testing• Repeat Recommendations
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External IT Review
• What’s Included?– General Controls
Review– Internal Vulnerability
Testing– External
Vulnerability/ Penetration Testing
– Ongoing Support• Do IT Right
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Industry Issues
• ALM – interest rate risk– Currently CUs are generally very liquid
• Deposit growth far outpaced loan growth leading to increased liquidity
• Have open LOC, however many have been reduced
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Industry Issues
• ALM – interest rate risk– Future ALM concerns
• Those with long-term assets coupled with short-term liabilities will be high risk
• Future rising rate environment• Decrease in net interest margins• If margins decrease:
– Where will earnings come from?– Industry already performed severe operating
cost cut-backs over past year(s)
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Industry Issues
• ALM – interest rate risk– Does your credit union have a formal
established ALCO and is it meeting– Is management monitoring and
reporting this risk on at least quarterly basis• Shock balance sheet +/- 300, 400, 500
basis points– Should be used to measure:
• Interest rates offered• Concentrations of assets (long vs short
term)• Establish limits to reduce exposure
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Industry Issues
• ALM – interest rate risk– Should have established policies and
procedures– Is management maintaining balance
sheet in according with these policies and procedures
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REO
• Definition– Real estate acquired by a lender in whole
or partial satisfaction of debt owed• Typically through foreclosure or deed in lieu of
foreclosure, and• Held in inventory until sold
– REO does not include real property held for own business use or expansion
– Foreclosure means termination of all rights of a mortgagor or grantee in the property
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REO
• How reported under GAAP:–Recorded at fair value less costs to
sell at the time of foreclosure• Typically current appraisal less 10%
costs to sell• Costs to sell are: broker commissions,
legal and title transfer fees, and closing costs
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REO
• How reported under GAAP:– Initial write down (loss) posted
through the ALLL – loan charge-off–Reclassified from loans to foreclosed
(other) assets–After foreclosure each property must
be carried at the lower of (1) fair value less costs to sell or (2) cost
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REO
• How reported under GAAP:– Management must evaluate the unsold
properties and determine if further write down to occur (further deterioration of properties value)
– Costs to retain (holding costs) – must be expensed as incurred• Property taxes• Utilities• HOA fees
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REO
• How reported under GAAP:– Costs to improve property
• Capitalize only if increase sales value (new roof)
– Costs to finish construction• Capitalize up to fair value less costs to sell• Any costs above that must be expensed
– If rented during holding period• Recognize income on rental as operating
income (similar to renting own building)
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REO
• How reported under GAAP:–Selling of foreclosures
• If loss report as non-operating loss• If gain – 5 possibilities for treatment
dependant on type of sales contract– Full accrual, installment, cost recovery,
reduced profit, and deposit– Most gains will be recognized immediately
as non-operating gain
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REO
• Financial Statement Risk– Valuation
• Not written down to proper value• Overstating assets and understating
losses• Appraisal/BPO should not be more than 90
days old• Subsequent measurement if property not
sold– New appraisals or BPO needed
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REO
• Financial Statement Risk– Classification
• Not reclassified to foreclosed assets– Overstating loans and understating other
assets/ foreclosed assets• Subsequent gains/losses posted through
ALLL vs. operations– Improper classification on income statement
• All expenses posted as operating expenses
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REO
• Other Risks–Protection of Assets
• Segregation of duties– Approval of foreclosures– Tracking of REOs
» Are all REOs identified and listed– Maintenance of REOs and contracts– Sales of REOs
» Who sets and approves prices» Arms length transactions
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REO
• Other Risks–Protection of Assets
• Additional loss when not warranted– Damage to property when holding– Selling at lower than market rates – fraud?– Contract approvals – to family/friends –
fraud?– Did CU file insurance claim for PMI for
losses• Title in CUs name• Property taxes and imsurance current
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REO
• Internal Controls–Policy and/or procedures in place–Proper accounting in place–Proper tracking/monitoring of status–Marketing efforts to sell
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REO
• Internal Controls–Proper segregation of duties over:
• Approval of foreclosure• Tracking and reporting of assets• Monitoring of title, taxes, insurance• Contracts going to bid• Acceptance of sales price
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Questions
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Thank You!
Bryan W. Mogensen, CPA
Clifton Gunderson LLP
602-604-3551