The Lending Process

8.02 This section discusses certain characteristics of and considerations involved in the lending process. The specific features will vary from institution to institution. To plan and design audit procedures properly, the auditor needs to understand the institution's loan portfolio, lending processes, loan accounting policies, market specialty, and trade area, as well as other factors such as economic conditions.

Credit Strategy

8.03 The institution's credit strategy includes its defined goals and objectives for loans, as well as the loan policies written to help achieve those goals and objectives. A guiding principle in credit strategy is to achieve profitable returns while managing risk within the loan portfolio. Credit strategy and policy are usually determined by senior management and approved by the board of directors.

8.04 The objectives of a sound credit plan are to identify profitable markets, determine appropriate risk tolerance levels for each type of loan, set goals for portfolio growth or contraction, and establish limits on industry and geographic concentrations. The plan establishes the institution's credit underwriting standards. These underwriting standards should consider recently issued regulatory requirements. Management’s procedures and controls should enable the monitoring of loan performance through periodic reporting and review in order to identify and monitor problem loan situations.

Credit Risk

8.05 The overriding factor in making a loan is the amount of credit risk associated with the loan in relation to the potential reward. For individual loans, credit risk pertains to the borrower's ability and willingness to make contractual loan payments and the fair value of any collateral pledged to secure the loan; it is assessed before credit is granted or renewed and periodically throughout the loan term.

8.06 An institution's credit exposure may be affected by external factors, such as the level of interest rates, unemployment, general economic conditions, real estate values, and trends in particular industries and markets. Internal factors—such as an institution's underwriting practices, credit practices, training, risk management techniques, familiarity and experience with its loan products and customers, the relative mix and geographic concentration of its loan portfolio and the strength of its internal control—also have a significant effect on an institution's ability to control and monitor its credit exposure.

8.07 Additional risks, however, are involved in the overall credit process, and the institution generally should assess them when developing a credit strategy, defining target markets, and designing proper controls over credit initiation and supervision. Those additional risks include the following:

• Collateral risk. The institution may be exposed to loss on collateralized loans if its security interest is not perfected or the collateral is not otherwise under the institution's control, and also, in the case of fraud, the collateral does not exist. Further risks are if the value of the collateral declines, or if environmental contingencies impair the value of the collateral or otherwise create liability for the institution.
• Concentration risk. Inadequate diversification of the loan portfolio in terms of different industries, geographic regions, loan products, terms of loan products, or the number of borrowers may result in significant losses. A high concentration of loans to companies in a single industry would constitute a concentration risk. For example, membership of credit unions may be limited to employees of one organization or to individuals of a geographic region. If the credit union’s sponsoring organization is experiencing financial problems or is anticipating layoffs of employees, the credit union could be exposed to significant losses. A high concentration of loans whose contractual features may increase the exposure of the originator to risk of nonpayment or realization would also constitute a concentration risk. For example, interest-only loans are designed to allow the borrower to only pay interest in the early part of the loan’s term, which may delay defaults. For these loans, evidence of risk to loss may not become apparent until the contractual provisions of the loans cause a change in required payments.
• Sovereign country risk. The economic, social, legal, and political conditions of a foreign country may unfavorably affect a borrower's ability to repay in the currency of the loan. Cross-border loans are those that borrowers must repay in a currency other than their local currency or to a lender in a different country. Losses may result if a country's foreign exchange reserves are insufficient to permit the timely repayment of cross-border loans by borrowers domiciled in that country, even if the borrowers possess sufficient local currency. In addition, foreign government decisions and associated events can affect business activities in a country as well as a borrower's ability to repay its loans.
• Foreign exchange risk. Changes in foreign exchange rates may affect lenders unfavorably. Fluctuations in foreign exchange rates could reduce the translated value of the cash flows, earnings, and equity investments in foreign currency denominated subsidiaries. Foreign exchange rate movements, if not effectively hedged, could also increase the funding costs of foreign operations as it is not uncommon for foreign operations to be funded by borrowings in currencies different than their functional currency.
• Fraud risk. Loans may expose the institution to loss by not being bona fide transactions.
• Insider risk. Loans to executive officers, directors, and principal shareholders of the institution and related interests of such insiders may expose the institution to loss if these loans are made to related individuals or companies, or both, with little credit history; if they lack an identified source of funds for repayment; or if they are made to newly organized or highly leveraged enterprises with insufficient collateral and inadequate financial information.
• Interest rate risk. The maturity and repricing characteristics of loans can have a significant impact on the interest-rate risk profile (and, therefore, interest income) of an institution. For example, an institution that holds primarily fixed-rate loans and finances itself with floating rate obligations could be adversely affected by a significant increase in interest rates.
• Legal and regulatory risk. Illegally granted loans, loans with usurious interest rates, and loans with terms that are not adequately disclosed to the borrower may expose the institution to loss.
• Management risk. Management's competence, judgment, and integrity in originating, disbursing, supervising, collecting, and reviewing loans could substantially affect the collectability of loans.
• Operational risk. Funds might be disbursed without proper loan authorization, collateral documentation, or loan documentation. Failure of the institution to evaluate and monitor potentially uncollectible loans also constitutes an operations risk.

Lending Policies and Procedures

8.08 Well-defined lending policies and comprehensive procedures for implementing such policies can contribute significantly to the institution's internal controls over financial reporting as they relate to the lending process.

8.09 The lending function can be broadly divided into the categories of (a) credit origination and disbursement, (b) credit supervision, (c) collection, and (d) loan review.

8.10 Credit origination and disbursement. Credit origination involves all the processes from the original request for credit to the disbursement of funds to the customer. Specific control features to meet operational—rather than financial reporting—objectives for credit origination usually include the following:

• Credit initiation, that is, obtaining complete and informative loan applications, including financial statements and the intended use of proceeds
• Credit investigation, including the following:

—  Credit reports or other independent investigations

—  Proper analysis of customer credit information, including the determination of projected sources of loan servicing and repayment

• Loan approval (new and renewed loans):

—  Loan approval limits according to officer expertise, administrative authority, or both

—  Committee approval or board of director approval, or both, for loans exceeding prescribed limits

—  The segregation of duties between the loan approval function and the disbursement and collection functions

—  Collateral ownership and control verified, including lien searches and documentation of the priority of security interest

—  Collateral margin determined

• Documentation of credit, or the inspection of supporting documents for proper form, completeness, and accuracy by someone other than the lending officer
• Perfection of collateral interest or proper security filings and recording of liens as well as possession of tangible collateral such as jewelry or bearer bonds
• The disbursement of loan proceeds or, to the extent possible, control of the disbursement to ensure that proceeds are used for the borrower's stated loan purpose

8.11 Credit supervision. Loan officers are responsible for closely monitoring the loans in their portfolios and bringing problem loans to the attention of management. Their duties normally include obtaining and analyzing the borrower's periodic financial statements and credit histories, reassessing collateral values, making periodic visits to the customer's place of operation, or in the case of collateral-based lending the place of the collateral, and generally keeping abreast of industry trends and developments and of the customer's financial requirements and ability to perform. Management reports concerning loan activity, renewals, and delinquencies are vital to the timely identification of problem loans. Input from loan officers is also important for identifying when loans should be restructured, reserved for, or charged off.

8.12 Collection. Loans identified as problem loans under the institution's established criteria should be monitored, restructured, or liquidated, as appropriate. The institution normally attempts to work with the customer to remedy a delinquency. Traditional mortgage collection procedures are not as effective in high loan-to-value (LTV) products. Delinquent borrowers who have little or no equity in the property may not have the incentive to work with the lender; therefore, high LTV lenders must intervene early to reduce the risk of default and loss. Sometimes the debt is restructured to include terms the customer can satisfy; at other times, the institution obtains additional collateral to support the loan. However, when the loan is delinquent for a specified period of time, as normally defined in the institution's lending policy, the institution may begin legal proceedings such as foreclosure or repossession to recover any outstanding interest and principal.

8.13 Loan review. Periodic review by institution personnel of the credit process and of individual loans is essential in assessing the quality of the loan portfolio and the lending process. Loan review should be conducted by personnel who are independent of the credit origination, disbursement, supervision, and collection functions. Depending on the complexity of the organizational structure, these personnel report directly to the board of directors, a designated committee of the board of directors, or to senior management. Loan review may be performed by specifically assigned staff or may be incorporated within an internal audit function, including the use of third party providers.

8.14 A loan review includes several distinct activities. The principal emphasis is on determining whether the loans adhere to the institution’s written lending policies and is likely to perform in accordance with the agreed-on terms and conditions, including compliance with any restrictive covenants in a loan agreement. The review normally includes analyzing the borrower’s financial statements, reviewing performance since origination or last renewal, and determining if sufficient credit information is available to assess the borrower’s current financial condition and determine the debt service coverage ratio.

8.15 Loan file contents should be reviewed as part of the institution’s internal loan review process to determine if credit reports, appraisals, and other third-party information existed before the credit or renewal was granted and if the quality of such information supported, and continues to support, the credit decision. If the loan is secured or guaranteed, the review should also determine that collateral is under control, security interest is perfected, guarantees have been executed properly, and the guarantor’s credit worthiness should be evaluated. Also, the value of collateral should be estimated at the review date to assess the LTV ratio and to identify deficiencies in collateral margins.

8.16 Loan reviews may identify weaknesses in the underwriting process or in the lending officers' skill in originating, supervising, and collecting loans. Loan review results should be documented and may be summarized in the form of subjective ratings of individual loans that are similar to regulatory examination classifications. In addition, loan review may reveal that individual loans are impaired and need a loss accrual or may identify other factors relevant in assessing the allowance for loan and lease losses (ALLL), as discussed in chapter 9, “Credit Losses,” of this guide.

Types of Lending

8.17 Lending institutions offer a variety of loan products to meet borrowers' needs and as part of their overall credit strategy and asset/liability management strategy. Loans may be made on a line-of-credit, installment, demand, time, or term basis. A brief description of each of those kinds of arrangements follows:

i.  construction, whereby the borrower may draw on the line as necessary to finance building costs to supplement (or pending the securing of) a construction loan;

ii.  liquidity, used by the borrower in overall management of its liquidity needs; and

iii.  warehousing, used by borrowers engaged in mortgage banking activities to fund origination of mortgage loans, generally pending sale of the loans to a secondary market investor.

8.18 Loans may be categorized in a variety of ways, depending on the institution. Institutions group loans in ways that are meaningful in their particular circumstances; for most, the groupings are based on the kind of borrower, the purpose of the loan, or other common risk characteristics. Some common categories of loans include (a) commercial, industrial, and agricultural; (b) consumer; (c) residential real estate; (d) lease financing; (e) trade financing; (f) commercial real estate (CRE) and construction; and (g) foreign.

Commercial, Industrial, and Agricultural Loans

8.19 Despite changes in corporate borrowing practices (and increased competition from other kinds of financial institutions), commercial, industrial, and agricultural loans (sometimes called C and I or business loans) are an important part of many institutions' business. There are a wide variety of commercial, industrial, and agricultural loans. They include

• factoring the purchase, usually without recourse, of trade accounts receivable;
• revolving or short term working capital loans or lines of credit, which are generally used by companies to finance the purchase of materials, inventory, or other production needs until the finished goods are sold;
• asset-based financing, usually secured by current assets such as accounts receivable or inventories, including receivable portfolio purchases;
• seasonal loans, which are used to provide cash to businesses (such as farms and retailers) during low-revenue periods of the year;
• floor-plan financing, which is used by automobile and durable goods dealers to finance inventories;
• long term working capital loans;
• loans and leases to finance the purchase of equipment; and
• loans to finance major projects, such as the construction of refineries, pipelines, and mining facilities.

8.20 Large commercial loans may involve more than one lender (see the discussion of loan participations that follows). Commercial loans may be secured (that is, the institution holds a lien against pledged assets, such as securities, inventories, property and equipment, an interest in the business, or accounts receivable) or unsecured. Also, such loans may be guaranteed or endorsed by third parties, including agencies of the U.S. government such as the Small Business Administration or the Export-Import Bank. Compensating-balance arrangements and commitment fees are often associated with commercial, industrial, and agricultural lending and are important factors in determining the interest rates on such loans. Commercial loans include demand loans, term loans, and line-of-credit arrangements.

8.21 Factoring. Factoring is the purchase, usually without recourse, of trade accounts receivable. A company that purchases trade accounts receivable is commonly called a factor. Factors buy trade accounts receivable from clients. Clients' customers send their payments directly to factors, often by means of a lockbox arrangement. Factored accounts receivable are not collateral for loans to clients; rather, the receivables are purchased outright. Except in certain instances involving advance factoring, as described in the following paragraphs, no loan is made. However, clients continue to remain contractually responsible for customer claims related to defective merchandise.

8.22 Factors buy clients' invoices, net of trade and cash discounts granted to customers, and provide clients with services that include assuming the clients' responsibilities of credit review, bookkeeping, and collection. Factors also assume risks of credit losses when customer credit is approved before a client ships the goods. Usually, if factors do not approve customers' credit, shipments are made at clients' risk. Factors buying accounts with recourse, however, provide bookkeeping and collection services and assume no credit risk, unless both the client and its customers become insolvent. Factors receive fees for services rendered to the client, usually computed as a percentage of net receivables bought.

8.23 Factoring usually mandates that customer notification be placed on the face of invoices, indicating that accounts have been sold and that factors are to be paid directly. Under nonnotification contracts, customers continue to pay clients and normally are unaware of factor ownership of the related accounts.

8.24 Two types of factoring arrangements are maturity and advance. Maturity factoring requires factors to pay clients only when related accounts are due (generally based on average due dates) or collected. In contrast, advance factoring allows clients to draw cash advances against the balance of the receivables before they are due or collected. Factors charge interest from the date on which advances are drawn to the date on which receivables are due or collected, at rates usually based on a stipulated percentage over commercial banks' prime rates.

8.25 In calculating limits for payments under advance factoring arrangements, factors generally retain a reserve against unpaid receivables to cover claims, returns, allowances, and other adjustments. Reserves ordinarily are a percentage of outstanding receivables based on factors' experience and judgment. Overadvances occur when clients draw cash advances that exceed uncollected receivable balances. Factors may permit overadvances to finance clients' seasonal business requirements. Such overadvances often can be anticipated. Overadvances also may result from unanticipated chargebacks, such as those resulting from defective merchandise and price disputes, because clients continue to remain contractually responsible for such problems. Overadvances may be collateralized by other assets, such as inventory or fixed assets, or may be secured by personal guarantees. In certain circumstances, overadvances also may be unsecured. Overadvances generally are reduced when receivables from additional sales are factored.

8.26 Revolving loans. Revolving loans, sometimes called working capital loans, generally provide borrowers with the cash needed for business operations. The loans typically are collateralized by accounts receivable and generally cannot exceed agreed percentages of the face values of those receivables. Such loans may also be referred to as accounts receivable loans. Collections against such receivables usually are remitted daily by borrowers to the lenders. Depending on the terms of the agreements, new accounts receivable acquired by borrowers and pledged to lenders may immediately qualify as collateral.

8.27 Lenders' policies may permit eligible collateral for revolving loans to be expanded to include inventories if borrowers require additional cash. In such cases, additional advances may be referred to as inventory loans. Inventory loans supplementing accounts receivable loans are common when seasonal businesses generate relatively low amounts of accounts receivable but demand large inventories in anticipation of the selling season. When the inventories are sold, the loans are paid off or accounts receivable generated by the sales replace inventories as collateral for such loans.

8.28 Receivables portfolio purchase agreements. Unlike factoring arrangements, receivables portfolio purchases are bulk purchases of trade accounts or finance receivables, often intended to provide sellers with cash for operations or improved financial ratios. Because the buyers usually assume all credit risks, a stipulated percentage of the purchase price is often retained to absorb credit losses. Credit losses in excess of that amount are borne by the buyer.

8.29 Terms of portfolio purchase agreements vary. Some provide for single purchases; others provide for continuing purchases on a revolving basis. In addition, customers may not be notified of purchases or may be notified and required to pay the buyer directly. Receivables acquired under this type of agreement generally are accounted for as assets owned by the buyer and are not considered to represent collateral for loans made to sellers. Instances where participating interests (such as senior interests) are purchased by buyers should be carefully evaluated to determine whether the buyer should recognize the underlying assets for accounting purposes.

8.30 Floor plan loans. Floor plan loans, commonly called wholesale loans, are made to businesses to finance inventory purchases. Some lenders make floor plan loans primarily to induce dealers to allow the lenders to buy the retail contracts generated from sales of inventories. Inventories serve as collateral for floor plan loans, the amounts of which usually are limited to the wholesale values of the inventories. Unlike revolving loans collateralized by inventory, floor plan loans generally are collateralized by specific inventory items. They also require minimum payments known as curtailments, with balances becoming due when collateral is sold or at the end of stipulated periods.

Consumer Loans

8.31 Consumer loans are loans to individuals for household, family, and other personal expenditures. Commonly, such loans are made to finance purchases of consumer goods, such as automobiles, boats, household goods, vacations, and education. Interest rates and terms vary considerably depending on many factors, including whether the loan is secured or unsecured. The two most significant kinds of consumer lending are installment loans and revolving credit arrangements (credit card lending).

8.32 Installment loans. Consumer installment loans, which are generally secured by the item purchased (for example, automobile loans), may be originated directly with an institution's customers (direct paper) or acquired indirectly from a dealer's customers (indirect paper or retail sales contracts).

8.33 Retail sales contracts. Many sales of consumer goods and services are financed through retail sales contracts. Those contracts are made, directly or through retailers and dealers, with individual consumers. The contracts often are sold to a lender. Retail sales contracts commonly are called three-party paper because they involve three parties, namely, an individual borrower, a dealer or distributor, and a lender.

8.34 Retail sales contracts usually are sold at a discount to a lender under terms that permit dealers or distributors to share a portion of the finance charges paid by borrowers. Provisions for dealers' shares of finance charges vary among lenders and dealers. Dealers' shares of finance charges may be based on stipulated percentages of the finance charges or the principal amounts of the retail contracts, on a fixed amount for each contract, or on other negotiated terms. The Office of the Comptroller of the Currency (OCC) frequently issues guidance on retail sales contracts.

8.35 Some agreements provide for a portion of the amounts due to dealers to be withheld to cover certain contingencies. Other agreements provide no such conditions. Amounts withheld from dealers may either be limited to or greater than the dealers' shares of finance charges. Dealer reserves represent liabilities for unpaid portions of dealers' shares of finance charges on retail contracts bought from dealers. Dealer holdbacks, which are not limited to dealers' shares of finance charges, also represent liabilities, but usually are for amounts withheld from dealers on retail contracts with greater-than-normal credit risk. Such risks may relate to factors such as the types of collateral, excessive loan periods, or the credit ratings of the borrowers involved. Dealer reserves and holdbacks may be required even if applicable contracts are bought with recourse.

8.36 Credit cards. Credit card lending is a major business for many institutions. Institutions may participate in the credit card market in various ways. Some institutions may issue or make credit cards available directly to customers. Institutions may also sponsor cards that are issued by another institution. The sponsoring institution may take credit applications, perform credit checks, and have its name printed on the cards, but the issuing institution records the consumer loans and assumes the credit risk. Most credit card lending is on an unsecured basis, although some secured programs exist. Within geographic areas, there are service companies that centralize card issuance, process transactions, and maintain customer accounts.

8.37 Credit card holders receive prenumbered cards under a prearranged line of credit with the institution issuing the card. Though the terms of credit cards vary, an annual fee is often charged for the use of the card and interest is charged on outstanding balances. Cards typically carry a grace period during which no interest is charged if outstanding balances are paid in full. Furthermore, merchants are generally charged a transaction fee.

8.38 Many institutions that issue credit cards have agreements with one of the two major international bank card systems, Visa and Interbank (MasterCard). However, a number of financial institutions have independent plans. The main functions that the bank card systems perform are enrolling merchant members and providing authorization and clearing systems. The main functions that the issuing institutions perform are issuing cards, setting credit limits, billing, collections, and customer service.

8.39 Overdraft protection. Another type of revolving credit is overdraft protection on checking accounts. Overdraft protection is an agreement between an institution and its customer to provide a prearranged line of credit that is automatically drawn if the customer writes checks greater than the amount in his or her deposit account. Interest is charged on amounts outstanding, and fees for usage may also be charged.

Residential Real Estate Loans

8.40 Loans secured by one-to-four-family residential property of the borrower are generally referred to as residential mortgage loans. Repayment terms for residential mortgage loans may vary considerably. Such loans may be structured to provide for the full amortization of principal, partial amortization with a balloon payment at a specified date, or negative amortization. Interest rates may be fixed, variable, or a combination of both. Variable-rate loans generally are referred to as adjustable-rate mortgages (ARMs). In addition, institutions may require borrowers in certain circumstances to purchase private mortgage insurance to reduce the institution's credit risk.

8.41 Many different types of nonpurchase related first and second lien residential mortgage loans have become popular, including

• reverse mortgages, which provide homeowners with monthly payments in return for increasing the principal amount of a loan (decreasing the equity the homeowner has), wherein the institution may eventually gain ownership of real estate;
• second-lien fixed-term (or closed end) loans through which homeowners borrow a portion of their equity (property value in excess of the first-lien balance) and repay such over a fixed period of time with fixed or variable interest rates;
• home equity lines of credit allow the homeowner to borrow on demand, a portion of their equity, repay such and reborrow, if desired;

8.42 The Federal Housing Administration (FHA) insures and the U.S. Department of Veterans' Affairs (VA) partially guarantees many residential real estate mortgages.¹ The FHA sets minimum down payments and interest rates for FHA loans. FHA-insured borrowers pay an annual insurance premium computed each year on the loan balance at the beginning of the year. The VA guarantee program, which was initiated to enable veterans to obtain homes when they return from military service, provides certain features, including an interest-rate ceiling that is generally lower than prevailing market rates, a partial guarantee to the lender, a low (or no) down payment, and a prohibition against mortgage brokers' commissions. Residential mortgage loans that are not FHA-insured or VA-guaranteed are called conventional loans.

8.43 Chapters 4, “Industry Overview – Mortgage Companies,” and 10 of this guide include further discussion on mortgage banking activities.

Lease Financing

8.44 Institutions also may be involved in direct lease financing, in which an institution owns and leases personal property for the use of its customers at the customers' specific request. A typical lease agreement contains an option providing for the purchase of the leased property, at its fair value or at a specified price, by the lessee at the expiration of the lease. Such leases may be financing transactions (discussed in paragraph 8.140). Despite similarities between leases and other forms of installment loans, continuing legal and tax changes have resulted in language and procedures unique to leasing activities.

8.45 Operating leases. An operating lease is a rental agreement in which asset ownership resides with the lessor. At the end of the lease term, the lessee may renew the lease, purchase the equipment, or return it to the lessor. During the course of the lease, the lessee expenses the rental payment made. As these types of agreements are in substance usage agreements, the debt is allowed to remain off the lessee’s balance sheet. The lessor records the equipment as an asset and is required to depreciate it. Operating leases generally run for periods considerably shorter than the useful lives of related assets. At the expiration of such leases, the assets generally are sold or leased again.

8.46 Direct financing leasing. Direct financing leases are similar to other forms of installment lending in that lessors generally do not retain benefits and risks incidental to ownership of the property subject to leases. Such arrangements are essentially financing transactions that permit lessees to acquire and use property.

8.47 Leveraged leasing. Leveraged leasing involves at least three parties, namely, a lessee, a long term creditor, and a lessor (commonly called the equity participant). The lessor may, however, be represented by an owner trustee. Finance companies and other lenders frequently enter into leveraged lease transactions as lessors or equity participants. A substantial portion of the purchase price of assets is supplied nonrecourse by unaffiliated long term lenders. If a lessee defaults on lease payments, the long term lender has no recourse to the lessor, but usually has recourse to the specific property being leased. The gross return to a finance company or lender is measured using the discounted net cash receipts generated from investment tax credits and the tax effects of timing differences resulting principally from the use of accelerated depreciation in tax returns, rental payments minus debt service costs, and the estimated residual values of equipment leased.

8.48 Transactions and vendor leasing. Leasing arrangements also may be categorized as transactional, involving direct negotiations between a lessor and lessee, and as vendor leasing. Transactional lease financing tends to be a time-consuming and expensive process that is economically feasible only for transactions sufficiently large to generate profits in excess of the costs of preparing custom-made leases. Vendor leasing has developed to finance asset acquisitions that would not be profitable to finance with transactional leasing arrangements. Vendor leasing involves a third-party lessor that offers a vendor's or manufacturer's customers a basic finance package. The lessor usually establishes interest rates within given dollar ranges and uses a standardized credit scoring process to approve credit and keep documentation simple. As a result, vendors are promptly paid for sales and avoid the need to perform in-house financing operations. Some lenders also may serve as lease brokers—that is, as intermediaries between lessors and lessees for a fee.

Trade Financing

8.49 Trade financing is a specialized area of commercial lending frequently used by businesses that engage in international activities. Such financing includes open account financing, sales on consignment, documentary collections, advances against collections, letters of credit, bankers' acceptances, factoring, and forfeiting. Lending institutions charge fees for such arrangements. The most commonly used of these arrangements is the letter of credit.

8.50 The two primary types of letters of credit are the commercial letter of credit and the standby letter of credit. A commercial letter of credit represents a commitment by the issuing institution to make payment for a specified buyer to a specified seller in accordance with terms stated in the letter of credit. Under a standby letter of credit, the issuing institution guarantees that the buyer will make payment. The issuing institution is not ordinarily expected to make payment; however, if it does make payment, the buyer is obligated under the agreement to repay the institution. Standby letters of credit are also used to guarantee the performance of U.S. companies under contracts with foreign corporations and foreign or domestic governments. Depending on the nature of the agreement, these transactions may involve a high degree of credit risk. Portions of loans for cross-border transactions are often guaranteed by the Export-Import Bank.

CRE and Construction Loans

8.51 Loans made on real property such as office buildings, apartment buildings, shopping centers, industrial property, and hotels are generally referred to as CRE loans. Such loans are usually secured by mortgages or other liens on the related real property such as an assignment of rents or a lien on the property, plant, and equipment within the real property. Repayment terms on CRE loans vary considerably. Interest rates may be fixed or variable, and the loans may be structured for full, partial, or no amortization of principal (that is, periodic interest payments are required and the principal is to be paid in full at the loan maturity date). Some give the institution recourse to third parties, who guarantee repayment of all or a portion of the loans. Others are nonrecourse, that is, if the borrower cannot repay the loan, the lender has only the collateral as a source of repayment—the lender does not have recourse to any other source of repayment.

8.52 Construction lending involves advances of money from a bank or savings institution to finance the construction of buildings or the development of raw land. The institution generally agrees to a specified loan amount, part of which will be disbursed to the borrower at the inception of the project and part of which will be disbursed as construction progresses, based on specified milestones that were agreed to by the institution and the borrower. Construction loans are usually made for the construction period only, which generally runs from one to seven years. Often, both interest and principal are payable at maturity. After construction is completed, the borrower commonly obtains long-term mortgage financing from the same or another financial institution. Large CRE and construction loans may involve more than one lender (discussed in paragraphs 8.55–.56).

8.53 Certain real estate loan arrangements, in which the lender has virtually the same risks and potential rewards as those of the owners of the property, should be considered and accounted for as investments in real estate. Certain real estate acquisition, development, and construction (ADC) arrangements that should be accounted for as investments in real estate are discussed in chapter 11, “Real Estate Investments, Real Estate Owned, and Other Foreclosed Assets,” of this guide.

Foreign Loans

8.54 Foreign (or cross-border) loans are made primarily by larger institutions and consist of loans to foreign governments, loans to foreign banks and other financial institutions, and commercial and industrial loans. Foreign loans also include consumer and commercial lending, including real estate loans, made by foreign branches. Such loans may contain certain risks, not associated with domestic lending, such as foreign exchange and country or transfer risks, as described previously in paragraph 8.07. This type of lending exposes the institution to cross-border risk, which is the possibility that the borrowing country's exchange reserves are insufficient to support its repayment obligations.

Loans Involving More Than One Lender

8.55 Institutions sometimes receive requests for loans that exceed the institution's capacity or willingness to lend. In response, shared lending arrangements have been created. In a syndication lending arrangement, a group of institutions agrees to collectively provide a loan, with each institution being a direct creditor of the borrower for its portion but with uniform lending terms applied by all the institutions. One institution is typically appointed as the agent, or lead institution, having primary responsibility for communication and negotiation with the borrower. The lead institution generally services the loan for the group, including disbursement of all funds and supervision of the perfection of legal interests in the underlying collateral. In some cases, an institution that is part of syndication may subsequently transfer via an assignment all or a portion of their share of the loan to another institution. If the borrower approves the assignment, the new institution becomes an official party to the lending agreement (for example, direct creditor to the borrower). In a participation lending arrangement, a lead institution originates a loan for the entire amount and sells to other lenders (participating institutions) portions of the loan it originated. Loan participations may be negotiated on either a recourse or nonrecourse basis. Also, a participation may be sold on terms that differ from the original loan terms. The participating institutions have rights to their respective share of the cash flows from the original loan but do not become an official party to the loan agreement (for example, direct creditor). The borrower may not even be aware of the participation agreement.

8.56 In a loan syndication, the participating institutions arrange a lending syndicate in which the lead syndicator and participants in the syndication fund their respective portions of the loan. A syndication typically involves less risk to a lead institution than a participation because the lead institution funds only its portion—rather than the entire amount—of the loan at origination. A major difference between syndications and participations relates to the accounting by the agent or lead institution. Refer to paragraphs 19–20 of FASB ASC 310-20-25 for additional guidance. Depending on the nature of the loan participation agreement (particularly those that do not involve pari passu loan participations), the lead institution may be unable to derecognize the participations transferred to other banks under FASB ASC 860, Transfers and Servicing. See further discussion on transfers of financial assets within chapter 10 of this guide.

Real Estate Lending Standards

8.57 The Board of Governors of the Federal Reserve System (Federal Reserve), the OCC, and the FDIC (collectively, the federal banking agencies) have established real estate lending standards and related guidelines that describe the factors management should address in its real estate lending policies.² According to regulations, each institution is required to adopt and maintain written policies that establish limits and standards for extensions of credit related to real estate. The lending policies must establish

8.58 Management's policies are to be consistent with safe and sound banking practices, appropriate to the size of the institution and the nature and scope of its operation, and reviewed and approved by the institution’s board of directors at least annually.

8.59 The policies also outline considerations for loan portfolio management, underwriting standards, loan administration, supervisory LTV limits and excluded transactions, policy exceptions, and supervisory review of real estate lending policies and practices.

8.60 On October 8, 1999, the federal banking agencies, including the Office of Thrift Supervision (OTS), prior to its transfer of powers to the federal banking agencies,³ jointly issued the Interagency Guidance on High Loan-to-Value Residential Real Estate Lending, which highlight the risks inherent in this activity and provides for supervisory limits and capital considerations. The guidelines set forth the supervisory expectation that high LTV portfolios, as defined, will not exceed 100 percent of total capital. Institutions that approach this limit will be subject to increased supervisory scrutiny. If the limit is exceeded, then its regulatory agency will determine if the activity represents a supervisory concern and take action accordingly. Policy and procedure guidelines provided in the 1992 Interagency Guidelines for Real Estate Lending Policies apply to these transactions.

8.61 The federal banking agencies issued interagency guidance Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, which was effective on December 6, 2006. The guidance was intended to help ensure that institutions pursuing a significant CRE lending strategy remained healthy and profitable while continuing to serve the credit needs of their communities. The guidance encourages ongoing risk assessments and analysis of CRE lending policies. This includes evaluating the appropriateness of an institution’s risk practices, as well as capital levels in relation to the size and complexity of its CRE portfolio. The guidance is applicable for state member banks and bank holding companies, as well as their nonbank subsidiaries.

8.62 The federal banking agencies, along with the National Credit Union Administration (NCUA), adopted a Policy Statement on Prudent Commercial Real Estate Loan Workouts on October 30, 2009. This policy statement provides guidance for examiners, and for financial institutions working with CRE borrowers who are experiencing diminished operating cash flows, depreciated collateral values, or prolonged delays in selling or renting commercial properties. This guidance addresses supervisory expectations for an institution’s risk management elements for loan workout programs, loan workout arrangements, classification of loans,⁴ and regulatory reporting and accounting considerations. The statement also includes references and materials related to regulatory reporting, but it does not change existing regulatory reporting guidance provided in relevant interagency statements issued by the banking regulators or accounting requirements under U.S. generally accepted accounting principles (GAAP). The guidance includes a series of examples of CRE loan workouts, which are provided for illustrative purposes. This guidance replaces the Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans (November 1991 and June 1993). Readers are encouraged to view the press release under the “Press Releases” page at www.ffiec.gov for additional information.

8.63 Appraisals. On December 10, 2010, the federal banking agencies, along with the NCUA, issued Interagency Appraisal and Evaluation Guidelines, which replaced the guidelines issued in 1994. These guidelines describe the elements of a sound program for conducting appraisals and evaluations in compliance with the agencies’ appraisal regulations. The guidelines provide additional clarification for when a real estate appraisal and evaluation is required to support a real estate-related financial transaction. Further, they explain the minimum regulatory appraisal standards and the supervisory expectations for the development and content of an evaluation, which is permitted in certain situations in lieu of an appraisal. The guidelines build on the existing federal regulatory framework and reaffirm long-standing supervisory expectations. They also incorporate the agencies’ recent supervisory issuances and, in response to advances in information technology, clarify standards for the industry’s appropriate use of analytical methods and technological tools in developing evaluations. The Dodd–Frank Wall Street Financial Reform and Consumer Protection Act of 2010 underscores the importance of sound real estate lending decisions; revisions to the guidelines may be necessary after regulations are adopted to implement the act. Financial institutions should review their appraisal and evaluation programs to ensure that the programs are consistent with the guidelines. Readers are encouraged to access the guidance from any of the agencies’ websites.

8.64 In January 2013, the federal banking agencies, along with the Consumer Financial Protection Bureau (CFPB), the Federal Housing Finance Agency, and the NCUA, issued a final rule Appraisals for Higher-Priced Mortgage Loans to establish new appraisal requirements for higher-priced mortgage loans. Higher-priced mortgages are those mortgages with an annual percentage rate that exceeds the average prime offer rate by a specified percentage.⁵

8.65 For higher-priced mortgage loans, the rule requires creditors to use a licensed or certified appraiser who prepares a written appraisal report based on a physical inspection of the interior of the property. The rule also requires creditors to disclose to applicants information about the purpose of the appraisal and provide consumers with a free copy of any appraisal report. If the seller acquired the property for a lower price during the prior six months and the price difference exceeds certain thresholds, creditors will have to obtain a second appraisal at no cost to the consumer. This requirement for higher-priced home-purchase mortgage loans is intended to address fraudulent property flipping by seeking to ensure that the value of the property legitimately increased.

8.66 The rule exempts several types of loans, such as qualified mortgages; temporary bridge loans and construction loans; loans for new manufactured homes; and loans for mobile homes, trailers, and boats that are dwellings. The rule also has exemptions from the second appraisal requirement to facilitate loans in rural areas and other transactions. Readers can access the full text of this final rule from any of the respective agencies’ websites.

8.67 The federal banking agencies and the NCUA require an appraisal by a state certified or licensed appraiser for all real estate-related financial transactions (as defined in the U.S. Code of Federal Regulations) having a value greater than $250,000. The appraisal regulations do exempt certain real estate-related financial transactions from the appraisal requirement.⁶ The federal banking agencies and the NCUA also reserve the right to require an appraisal under the appraisal regulations to address safety and soundness concerns in a transaction. As a matter of policy, the OCC and the FDIC use their supervisory authority to require problem federal and state savings associations and federal and state savings associations in troubled condition to obtain appraisals for all real estate-related transactions over $100,000 (unless the transaction is otherwise exempt). The NCUA requires a written estimate of market value for all real estate-related transactions valued at the appraisal threshold or less, or that involve an existing extension of credit where there is either an advancement of new monies or a material change in the condition of the property.

Retail Credit Loans and Residential Mortgage Loans

8.68 On June 12, 2000, the federal banking agencies issued the Revised Uniform Retail Credit Classification and Account Management Policy (initially issued in 1999), which instructs institutions on the review and classification of retail credit loans and residential mortgage loans. Institutions should adopt the standards contained in the policy as part of their loan review program. The guidelines include requirements for the classification and charge-off of retail credit and mortgage loans, as well as fraudulent loans and bankruptcy cases.⁷ On April 30, 2009, the FDIC issued Financial Institution Letter-19-2009, Classification Treatment for High Loan-to-Value (LTV) Residential Refinance Loans, in which the FDIC affirmed that the standards in the Uniform Retail Credit Classification and Account Management Policy should be followed relative to the classification treatment for high LTV residential refinance loans. The guidance establishes that retail loan classifications should be based on the borrower’s payment performance, not the value of the collateral, which can rise and fall as market conditions change.

8.69 On March 26, 2001, the federal banking agencies, along with the NCUA, issued Interagency Guidance on Certain Loans Held for Sale, to provide instruction to institutions and examiners about the appropriate accounting and reporting treatment for certain loans that are sold directly from the loan portfolio or transferred to a held for sale (HFS) account. That guidance also addresses subsequent declines in value for loans within its scope and states the following:

After a loan or group of loans is transferred to the HFS account, those assets must be revalued at each subsequent reporting date until sold and reported at the lower of cost or fair value. Any declines in value (including those attributable to changes in credit quality) and recoveries of such declines in value occurring after the transfer to the HFS account should be accounted for as increases and decreases in a valuation allowance for HFS loans, not as adjustments to the ALLL. Changes in this valuation allowance should be reported in current earnings. The valuation allowance for HFS loans cannot be reduced below zero (that is cannot have a debit balance).

8.70 In September 2009, the NCUA issued Letter to Credit Union 09-CU-19, Evaluating Residential Real Estate Mortgage Loan Modification Program, which provides certain financial reporting considerations for credit unions, as well as several other considerations related to loan modifications. Readers are encouraged to view the full text of this letter under the “Letters to Credit Unions—2009” page at www.ncua.gov.

Troubled Debt Restructurings

8.71 In April 2012, the OCC issued Bulletin OCC 2012-10, Troubled Debt Restructurings: Supervisory Guidance on Accounting and Reporting Requirements, to national banks and federal savings associations to address many inquiries received from bankers and examiners on accounting and reporting requirements for troubled debt restructurings (TDRs), especially related to loan renewals and extensions of substandard commercial loans. The bulletin focuses on factors and key concepts to consider when evaluating loans for TDR designation and considerations for the appropriateness of accrual status and impairment analyses.

8.72 The bulletin specifically highlights that all substandard loans on accrual status that are renewed, extended, or otherwise modified should not automatically be considered TDRs. Rather, the institution needs to consider the totality of the transaction given the borrower’s financial condition. As such, it is important for banks to establish an appropriate process for identification and analysis of TDRs and to document such an analysis. For example, the procedures should address the process for flagging a modified or renewed loan for review, considering factors to assess TDR status, designating responsibility for the TDR decision, and clearly documenting the facts and circumstances analyzed for each modification or renewal and the conclusion reached. Further guidance regarding TDRs that may assist when considering whether a loan modification or renewal is a TDR can be found in the interagency’s Policy Statement on Prudent Commercial Real Estate Loan Workouts and the BAAS.

8.73 The bulletin further reminds banks that renewals, extensions, or modifications deemed to be TDRs must be evaluated for the appropriate impairment measurement under FASB ASC 310-10 to ensure that the ALLL and accrual status are appropriate and consistent with the Federal Financial Institutions Examination Council’s (FFIEC’s)Instructions for Preparation of Consolidated Reports of Condition and Income. The bulletin also addresses separate considerations that should be given when disclosing of a loan as a TDR and its evaluation under FASB ASC 310-10. Readers can access Bulletin OCC 2012-10 from the OCC website at www.occ.gov.

8.74 In October 2013, the federal banking agencies and the NCUA issued Interagency Supervisory Guidance Addressing Certain Issues Related to Troubled Debt Restructurings. The supervisory guidance for financial institutions⁸ addresses certain issues related to the accounting treatment and regulatory credit risk grade or classification of commercial and residential real estate loans that have undergone TDRs. The document reiterates key aspects of previously issued regulatory guidance (such as the interagency Policy Statement on Prudent Commercial Real Estate Loan Workouts) and discusses the definition of collateral-dependent loans and the circumstances under which a charge-off is required for TDRs. Readers can access the full text of this guidance from any of the respective agencies’ websites.

8.75 The FFIEC issued Supplemental Instructions for September 2014 Call Reports that address the accounting for subsequent restructurings of TDRs. Pursuant to this guidance, certain TDRs that are subsequently modified may no longer be considered to be TDRs if on the subsequent modification the borrower is no longer experiencing financial difficulties and no concession is granted to the borrower as a part of this modification. The subsequent modification must carry a market rate of interest for similar debt. Loans with principal forgiveness are considered to carry a continuing concession and therefore are not eligible for reconsideration of TDR status upon a subsequent modification. Loans that are no longer considered TDRs would be measured for impairment under FASB ASC 450-20.

Credit Card Lending

8.76 On January 8, 2003, the federal banking agencies issued Account Management and Loss Allowance Guidance for Credit Card Lending. The issuance communicated the expectations for prudent practices in a variety of account management, risk management, and loss allowance practices of institutions engaged in credit card lending. The account management portion of the guidance covers credit lines, overlimit practices, negative amortization, workout programs, and settlements. The loss allowance portion of the guidance covers a number of factors that should be considered by institutions when they estimate and account for their allowance for loan losses. On September 24, 2009, the OTS issued CEO Memo 321, No Interest, No Payment Credit Card Programs, which reminds savings associations of some of the specific requirements of the January 8, 2003, guidance, such as requiring a minimum payment from the borrower each month for all credit card programs, including private label arrangements with retailers. Readers are encouraged to visit the “OTS CEO Memos” page at www.occ.gov to review the full text of this memo.

8.77 For further information, on credit losses, see chapter 9 of this guide.

Nontraditional Mortgage Products

8.78 Because of increased consumer demand for closed-end residential mortgage loan products that allow borrowers to defer repayments of principal and sometimes interest, mortgage institutions are offering nontraditional mortgage loans such as “interest only” mortgages, or mortgages with subprime interest rates. On October 4, 2006, the federal banking agencies and the NCUA adopted Interagency Guidance on Nontraditional Mortgage Product Risks including the use of subprime loans. The guidelines remind banks of the risks inherent in nontraditional mortgage lending and outline the types of risks and controls that are expected for an institution that enters this field of lending. Institutions should establish an appropriate ALLL for estimated credit losses inherent in their nontraditional mortgage loan portfolios. Capital levels should be commensurate with the risk characteristics of the nontraditional mortgage loan portfolios. Institutions should also use “stress tests” to analyze the performance of their nontraditional mortgage portfolios. On June 8, 2007, the federal banking agencies and the NCUA adopted Illustrations of Consumer Information for Nontraditional Mortgage Products to assist institutions in implementing the consumer protection portion of the Interagency Guidance on Nontraditional Mortgage Product Risks.

Correspondent Concentration Risks

8.79 On May 4, 2010, the federal banking agencies issued Correspondent Concentration Risks Interagency Guidance. The interagency guidance outlines the agencies' expectations for identifying, monitoring, and managing correspondent concentration risks between financial institutions. The guidance also addresses the agencies' expectations relative to performing appropriate due diligence on all credit exposures to and funding transactions with other financial institutions.

Leveraged Lending

8.80 In March 2013, the federal banking agencies issued Interagency Guidance on Leveraged Lending. This guidance, which replaces the 2001 leveraged lending guidance, outlines high-level principles related to safe-and-sound leveraged lending activities, including underwriting considerations, assessing and documenting enterprise value, risk management expectations for credits awaiting distribution, stress-testing expectations, pipeline portfolio management, and risk management expectations for exposures held by the institution. This guidance applies to all financial institutions supervised by the federal banking agencies that engage in leveraged lending activities. The number of community banks with substantial involvement in leveraged lending is small; therefore, the agencies generally expect community banks to be largely unaffected by this guidance. In November 2014, the federal banking agencies subsequently released a frequently asked questions document to foster industry and examiner understanding of the 2013 leveraged lending guidance and to promote consistent application of the guidance in policy formulation, implementation, and regulatory supervisory assessments.

Income Recognition on Problem Loans

8.81 The federal banking regulators have issued guidance specifically for nonaccrual policies. Following issuance of FASB Statement No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures—an amendment of FASB Statement No. 114, which is codified in FASB ASC 310-10 and 310-40, the federal banking agencies announced they would retain their existing nonaccrual policies governing the recognition of interest income. This guidance was published in the Federal Register on February 10, 1995.

8.82 NCUA guidelines state that loans delinquent for 3 months or more should be placed on nonaccrual status and that accrual of interest on loans should be reversed when the loan is determined to be a loss or when it becomes 12 months delinquent, whichever occurs first. State credit union regulators may also have specific requirements for the discontinuance and reversal of accrued income.

Credit Union Lending Restrictions

8.83 Credit unions can generally only make loans to members. Further restrictions include, but are not limited to, LTV limits, limits on loans to one borrower, limits on member business loans, and limits on loans to officers, directors, and employees.

Lending Statutes

8.84 Certain of the more significant federal and state statutes related to consumer and mortgage lending activities follow:

• Home Mortgage Disclosure Act (HMDA). The HMDA requires that mortgage lenders compile and report to the institution’s regulatory agency, certain information applicable to applications for home acquisition and improvement loans. The objectives of the regulation are to provide information to the public regarding whether the institution is serving the credit needs of the neighborhoods it serves, and to assist public officials in targeting private-sector investments to the areas in which they are most needed.
• Fair lending statutes. These statutes include the Equal Credit Opportunity Act and the Fair Housing Act, which prohibit discrimination in lending and housing-related activities, and the Fair Credit Reporting Act, which regulates consumer credit reporting activities.
• Real Estate Settlement Procedures Act (RESPA). The RESPA is administered by the CFPB and requires the disclosure of information to mortgage loan applicants about the costs and procedures involved in loan settlement.
• Direct consumer lending. State laws regulating consumer finance operations are designated as licensed-lending, small-loan, or consumer-financing statutes. Diverse state statutes usually regulate mortgage loans and other direct consumer loans. Each branch office of a company that makes direct consumer loans must be licensed by the state in which the office is located. State licensing authorities, many of which are divisions of state banking departments, examine loans to ascertain that they comply with statutory provisions and to determine whether rebates and refunds are properly computed.
• Retail sales financing. Laws governing retail sales financing may require offices to be licensed or registered. The laws vary widely among states. For example, all goods statutes may govern consumer goods loans; other goods laws may govern loans for consumer goods excluding automobiles. Additional statutes may affect revolving credit arrangements.
• Federal Consumer Credit Protection Act (Truth in Lending Act). The act, through Federal Reserve Regulation Z, requires disclosure of finance charges and annual percentage rates so that consumers can more readily compare various credit terms. It does not set maximum or minimum rates of charges.

Uniform Commercial Code

8.85 The Uniform Commercial Code (UCC), fully adopted by all states, is a set of statutes designed to provide consistency among state laws concerning various commercial transactions. Article 9 of the UCC, which addresses secured transactions, contains especially significant laws that affect financing activities. It applies to two-party collateralized loan transactions as well as to sales of accounts receivable and retail sales contracts, which are essentially three-party transactions. Article 9 generally provides certain rights to the secured parties and the debtors involved in secured transactions. The definition of a secured party includes a lender who obtains a security interest as well as a buyer of trade accounts receivable or retail sales contracts. Similarly, the definition of a debtor includes both the individual obligor and the seller of trade accounts receivable or retail sales contracts.

8.86 Under Article 9, all transactions creating a security interest are treated alike. The article sets forth various procedures necessary to safeguard, or perfect, the potential creditor's interest in collateral against the interests of other creditors. According to Article 9, those procedures generally require that the creditor file a financing statement at a specified public office. The statement, available for public inspection, provides legal notice of a perfected security interest. Consequently, before making collateralized loans, prospective lenders generally search the public files to determine if other lenders have already filed financing statements against the collateral.

8.87 For certain commercial financing activities, Article 9 permits continuing general lien arrangements, in which a security interest applies continuously to all present and future collateral of the type described in the financing statement for as long as the financing statement is effective. That provision simplifies, for example, maintaining security interests in purchased receivables and in collateral securing revolving loans. The underlying collateral becomes subject to the security interest as soon as it comes into existence or into the debtor's possession. The financing statement is generally effective for five years from the date of filing and then lapses, unless a continuation statement is filed within the six-month period before the expiration date. The continuation statement extends the security interest for another five years.

Bank Accounting Advisory Series

8.88 The OCCs Bank Accounting Advisory Series (BAAS) is updated periodically to express the Office of the Chief Accountant’s current views on accounting topics of interest to national banks and federal savings associations. See further discussion of the BAAS in paragraph 7.82 of this guide. Topic 2, “Loans,” of the BAAS includes interpretations and responses on (a) TDRs, (b) nonaccruals, (c) commitments, (d) origination fees and costs, (e) loans HFS, and (f) loan recoveries. Readers are encouraged to view this publication under the “Publications—Bank Management” page at www.occ.gov.

Interest Income, Delinquency Fees, Prepayment Fees, and Rebates

8.95 Interest income on performing loans should be accrued and credited to interest income as it is earned, using the interest method.

8.96 Entities involved in transactions in which captive finance companies offer favorable financing to increase sales of related companies should account for such transactions under the guidance in FASB ASC 835-30. FASB ASC 835-30 provides guidance for the appropriate accounting when the face amount of a note does not reasonably represent the present value of the consideration given or received in an exchange.

8.97 Delinquency fees are amounts debtors pay because of late payment on loans. Such fees are generally small and are intended to represent additional interest to compensate the lender for the time value and additional collection costs associated with delinquencies.

8.98 Finance companies may charge various types of fees to customers in connection with lending transactions, including prepayment penalties—amounts borrowers pay to lenders, in addition to remaining outstanding principal, if borrowers pay off loans prior to contractual maturity.

8.99 Paragraphs 12–13 of FASB ASC 310-10-25 address recognition guidance related to prepayment and delinquency fees. Prepayment penalties should not be recognized in income until loans (or trade receivables, if applicable) are prepaid, except that the existence of prepayment penalties may affect the accounting resulting from the application of item (a) in FASB ASC 310-20-35-18. Delinquency fees should be recognized in income when chargeable, assuming collectibility is reasonably assured.

8.100 FASB 310-10-05-7 states that rebates represent refunds of portions of the precomputed finance charges on installment loans (or trade receivables, if applicable) that occur when payments are made ahead of schedule. Rebate calculations generally are governed by state laws and may differ from unamortized finance charges on installment loans or trade receivables because many states require rebate calculations to be based on the Rule of 78s or other methods instead of the interest method. FASB ASC 310-10-25-11 states that the accrual of interest income on installment loans or trade receivables should not be affected by the possibility that rebates may be calculated on a method different from the interest method, except that the possibility of rebates affects the accounting resulting from the application of item (a) in FASB ASC 310-20-35-18. Differences between rebate calculations and accrual of interest income merely adjust original estimates of interest income and should be recognized in income when loans or trade receivables are prepaid or renewed.

Loan Fees, Costs, Discounts, and Premiums

8.101 FASB ASC 310-20 provides guidance on the recognition, measurement, derecognition, and disclosure of nonrefundable fees, origination costs, and acquisition costs associated with lending activities and loan purchases. FASB ASC 310-20-35-2 states that loan origination fees deferred in accordance with FASB ASC 310-20-25-2 should be recognized over the life of the loan as an adjustment of yield (interest income). Likewise, direct loan origination costs deferred in accordance with FASB ASC 310-20-25-2 should be recognized as a reduction in the yield of the loan except as set forth in FASB ASC 310-20-35-12 (for a TDR).¹⁰ FASB ASC 310-20-30-2 explains that loan origination fees and related direct loan origination costs for a given loan should be offset and only the net amount should be deferred. If the entity holds a large number of similar loans for which prepayments are probable and timing and amount of prepayments can be reasonably estimated, the entity may consider estimates of future principal prepayments in the calculation of the constant effective yield necessary to apply the interest method, in accordance with FASB ASC 310-20-35-26. Otherwise, the payment terms required by the loan contract should be used.

8.102 Direct loan origination costs must be deferred irrespective of the existence of related loan fees. As defined in the FASB ASC glossary, direct loan origination costs include only incremental direct costs of loan origination incurred in transactions with independent third parties and certain costs directly related to specified activities performed by the lender for that loan. Unsuccessful loan origination efforts and other indirect costs, which include administrative costs, rent, depreciation, and all other occupancy and equipment costs, should be charged to expense as incurred, according to FASB ASC 310-20-25-3.

8.103 FASB ASC 310-20-35-3 explains that, except as set forth in this paragraph, fees received for a commitment to originate or purchase a loan or group of loans should be, if the commitment is exercised, recognized over the life of the loan as an adjustment of yield or, if the commitment expires unexercised, recognized in income upon expiration of the commitment:

8.104 FASB ASC 310-20 does not apply to fees and costs related to a commitment to originate, sell, or purchase loans that is accounted for as a derivative instrument under FASB ASC 815-10, as stated in item (d) in FASB ASC 310-20-15-3.

8.105 FASB ASC 310-20-25-22 considers that for a purchased loan or a group of loans, the initial investment should include the amount paid to the seller, net of fees paid or received. All other costs related to acquiring purchased loans or committing to purchase loans should be charged to expense as incurred. FASB ASC 310-20-35-15 explains that the difference between the initial investment and the related loan's principal amount at the date of purchase should be recognized as an adjustment of yield over the contractual life of the loan.

8.106 FASB ASC 310-20-35-21 explains that certain loan agreements provide no scheduled payment terms (demand loans). Other loan agreements provide the borrower with the option to make multiple borrowings up to a specified maximum amount, to repay portions of previous borrowings, and then reborrow under the same contract (revolving lines of credit). Paragraphs 22–23 of FASB ASC 310-20-35 stipulate that any net fees or costs for a loan that is payable at the lender’s demand may be recognized as an adjustment of yield on a straight-line basis over a period that is consistent with (a) the understanding between the borrower and the lender or (b) if no understanding exists, the lender’s estimate of the period over which the loan will remain outstanding. The net fees or costs on revolving lines of credit (or similar loan arrangements) should be recognized in income on a straight-line basis over the period the revolving line of credit is active, assuming that borrowings are outstanding for the maximum term provided in the loan contract.

8.107 Paragraphs 9–10 of FASB ASC 310-20-35 state that if the terms of the new loan resulting from a loan refinancing or restructuring other than a TDR are at least as favorable to the lender as the terms for comparable loans to other customers with similar collection risks who are not refinancing or restructuring a loan with the lender, the refinanced loan should be accounted for as a new loan. This condition would be met if the new loan's effective yield is at least equal to the effective yield for such loans and modifications of the original debt instrument are more than minor. Any unamortized net fees or costs and any prepayment penalties from the original loan should be recognized in interest income when the new loan is granted. If the refinancing or restructuring does not meet the condition set forth in FASB ASC 310-20-35-9 or if only minor modifications are made to the original loan contract, the unamortized net fees or costs from the original loan and any prepayment penalties should be carried forward as a part of the net investment in the new loan.

8.108 FASB ASC 310-20-35-11 states that a modification of a debt instrument should be considered more than minor under FASB ASC 310-20-35-10 if the present value of the cash flows under the terms of the new debt instrument is at least 10 percent different from the present value of the cash flows under the terms of the original instrument. If the difference between the present value of the cash flows under the terms of the new debt instrument and the present value of the remaining cash flows under the terms of the original debt instrument is less than 10 percent, a creditor should evaluate whether the modification is more than minor based on the specific facts and circumstances (and other relevant considerations) surrounding the modification. The guidance in FASB ASC 470, Debt, should be used to calculate the present value of the cash flows for purposes of applying the 10 percent test.

8.109 Paragraphs 17–25 of FASB ASC 310-20-35 also discuss a variety of other amortization matters, including the treatment of increasing, decreasing, and variable-rate loans.

TDRs¹³

8.123 FASB ASC 310-40 addresses measurement, derecognition, disclosure, and implementation guidance issues concerning TDRs focused on the creditor's records. See paragraph 8.75 for a discussion on the FFIEC’s Supplemental Instructions for September 2014 Call Reports that address the accounting for subsequent restructurings of TDRs.

8.124 For creditors, TDRs include certain modifications of terms of loans and receipt of assets from debtors in partial or full satisfaction of loans.

8.125 According to FASB ASC 310-40-15-5, a restructuring of a debt constitutes a TDR for purposes of FASB ASC 310-40 if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider.

8.126 Creditor’s concession determination. According to paragraphs 13–14 of FASB ASC 310-40-15, a creditor has granted a concession when, as a result of the restructuring, it does not expect to collect all amounts due, including interest accrued at the original contract rate. In that situation, and if the payment of principal at original maturity is primarily dependent on the value of collateral, an entity should consider the current value of that collateral in determining whether the principal will be paid. A creditor may restructure a debt in exchange for additional collateral or guarantees from the debtor. In that situation, a creditor has granted a concession when the nature and amount of that additional collateral or guarantees received as part of a restructuring do not serve as adequate compensation for other terms of the restructuring. When additional guarantees are received in a restructuring, an entity should evaluate both a guarantor’s ability and its willingness to pay the balance owed.

8.127 Paragraphs 15–16 of FASB ASC 310-40-15 state if a debtor does not otherwise have access to funds at a market rate for debt with similar risk characteristics as the restructured debt, the restructuring would be considered to be at a below-market rate, which may indicate that the creditor has granted a concession. In that situation, a creditor should consider all aspects of the restructuring in determining whether it has granted a concession. A temporary or permanent increase in the contractual interest rate as a result of a restructuring does not preclude the restructuring from being considered a concession because the new contractual interest rate on the restructured debt could still be below market interest rates for new debt with similar risk characteristics. In that situation, a creditor should consider all aspects of the restructuring in determining whether it has granted a concession.

8.128 Paragraphs 17–18 of FASB ASC 310-40-15 provide guidance in evaluating whether a restructuring resulting in a delay in payment is insignificant; and therefore, would not be considered a concession.

8.129 Debtor’s financial difficulties determination. In evaluating whether a receivable is a TDR, a creditor must determine whether the debtor is experiencing financial difficulties, according to FASB ASC 310-40-15-20. In making this determination, a creditor should consider the following indicators:

The preceding list of indicators is not intended to include all indicators of a debtor’s financial difficulties.

8.130 Restructuring Characteristics. As stated in FASB ASC 310-40-15-9, a TDR may include, but is not necessarily limited to, one or a combination of the following (a) transfer from the debtor to the creditor of receivables from third parties, real estate, or other assets to satisfy fully or partially a debt (including a transfer resulting from foreclosure or repossession), (b) issuance or other granting of an equity interest to the creditor by the debtor to satisfy fully or partially a debt unless the equity interest is granted pursuant to existing terms for converting the debt into an equity interest, and (c) modification of terms of a debt.

8.131 FASB ASC 310-40-15-9 further states that modification of terms of debt may include one or a combination of any of the following:

8.132 Modification of terms. A creditor in a TDR involving only a modification of terms of a receivable—that is, not involving receipt of assets (including an equity interest in the debtor)—should account for the TDR in accordance with the provisions of FASB ASC 310, as explained in FASB ASC 310-40-35-5.

8.133 Item (a) in FASB ASC 320-10-55-2 clarifies that any loan that was restructured as a security in a TDR involving a modification of terms would be subject to the provisions of FASB ASC 320 if the debt instrument meets the definition of a security (as provided in the FASB ASC glossary). FASB 310-40-40-8A provides guidance on how to account for any excess of the fair value of the debt security received in restructuring over the net carrying amount of the loan at the date of the restructuring.

8.134 Partial Satisfaction of a Receivable. In accordance with FASB ASC 310-40-35-7, TDRs involving receipt of assets (including an equity interest in the debtor) in partial satisfaction of a receivable and a modification of terms of the remaining receivable should be accounted for as prescribed in FASB ASC 310 except that, first, the assets received should be accounted for as prescribed in paragraphs 2–4 of FASB ASC 310-40-40 (see paragraph 8.135) and the recorded investment in the receivable should be reduced by the fair value less cost to sell of the assets received. If cash is received in a partial satisfaction of a receivable, the recorded investment in the receivable should be reduced by the amount of cash received.

8.135 Receipts of assets. According to paragraphs 2–3 of FASB ASC 310-40-40, a creditor that receives from a debtor in full satisfaction of a receivable either (a) receivables from third parties, real estate, or other as-sets or (b) shares of stock or other evidence of an equity interest in the debtor, or both, should account for those assets (including an equity interest) at their fair value at the time of the restructuring (see FASB ASC 820, Fair Value Measurement, for guidance regarding fair value measurements and chapter 20 of this guide for a summary of FASB ASC 820). A creditor that receives long-lived assets that will be sold from a debtor in full satisfaction of a receivable should account for those assets at their fair value less cost to sell as that term is used in FASB ASC 360-10-35-43. The excess of the recorded investment in the receivable satisfied over the fair value of assets received (less cost to sell, if required) is a loss to be recognized. For purposes of this paragraph, losses, to the extent they are not offset against allowances for uncollectible amounts or other valuation accounts, should be included in measuring net income for the period.

8.136 Impairment. A loan restructured in a TDR is an impaired loan, as stated in FASB ASC 310-40-35-10. It should not be accounted for as a new loan because a TDR is part of a creditor’s ongoing effort to recover its investment in the original loan. A loan usually will have been identified as impaired because the conditions specified in paragraphs 16–17 of FASB ASC 310-10-35 will have existed before a formal restructuring. FASB ASC 310-10-35-21 explains that some impaired loans have risk characteristics that are unique to an individual borrower and the creditor should apply the measurement methods described in FASB ASC 310-30-30-2; 310-10-35-22 through 310-10-35-28; and 310-10-35-37 on a loan-by-loan basis. However, some impaired loans may have risk characteristics in common with other impaired loans. A creditor may aggregate those loans and may use historical statistics, such as average recovery period and average amount recovered, along with a composite effective interest rate as a means of measuring impairment of those loans.

8.137 Foreclosed Assets in TDRs. “Pending Content” in FASB ASC 310-40-40-6 explains that except in the circumstances described in FASB ASC 310-40-40-6A, a TDR that is in substance a repossession or foreclosure by the creditor (that is, the creditor receives physical possession of the debtor's assets regardless of whether formal foreclosure proceedings take place, or in which the creditor otherwise obtains one or more of the debtor's assets in place of all or part of the receivable) should be accounted for according to the provisions of FASB ASC 310-40-35-7 (see paragraph 8.134), paragraphs 2–4 of FASB ASC 310-40-40 and, if appropriate, FASB ASC 310-40-40-8 (see paragraph 8.138). See further discussion on the classification and measurement of certain government-guaranteed mortgage loans upon foreclosure in the “Foreclosed Assets” section of chapter 11 of this guide. For guidance on when a creditor should be considered to have received physical possession (resulting from an in-substance repossession or foreclosure) of residential real estate properly collateralizing a consumer mortgage loan, see FASB ASC 310-40-55-10A.

8.138 Sale of Assets from a TDR. FASB ASC 310-40-40-8 states that a receivable from the sale of assets previously obtained in a TDR should be accounted for according to FASB ASC 835-30 regardless of whether the assets were obtained in satisfaction (full or partial) of a receivable to which FASB ASC 835, Interest, was not intended to apply. A difference, if any, between the amount of the new receivable and the carrying amount of the assets sold is a gain or loss on sale of assets.

Real Estate Investments

8.139 The “Acquisition, Development, and Construction Arrangements” subsections in FASB ASC 310-10 provide guidance for determining whether a lender should account for an ADC arrangement as a loan or as an investment in real estate or a joint venture. As explained in FASB ASC 310-10-05-9, lenders may enter into ADC arrangements in which they have virtually the same risks and potential rewards as those of owners or joint venturers. Loans granted to acquire operating properties sometimes grant the lender a right to participate in expected residual profit from the sale or refinancing of the property. The expected residual profit may take the form of a percentage of the appreciation of the property determined at the maturity of the loan. If the lender is expected to receive over 50 percent of the expected residual profit from the project, item (a) in FASB ASC 310-10-25-27 states that the lender should account for income or loss from the arrangement as a real estate investment as specified in FASB ASC 970, Real Estate—General. See chapter 11 of this guide. Effective January 1, 2015, high volatility CRE loans carry a capital charge that is 50 percent higher than the capital charge for other CRE loans.

Lease Financing¹⁴

8.140 Accounting for leases by lessees and lessors is established in FASB ASC 840. FASB ASC 840-40-55-38 states that a transaction should be considered a sale-leaseback transaction subject to FASB ASC 840-40 if the preexisting lease is modified in connection with the sale, except for insignificant changes. Accordingly, transactions with modifications to the preexisting lease involving real estate should be accounted for in accordance with the guidance in FASB ASC 840-40 that addresses sale-leaseback transactions involving real estate. If the preexisting lease is not modified in conjunction with the sale, except for insignificant changes, profit should be deferred and recognized in accordance with FASB ASC 840-40-25-3.

Foreign Loans

8.141 Accounting for foreign loans is generally the same as for single-jurisdiction, domestic loans. However, unique issues arise regarding the accounting for restructured debt of developing countries and the recognition of interest income on such loans.

8.142 FASB ASC 942-310 addresses situations where a financially troubled country may suspend the payment of interest on its loans. Debt-equity swap programs are in place in several financially troubled countries, as stated in FASB ASC 942-310-05-3. Although the programs differ somewhat among the countries, the principal elements of each program generally are as follows:

8.143 In accordance with paragraph 1-2 of FASB ASC 942-310-30, debt/equity swaps (defined in the FASB ASC glossary as an exchange transaction of a monetary asset for a nonmonetary asset) should be measured at fair value at the date the transaction is agreed to by both parties. Because the secondary market for debt of financially troubled countries may be considered to be thin, it may not be the best indicator of the fair value of the equity investment or of net assets received. FASB ASC 942-310-30-3 provides factors to consider in measuring fair values of debt/equity swap transactions.

8.144 If amounts are received on a financially troubled country’s loan on which the accrual of interest has been suspended, FASB ASC 942-310-35-2 notes that a determination should be made about whether the payment should be recorded as a reduction of the principal balance of the loan or as interest income.

Commitments

8.145 Paragraphs 69–71 of FASB ASC 815-10-15 provide guidance on the types of loan commitments that are derivatives under FASB ASC 815-10 (and therefore required to be accounted for as derivatives) and those that are excluded from the scope. Notwithstanding the characteristics discussed in FASB ASC 815-10-15-83, loan commitments that relate to the origination of mortgage loans that will be HFS (as discussed in FASB ASC 948-310-25-3) should be accounted for as derivative instruments by the issuer of the loan commitment (that is, the potential lender). For the holder of a commitment to originate a loan (that is, the potential borrower), that loan commitment is not subject to the requirements of FASB ASC 815-10. For issuers of loan commitments to originate mortgage loans that will be held for investment purposes, as discussed in paragraphs 3–4 of FASB ASC 948-310-25, those loan commitments are not subject to FASB ASC 815-10.

8.146 Loan commitments to originate loans, excluded from the scope of FASB ASC 815-10, are accounted for under FASB ASC 948, Financial Services—Mortgage Banking, or FASB ASC 310-20, as appropriate.

8.147 However, commitments to purchase or sell mortgage loans or other types of loans at a future date must be evaluated under the definition of a derivative instrument to determine whether FASB ASC 815-10 applies, according to FASB ASC 815-10-15-70.

8.148 Commitments to originate mortgage loans that will be HFS generally qualify as derivative instruments and are recorded at fair value at inception and changes in fair value are recorded in current earnings. Chapters 10 and 18, “Derivative Instruments: Futures, Forwards, Options, Swaps, and Other Derivative Instruments,” of this guide address commitments to sell loans. Chapter 9 and subsequent paragraphs of this guide address accounting for loss contingencies in conformity with FASB ASC 450.

8.149 FASB ASC 310-10-05-5 states that entities sometimes enter into forward standby commitments to purchase loans at a stated price in return for a standby commitment fee. In such an arrangement, settlement of the standby commitment is at the option of the seller of the loans and would result in delivery to the entity only if the contract price equals or exceeds the market price of the underlying loan or security on the settlement date. A standby commitment differs from a mandatory commitment in that the entity assumes all the market risks of ownership but shares in none of the rewards. A standby commitment is, in substance, a written put option that will be exercised only if the value of the loans is less than or equal to the strike price.

8.150 Many entities use standby commitments to supplement their normal loan origination volume. Such standby commitments may be subject to the scope of FASB ASC 815 if they satisfy the definition of a derivative in paragraphs 83–139 of FASB ASC 815-10-15. Standby commitments discussed in the previous paragraph that satisfy the definition of a derivative are recognized in the statement of financial position at inception and measured at the fair value of the commitment. In accordance with FASB ASC 815-10-35-2, changes in fair value of derivative instruments not designated in hedging relationships are recognized currently in earnings.

8.151 FASB ASC 310-10-30-7 states that if a standby commitment is viewed under FASB ASC 310-10-25-6 as part of the normal production of loans, an entity should record loans purchased under the standby commitment at cost on the settlement date, net of the standby commitment fee received, in conformity with FASB ASC 310-20. If a standby commitment is accounted for as a written option as discussed in FASB ASC 310-10-25-6, the option premium received (standby commitment fee) should be recorded as a liability representing the fair value of the standby commitment on the trade date.

8.152 As stated in FASB ASC 310-10-35-46, this guidance applies only to standby commitments to purchase loans. It does not apply to other customary kinds of commitments to purchase loans, nor does it apply to commitments to originate loans. See FASB ASC 310-10-35-46 for subsequent measurement guidance related to standby commitments to purchase loans.

Financial Statement Presentation and Disclosure

8.153 Loans and trade receivables. FASB ASC 310-10-50-2 states that the summary of significant accounting policies should include the following:

• The basis for accounting for loans and trade receivables.
• The classification and method of accounting for interest-only strips, loans, other receivables, or retained interests in securitizations that can be contractually prepaid or otherwise settled in a way that the holder would not recover substantially all of its recorded investment.¹⁵
• The method used in determining the lower of cost or fair value of nonmortgage loans HFS (that is, aggregate or individual asset basis).¹⁶
• The method for recognizing interest income on loans and trade receivables, including a statement about the entity’s policy for the treatment of related fees and costs, including the method of amortizing net deferred fees or costs.

8.154 FASB ASC 310-10-45-2 states that loans or trade receivables may be presented on the balance sheet as aggregate amounts. However, such receivables HFS should be a separate balance sheet category. Major categories of loans or trade receivables should be presented separately either in the balance sheet or in the notes to the financial statements.

8.155 FASB ASC 310-10-50-4 states that the allowance for credit losses (also referred to as the allowance for doubtful accounts) and, as applicable, any unearned income, any unamortized premiums and discounts, and any net unamortized deferred fees and costs should be disclosed in the financial statements.

8.156 Except for credit card receivables, FASB ASC 310-10-50-4A requires that an entity disclose its policy for charging off uncollectible trade accounts receivable that have both a contractual maturity of one year or less and arose from the sale of goods or services.

8.157 Nonaccrual and past due financing receivables. FASB ASC 310-10-50-6 requires that a entity’s summary of significant accounting policies for financing receivables should include

• the policy for placing financing receivables, if applicable, on nonaccrual status (or discontinuing accrual of interest)
• the policy for recording payments received on nonaccrual financing receivables (if applicable),
• the policy for resuming accrual of interest, and
• the policy for determining past due or delinquency status.

8.158 According to paragraphs 7–7A of FASB ASC 310-10-50, an entity should provide both the following disclosures related to nonaccrual and past due financing receivables as of each balance sheet date: (a) the recorded investment in financing receivables on nonaccrual status and (b) the recorded investment in financing receivables past due 90 days or more and still accruing. An entity should also provide an analysis of the age of the recorded investment in financing receivables at the end of the reporting period that are past due, as determined by the entity’s policy. The guidance in FASB ASC 310-10-50-7A does not apply to the financing receivables listed in FASB ASC 310-10-50-7B.

8.159 For trade receivables that do not accrue interest until a specified period has elapsed, nonaccrual status would be the point when accrual is suspended after the receivable becomes past due, as stated in FASB ASC 310-10-50-8.

8.160 The guidance in paragraphs 6–8 of FASB ASC 310-10-50 does not apply to loans acquired with deteriorated credit quality. Instead, disclosures of such loans should be in accordance with FASB ASC 310-30. In addition, the guidance in paragraphs 6–7A of FASB ASC 310-10-50 should be provided by class of financing receivable except for the financing receivables listed in FASB ASC 310-10-50-5B.

8.161 Impaired loans. See discussion on disclosure requirements of impaired loans in paragraph 9.54 of this guide.

8.162 Credit quality. According to paragraphs 28–30 of FASB ASC 310-10-50, an entity should provide information that enables financial statement users to (a) understand how and to what extent management monitors the credit quality of its financing receivables in an ongoing manner and (b) assess the quantitative and qualitative risks arising from the credit quality of its financing receivables. To meet this objective, an entity should provide quantitative and qualitative information by class about the credit quality of financing receivables, including all of the following:

• A description of the credit quality indicator
• The recorded investment in financing receivables by credit quality indicator
• For each credit quality indicator, the date or range of dates in which the information was updated for that credit quality indicator

If an entity discloses internal risk ratings, then the entity should provide qualitative information on how those internal risk ratings relate to the likelihood of loss. This guidance does not apply to the financing receivables listed in FASB ASC 310-10-50-7B, as stated in FASB ASC 310-10-50-27.

8.163 Modifications. As required by FASB ASC 310-40-50-1, as of the date of each balance sheet presented, a creditor should disclose, either in the body of the financial statements or in the accompanying notes, the amount of commitments, if any, to lend additional funds to debtors owing receivables whose terms have been modified in TDRs.

8.164 Paragraphs 2–3 of FASB ASC 310-40-50 explains that information about an impaired loan that has been restructured in a TDR involving a modification of terms need not be included in the disclosures required by items (a) and (c) in FASB ASC 310-10-50-15 in years after the restructuring if (a) the restructuring agreement specifies an interest rate equal to or greater than the rate that the creditor was willing to accept at the time of the restructuring for a new loan with comparable risk and (b) the loan is not impaired based on the terms specified by the restructuring agreement. That exception should be applied consistently for items (a) and (c) in FASB ASC 310-10-50-15 to all loans restructured in a TDR that meet the criteria in items (a) and (b) in FASB ASC 310-40-50-2.

8.165 For each period for which a statement of income is presented, FASB ASC 310-10-50-33 requires an entity to disclose the following about TDRs of financing receivables that occurred during the period:

8.166 For each period for which a statement of income is presented, FASB ASC 310-10-50-34 requires an entity to disclose the following for financing receivables modified as TDRs within the previous 12 months and for which there was a payment default during the period:

8.167 Assets serving as collateral. For required disclosures of the carrying amount of loans, trade receivables, securities, and financial instruments that serve as collateral for borrowings see FASB ASC 860-30-50-1A.

8.168 Transfers of financial assets. Accounting and financial reporting matters related to the sales or other dispositions of loans are addressed in chapter 10 of this guide.

8.169 Lease financing.¹⁷ Paragraphs 4–5 of FASB ASC 840-10-50 require certain disclosures by lessors when leasing is a significant part of a lessor's business activities in terms of revenue, net income, or assets.

8.170 Fair value option. As of each date for which a statement of financial position is presented, item (e) in FASB ASC 825-10-50-28 states that entities should disclose for loans held as assets, for which the fair value option has been elected, all of the following:

8.171 For each period for which an income statement is presented, item (c) in FASB ASC 825-10-50-30 requires that entities disclose for loans and other receivables held as assets, for which the fair value option has been elected, both of the following:

• The estimated amount of gains or losses included in earnings during the period attributable to changes in instrument-specific credit risk
• How the gains or losses attributable to changes in instrument-specific credit risk were determined

8.172 Concentrations of credit risk of all financial instruments. Paragraphs 20–21 of FASB ASC 825-10-50 require disclosures about all significant concentrations of credit risk arising from all financial instruments except for the instruments described in FASB ASC 825-10-50-22. The following should be disclosed for each significant concentration:

An entity is encouraged, but not required, to disclose quantitative information about the market risks of financial instruments that is consistent with the way it manages or adjusts those risks. See FASB ASC 825-10-50-23 for possible disclosures.

8.173 Information about loan products and terms of loan products that identifies the concentration may also be disclosed.

8.174 Disclosure requirements under FASB ASC 825 which might be challenging for financial institutions, may include requirements related to loan fair values based on pricing models, the reconciliation of the beginning and ending balances for fair value measurements using significant unobservable inputs (level 3), and nonrecurring measurements such as real estate owned. See FASB ASC 820-10-50 for the required disclosures for recurring and nonrecurring fair value measurements.

8.175 Off-balance-sheet credit risk. FASB ASC 942-825-50-1 states that off-balance-sheet credit risk refers to credit risk on off-balance-sheet loan commitments, standby letters of credit, financial guarantees, and other similar instruments, except those instruments within the scope of FASB ASC 815. For financial instruments with off-balance-sheet credit risk, except for those instruments within the scope of FASB ASC 815, an entity should disclose the following information:

i.  credit and market risk of those instruments

ii.  cash requirements of those instruments

iii.  related accounting policy pursuant to FASB ASC 235-10

8.176 Examples of activities and financial instruments with off-balance-sheet credit risk include obligations for loans sold with recourse (with or without a floating-interest-rate provision), fixed-rate and variable-rate loan commitments, financial guarantees, note issuance facilities at floating rates, and letters of credit, as stated in FASB ASC 942-825-50-2.

8.177 Related party disclosures. FASB ASC 850, Related Party Disclosures, contains guidance on disclosures about transactions with various related parties. Institutions frequently make loans to parent and affiliated companies, directors, officers, and stockholders, as well as to entities with which directors, officers, and stockholders are affiliated. The aggregate amount of such loans should be disclosed. See paragraphs 5.38–.39 of this guide for Regulation O requirements regarding extension of credit to certain related parties.

8.178 Guarantees. FASB ASC 460, Guarantees, establishes the accounting and disclosure requirements to be met by a guarantor for certain guarantees issued and outstanding. Commercial letters of credit and other loan commitments, which are commonly thought of as guarantees of funding, are not included in the scope of FASB ASC 460, as stated in item (a) in FASB ASC 460-10-55-16. However, FASB ASC 460-10-55-2 provides that a financial standby letter of credit is an example of a guarantee contract under the scope of FASB ASC 460. A financial standby letter of credit is defined in the FASB ASC glossary as an irrevocable undertaking (typically by a financial institution) to guarantee payment of a specified financial obligation. See paragraphs 4–7 of FASB ASB 460-10-15 for types of guaranteed contracts included and excluded from the scope of FASB ASC 460.

8.179 In accordance with FASB ASC 460-10-25-4, at the inception of a guarantee, the guarantor should recognize in its statement of financial position a liability for that guarantee. FASB ASC 460-10 does not prescribe a specific account for the guarantor’s offsetting entry when it recognizes the liability at the inception of a guarantee. That offsetting entry depends on the circumstances in which the guarantee was issued. The liability that the guarantor initially recognized under FASB ASC 460-10-25-4 would typically be reduced (by a credit to earnings) as the guarantor is released from risk under the guarantee, as stated in FASB ASC 460-10-35-1.

8.180 In accordance with paragraphs 2–3 of FASB ASC 460-10-30, the objective of the initial measurement of a guarantee liability is the fair value of the guarantee at its inception. In the event that, at the inception of the guarantee, the guarantor is required to recognize a liability under FASB ASC 450-20-25 for the related contingent loss, the liability to be initially recognized for that guarantee should be the greater of (a) the amount that satisfies the fair value objective or (b) the contingent liability amount required to be recognized at inception of the guarantee in FASB ASC 450-20-30.

8.181 FASB ASC 460-10-50-4 requires a number of disclosures about a guarantor’s obligations under guarantees. A guarantor should disclose all of the following information about each guarantee, or each group of similar guarantees, even if the likelihood of the guarantor’s having to make any payments under the guarantee is remote:

i.  The approximate term of the guarantee

ii.  How the guarantee arose

iii.  The events or circumstances that would require the guarantor to perform under the guarantee

iv.  The current status (that is, as of the date of the statement of financial position) of the payment/performance risk of the guarantee (for example, the current status of the payment/performance risk of a credit-risk-related guarantee could be based on either recently issued external credit ratings or current internal groupings used by the guarantor to manage its risk)

v.  If the entity uses internal groupings for purposes of item (a)(iv), and how those groupings are determined and used for managing risk

i.  The maximum potential amount of future payments (undiscounted) the guarantor could be required to make under the guarantee, which should not be reduced by the effect of any amounts that may possibly be recovered under recourse or collateralization provisions in the guarantee

ii.  If the terms of the guarantee provide for no limitation to the maximum potential future payments under the guarantee

iii.  If the guarantor is unable to develop an estimate of the maximum potential amount of future payments under its guarantee, the reasons why it cannot estimate the maximum potential amount

Objectives

8.182 The primary objectives of audit procedures in the loan area are to obtain sufficient appropriate evidence that

Planning

8.183 In accordance with AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AICPA, Professional Standards), the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement (see chapter 5, “Audit Considerations and Certain Financial Reporting Matters,” of this guide for additional information). As described earlier in this chapter, credit risk is normally the principal risk inherent in lending. The composition of an institution's loan portfolio, which can vary widely from institution to institution, is one of the most important factors in assessing the risks of material misstatement related to loans. For example, the risks associated with construction lending are very different from the risks associated with credit card lending. The current year's interim financial statements and other financial information (for example, board of directors' minutes, asset-classification reports, credit management reports, and reports of the institution's regulators) should be helpful in understanding an institution's credit strategy and loan portfolio characteristics and, thereby, in assessing the related risks of material misstatement. Those reports generally include information about such items as dollar amounts and types of loans; the volume of current originations by type and related net deferred loan fees or costs; identification of TDRs; ADC arrangements; purchases and sales of loans, including gains and losses; and wash sales, among others. Controls over loans should also include controls over allowances and write-offs. Readers may refer to chapter 9 of this guide for guidance.

8.184 The following factors related to loans may be indicative of risks of material misstatement (and, often, higher control risk) for loans and related amounts:

• Lack of a formal written lending policy
• High rate of growth in the loan portfolio
• Concentration of lending authority in one individual
• Lack of personnel with skills and knowledge of a particular kind of loan, such as credit card or construction
• Significant changes in the composition of an institution's portfolio
• Poor underwriting standards and procedures
• Poor recordkeeping and monitoring of principal and interest receipts
• Significant nontraditional lending activities that involve a higher degree of risk, such as highly leveraged lending transactions
• Significant originations or purchases of loans outside the institution's normal activities or market area
• Sales of loans with significant recourse provisions
• Ambiguous transactions involving the sale or transfer of loans, especially when there is a lack of analysis prior to the transactions
• Failure of personnel to follow management's written lending policies for underwriting and documentation
• Loans that are continuously extended, restructured, or modified
• Loans that are of a type, customer, collateral, industry, or geographical location not authorized by management's written lending policies
• Loans of unusual size or with unusual interest rates or terms
• Significant concentrations of loans in a particular industry or geographic area, or with a particular borrower or relationship of borrowers
• The potential for insider abuse because of significant loans to the institution's officers, directors, shareholders, or other related parties that do not meet normal underwriting standards, such as nominee loans, loans with questionable collateral, and multiple transactions with a single related party or group of affiliated parties
• Significant concentrations of loan products with terms that give rise to a credit risk; such as, negative amortization loans, loans with high LTV ratios, multiple loans on the same collateral that when combined result in a high LTV ratio, and interest-only loans
• Additional charge-off of loans upon resolution exceeding the specific reserve established for impaired loans

Internal Control Over Financial Reporting and Possible Tests of Controls¹⁹

8.185 AU-C section 315 addresses the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements through understanding the entity and its environment, including the entity’s internal control. Paragraphs .13–.14 of AU-C section 315 state that the auditor should obtain an understanding of internal control relevant to the audit and, in doing so, should evaluate the design of those controls and determine whether they have been implemented by performing procedures in addition to inquiry of the entity’s personnel. (See chapter 5 of this guide for further discussion of the components of internal control.) To provide a basis for designing and performing further audit procedures, paragraph .26 of AU-C section 315 states that the auditor should identify and assess the risks of material misstatement at the financial statement level and the relevant assertion level for classes of transactions, account balances, and disclosures.

8.186 An understanding of the internal control over the financial reporting of loans may include controls over transactions such as granting credit, disbursing loan funds, applying loan payments, amortizing discounts, accruing interest income, purchased loans, participations, and syndications as those transactions relate to each significant type of lending activity. Also, procedures are needed to ensure that all appropriate liens have been filed.

8.187 Effective controls in this area should provide assurance that errors or fraud in management's financial statement assertions about the loan portfolio—including those due to the failure to execute lending transactions in accordance with management's written lending policies—are prevented or detected. For example, failure to document a second lien as mandated by management's written loan documentation policy could affect financial statement assertions about ownership and valuation.

8.188 Factors that contribute to an effective control environment may include

• those charged with governance take an active role in monitoring lending policies and practices;
• information systems which enforce the segregation of duties and the monitoring of activities, and maintain the integrity of information on which management relies upon to identify problem loans;
• a well-defined lending approval and review system that includes established credit limits, limits and controls over the types of loans made, and limits on maturities of loans; and
• a reporting system that provides the institution with the information needed to manage the loan portfolio including monitoring of payment and past due status and credit quality.

8.189 In obtaining an understanding of the entity and its environment, including its internal control, the auditor should obtain an understanding about the institution's accounting system as it relates to loans receivable, including the methods used by the institution when processing and recording new loans, applying loan payments, accruing interest, and amortizing discounts.

8.190 With respect to some risks, paragraph .31 of AU-C section 315 states that the auditor may judge that it is not possible or practicable to obtain sufficient appropriate audit evidence only from substantive procedures. Such risks may relate to the inaccurate or incomplete recording of routine and significant classes of transactions or account balances, the characteristics of which often permit highly automated processing with little or no manual intervention. In such cases, the entity’s controls over such risks are relevant to the audit, and the auditor should obtain an understanding of them. Typical controls relating to loans include the following:

• All loans and credit lines (including all new loans, renewals, extensions, and commitments) are approved by officers or committees in conformity with management's written lending policies and authority limits.
• An inventory of loan documents, including evidence of collateral and of the recording of liens, is monitored to ensure the timely receipt of necessary documents.
• Pertinent loan information is entered into the data-processing system on a timely basis and is independently verified to ensure accuracy.
• Subsidiary ledgers and trial balances are maintained and reconciled with the general ledger on a timely basis, differences found are investigated and resolved, and appropriate supervisory personnel review and approve completed reconciliations on a timely basis.
• Loans HFS are properly identified in the accounting records.
• Loans that were sold and are removed from the lender’s balance sheet meet the requirements for removal under FASB ASC 860.
• Payments due for principal or interest are monitored for their eventual receipt, aging of delinquencies, and follow-up with late payers.
• There is segregation of duties among those who (a) approve loans, (b) control notes and collateral, (c) receive payments, (d) post subsidiary ledgers, and (e) reconcile subsidiary and general ledgers.
• Procedures are periodically performed to ensure that interest income is properly accrued and recorded.
• Notes and collateral on hand are kept in secure, locked, fireproof compartments. Negotiable collateral is kept under dual access control. Physical inventory and other processes are in place to identify losses or impairment of collateral.
• Construction loan advances are adequately documented, and periodic on-site inspections of properties are made to ensure construction progress is consistent with amounts advanced.

8.191 Loan files. Complete and accurate loan files are an element of internal control over financial reporting. Paragraph 8.192 details information that may be found in a loan file. The contents of the files vary, depending on the type of loan, the requirements of local law, and whether the institution intends to hold the loan or not. However, all loan files should contain a signed note. An inspection of the files supporting loans originated in prior audit periods, as well as new loans (including some of the loans still in the process of disbursement), generally permits the auditor to understand the institution's internal control in this area as a basis for planning substantive tests. It may also be useful to design dual-purpose tests in this area.

8.192 Following are items a loan file may contain. The specific items contained in a loan file will vary based on the size, complexity, and type of loan. The location of the contents listed will vary from one institution to another depending on the type of loan and a particular institution's policies and procedures:

i.  Loan application

ii.  Credit approval document that summarizes the following:

(1)  Borrower

(2)  Amount of request, rate, payment terms, and fees

(3)  Purpose

(4)  Repayment sources (primary and secondary)

(5)  Collateral description and valuation

(6)  Guarantors

(7)  Other conditions and requirements of approval

iii.  Evidence of loan committee or other required approval (for example, borrower’s board resolutions concerning loan approval) and date approval was granted

iv.  Recent financial statements of borrower, guarantor, or both

v.  Spreadsheets and other analyses of the financial situation of the borrower including analysis of debt service capability

vi.  Credit agency reports and other account information reports, as well as direct trade creditor references

vii.  Newspaper clippings about borrower

viii.  Various other pertinent data, including the borrower's history and forecasts

ix.  Correspondence

x.  Loan summary sheet, containing information such as the following:

(1)  Lending committee approval date

(2)  Drawdown amounts and dates

(3)  Interest rates and adjustment dates

(4)  Amount of undrawn commitment

(5)  Rate of commitment fee and due dates

(6)  Date commitment fee received

(7)  Repayment terms

(8)  Name of country risk

(9)  Name and country of any guarantor

(10)  Amount of participation fee (if applicable)

(11)  Indication of overdue payments of interest, fees, or installments

xi.  Memorandum to the file, by the lending officer, with description of the credit and commentary on its quality and potential future developments

i.  Signed loan agreement

ii.  Legal opinion

iii.  Signed note

iv.  Signed mortgage or deed of trust, with evidence of recordation

v.  Signed guarantee

vi.  Periodic report of collateral, including its location and value and any related environmental studies

vii.  Participation certificates and participation agreements (if applicable)

viii.  Evidence of insurance, including loss payable clauses that protect the bank's interest

ix.  Approvals

x.  Security agreements or other collateral pledge agreements, titles, or financing statements recorded in the proper jurisdictions to perfect lien position (nonpossessory collateral); negotiable collateral (such as stocks and bonds) with proper endorsements/assignments; hypothecation agreement for third-party pledge of collateral

xi.  Collateral ledger used to record the instruments (including stocks and bonds, which are typically held in a vault separate from loan files or with an independent custodian) that secure a borrower's indebtedness

8.193 For commercial loans, the credit file usually contains the borrower's financial statements, memoranda about the borrower's financial or personal status, financial statements of guarantors (individual or corporate), internally prepared analyses of the credit, copies of supplemental agreements between the institution and the borrower, and other loan-related correspondence.

8.194 Files supporting either direct or indirect installment loans should include the borrower's application, discount sheet (loan computations), credit information, title or financing statement, evidence of the existence of an in-force insurance policy payable to the institution, and the note. Credit files are also maintained on dealers from whom the institution has purchased loan paper.

8.195 Mortgage loan files generally include the note, loan application, appraisal report, verifications of employment and assets, deed of trust, mortgage, title insurance or opinion, insurance policy, settlement statement, and VA guarantee or FHA insurance, if applicable.

8.196 Specific procedures the auditor may consider performing to test the operating effectiveness of controls for loans include

• inspecting loan documents, including sales and participation agreements, to determine whether the institution's lending policies and procedures are being followed, for example, to test whether

—  loans are being approved by authorized officers or committees in accordance with the institution's lending policies;

—  credit investigations are performed;

—  credit limits are adhered to;

—  the institution's procedure to capture all required loan documents is functioning

—  the information recorded in the institution's data-processing system and used for management reporting is being tested by personnel independent of the preparer and is accurate; and

—  loans sold meet the conditions in FASB ASC 860 for removal from the lender’s balance sheet.

• testing the institution's reconciliation process. This testing might include the daily activity balancing process as well as the reconciliation of subsidiary ledgers with the general ledger. The auditor should test whether reconciling differences are appropriately investigated and resolved in a timely manner and whether the reconciliations are reviewed and approved by appropriate supervisory personnel.
• testing the accuracy and performing a review of delinquency reports to determine whether the institution initiates follow-up procedures on delinquent loans in accordance with its policies and whether the system identifies potentially troubled loans for purposes of assessing impairment.
• checking the accuracy and performing a review of concentration reports (such as loans to one borrower, in a particular region, or in a specific industry) and related-party loan reports.
• reviewing internal audit, loan review, and examination reports to identify control weaknesses and exceptions.
• observing or otherwise obtaining evidence that proper segregation of duties exists among those who approve, disburse, record, and reconcile loans.
• performing detailed tests of initial recording of loans, application of cash receipts, and changes in loan details (such as adjustment of rates for ARMs and maturity dates).

See paragraph 8.220 for procedures around controls identified at a service organization.

8.197 Credit card activities. If the institution is involved in credit card operations, including credit card issuance and the processing of transactions, the auditor should consider internal control over financial reporting of credit card activities to the extent the auditor considers such internal control relevant to the audit. Audit procedures for testing financial statement assertions related to credit card activities depend on the degree of the institution's involvement in such activities. If the institution owns the customer receivables, the following may be appropriate:

• Review lending policies
• Confirm customer balances
• Test interest and service charges, collections, delinquencies, and charge-offs may be appropriate
• Test charge-off history and compare to reserve levels

If the institution only processes merchants' deposits and the resulting receivables are owned by other institutions, a review of the arrangements and a test of service fee income is generally performed.

8.198 To the extent the institution relies on other entities for some processing activities, the auditor should refer to the guidance in AU-C section 402, Audit Considerations Relating to an Entity Using a Service Organization (AICPA, Professional Standards).

Substantive Tests

8.199 Irrespective of the assessed risks of material misstatement, paragraph .18 of AU-C section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained (AICPA, Professional Standards), states that the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure, which for a financial institution would include loans. In accordance with paragraph .A45 of AU-C section 330, this requirement reflects the facts that (a) the auditor’s assessment of risk is judgmental and may not identify all risks of material misstatement and (b) inherent limitations to internal control exist, including management override.

8.200 Paragraph .06 of AU-C section 330 states that the auditor should design and perform further audit procedures whose nature, timing, and extent are based on, and are responsive to, the assessed risks of material misstatement at the relevant assertion level.

8.201 Analytical procedures. AU-C section 520, Analytical Procedures (AICPA, Professional Standards), addresses the auditor’s use of analytical procedures as substantive procedures (substantive analytical procedures). See chapter 5 of this guide for additional guidance regarding analytical procedures.

8.202 Analytical procedures that the auditor may apply in the loan area include the analysis and evaluation of the following:

• Changes in the mix between different types of loans in the portfolio
• Comparison of the aging of past-due loans with similar aging of prior year
• Comparison of loan origination volume by month with that of prior periods
• Current-year income compared with expectations and prior-year income
• Average loan balances by type in the current year compared with those of the prior year
• Comparison of yields on loans to the institution's established lending rates or pricing policies
• Reasonableness of balance sheet accruals based upon underlying terms and amounts of corresponding loans
• Average yield throughout the period computed for each loan category on a monthly or quarterly basis

8.203 In accordance with item a in paragraph .05 of AU-C section 520, when designing and performing analytical procedures, either alone or in combination with tests of details, as substantive procedures in accordance with AU-C section 330,²⁰ the auditor should determine the suitability of particular substantive analytical procedures for given assertions, taking into account the assessed risks of material misstatement and tests of details, if any, for these assertions. Analytical procedures may be used to help assess risk and identify areas that may require additional audit procedures. In using analytical procedures as a substantive test, the auditor might consider the implications of changes in important relationships and the extent of the difference between actual and expected results that can be accepted without further investigation. It is normally difficult to develop expectations to be used in with a sufficient level of precision analyzing yields on aggregated loans as a substantive test of related income amounts. Accordingly, analytical procedures in this area might be considered only as a supplement to other substantive procedures, except where an expected yield can be known with some precision (using computer-assisted audit techniques).

8.204 In accordance with item b in paragraph .05 of AU-C section 520, when designing and performing analytical procedures, either alone or in combination with tests of details, as substantive procedures in accordance with AU-C section 330,²¹ the auditor should evaluate the reliability and completeness of data from which the auditor’s expectation of recorded amounts or ratios is developed, taking into account the source, comparability, and nature and relevance of information available and controls over preparation. System generated information should be tested for completeness and accuracy. Paragraph .A19 of AU-C section 520 further explains that the auditor may consider testing the operating effectiveness of controls, if any, over the entity’s preparation of information used by the auditor in performing substantive analytical procedures in response to assessed risks. When such controls are effective, the auditor may have greater confidence in the reliability of the information and, therefore, in the results of analytical procedures. The operating effectiveness of controls over nonfinancial information may often be tested in conjunction with other tests of controls. Further requirements on the auditor’s evaluation of data reliability can be found in paragraph .09 of AU-C section 500, Audit Evidence (AICPA, Professional Standards).

8.205 When designing substantive analytical procedures, the auditor also might evaluate the risk of management override of controls. As part of this process, the auditor might consider evaluating whether such an override allowed adjustments outside of the normal period-end financial reporting process to have been made to the financial statements. Such adjustments might have resulted in artificial changes to the financial statement relationships being analyzed, causing the auditor to draw erroneous conclusions. For this reason, substantive analytical procedures alone are not well suited to detecting fraud. In addition, before using results obtained from substantive analytical procedures, the auditor could either test the design and operating effectiveness of controls over financial information used in the substantive analytical procedures or perform other procedures to support the completeness and accuracy of the underlying information.

8.206 For significant risks of material misstatement, it is unlikely that audit evidence obtained from substantive analytical procedures alone will be sufficient.

8.207 Subsidiary records. In accordance with paragraph .21 of AU-C section 330, the auditor’s substantive procedures should include audit procedures relating to the financial statement closing process, such as agreeing or reconciling financial statement balances, including loan principal balances and related accounts (accrued interest receivable, unearned discount, and net deferred loan fees and costs), with the underlying accounting records (trial balance, general ledger, and other subsidiary records). The auditor should test significant reconciling items.

8.208 Confirmation. Guidance on the extent and timing of audit procedures (that is, considerations involved in determining the number of items to confirm) is found in AU-C section 530, Audit Sampling (AICPA, Professional Standards),²² and AU-C section 320, Materiality in Planning and Performing an Audit (AICPA, Professional Standards). Readers may also refer to the AICPA Audit Guide Audit Sampling that provides guidance to help auditors apply audit sampling in accordance with AU-C section 530. Guidance on the timing of audit procedures is included in AU-C section 330.²³

8.209 AU-C section 505, External Confirmations (AICPA, Professional Standards), addresses the auditor’s use of external confirmation procedures to obtain audit evidence, in accordance with the requirements of AU-C sections 320 and 500.

8.210 When using external confirmation procedures, item (c) in paragraph .07 of AU-C section 505 states that the auditor should maintain control over external confirmation requests, including designing the confirmation requests, determining that requests are properly directed to the appropriate confirming party and providing for responses being directly to the auditor. Paragraphs .A4–.A5 of AU-C section 505 further explain that the design of a confirmation request may directly affect the confirmation response rate and the reliability and nature of the audit evidence obtained from responses. In addition, a factor to consider when designing confirmation requests is the ability of the intended confirming party to confirm or provide the requested information. For example, respondents may not be able to confirm the balances of installment loans, but they may be able to confirm whether their payments are up to date, the amounts of the payments, the interest rate, and the term of their loans.

8.211 Auditors may use either positive or negative requests to confirm loans. However, paragraph .15 of AU-C section 505 states that negative confirmations provide less persuasive audit evidence than positive confirmations. Accordingly, the auditor should not use negative confirmation requests as the sole substantive audit procedure to address an assessed risk of material misstatement at the assertion level, unless all of the following are present:

Positive confirmation procedures might be appropriate for larger loans and for loans that necessitate additional assurance or other related information in addition to the loan balance, such as amount and type of collateral.

8.212 Inspecting loan documents. Loan files vary considerably in content depending on the type of loan. Inspection of loan documents may provide evidence about the existence and ownership of the loan. It is important for the auditor to be alert when inspecting loan documents. Indicators such as notations could imply problems that merit further investigation or follow up. When loan documents are in the possession of an attorney or other outside parties, the auditor should consider confirming the existence and ownership of such documents.

8.213 When inspecting loan documents, the auditor may test the physical existence and read any evidence of assignment to the institution of the collateral that supports collateralized loans. For certain loans, the auditor might inspect collateral in the custody of the borrower, such as floor-plan merchandise. However, the auditor may conclude that a review of the reports of institution personnel who inspect collateral is sufficient audit evidence. The auditor may also consider examining or requesting confirmation of collateral not on hand. An inspection of loan documentation could include tests of the adequacy of both the current value of collateral in relation to the outstanding loan balance and, if needed, insurance coverage on the loan collateral.

8.214 While inspecting loan documents, the auditor should keep in mind the audit objectives discussed in chapter 9 of this guide. For example, reading the financial statements and other evidence of the financial condition of cosignatories and guarantors could be employed when the auditor tests guaranteed loans. Consideration might also be given to the institution’s historical experience with enforcing guarantees or confirmation of terms with guarantor.

8.215 While inspecting loan documents, the auditor might look for evidence of approvals by the board of directors or loan committee as required by management's written lending policies, a comparison of loan amounts with appraisals, and an inspection of whether hazard and title coverage meets coverage requirements set in management's written policy. For loans generated under certain governmental programs and other special arrangements, the auditor may be engaged to perform the additional procedures required under the specific trust or servicing agreement.

8.216 Construction loans. Audit procedures should be responsive to the assessed risk related to the institution's construction lending practices. For example, the auditor might perform tests to determine whether construction loans are properly classified as loans rather than real estate investments. The auditor might test origination, approval, inspection, and disbursements made based on progress on the particular construction project. The auditor might perform on-site inspections of significant construction projects to review the collateral and to determine whether construction has progressed in accordance with the loan terms.

8.217 Lease financing. When confirming basic lease terms, the confirmation requests typically would include cancellation provisions, if any. Confirmation should ordinarily be requested from the lessee. For leveraged leases, the material aspects of the lease agreement, including information necessary for income tax purposes, may be requested from the lease trustee. Although alternative methods may be used for reporting income for tax purposes, the auditor should determine that income for book purposes is being recorded in accordance with FASB ASC 840.²⁴

8.218 Whole loans or participations purchased. Audit procedures for purchased loans should be similar to those for direct loans, except that requests for the confirmation of balances, collateral, and recourse provisions, if any, are usually sent to the originating or servicing institution. Loan files for purchased participations should be available at the institution and contain pertinent documents, or copies of them, including credit files supporting loans in which the institution has purchased participations from other banks or savings institutions. The auditor should consider confirming the actual status of borrower payments with the servicer. Although it is usually not practicable to confirm balances of serviced loans with the individual borrowers, the servicer's auditors often perform audit procedures on individual loans, such as confirmation with borrowers and examination of loan documents. AU-C section 402 addresses the user auditor’s responsibility for obtaining sufficient appropriate audit evidence in an audit of the financial statements of a user entity that uses one or more service organizations. Statement on Standards for Attestation Engagements No. 16,²⁵ addresses examination engagements undertaken by a service auditor to report on controls at organizations that provide services to user entities when those controls are likely to be relevant to user entities’ internal control over financial reporting. It complements AU-C section 402 in that reports prepared in accordance with this section may provide appropriate evidence under AU-C section 402.

8.219 Paragraph .A24 of AU-C section 402 states that a type 1 or type 2 report (as defined in AU-C section 402) may assist the user auditor in obtaining a sufficient understanding to identify and assess the risks of material misstatement of the user entity’s financial statements. A type 1 report, however, does not provide any evidence of the operating effectiveness of the relevant controls.

8.220 When the user auditor’s risk assessment includes an expectation that controls at the service organization are operating effectively, paragraph .16 of AU-C section 402 states that the user auditor should obtain audit evidence about the operating effectiveness of those controls from one or more of the following procedures:

If the user auditor believes that the service auditor’s report may not provide sufficient appropriate audit evidence (for example, if a service auditor’s report does not contain a description of the service auditor’s tests of controls and results thereof), paragraph .A38 of AU-C section 402 further explains that the user auditor may supplement his or her understanding of the service auditor’s procedures and conclusions by contacting the service organization through the user entity to request a discussion with the service auditor about the scope and results of the service auditor’s work. Also, if the user auditor believes it is necessary, the user auditor may contact the service organization through the user entity to request that the service auditor perform procedures at the service organization, or the user auditor may perform such procedures. Further guidance for a user auditor can be found in AU-C section 402.

8.221 Accrued interest receivable and interest income. Provided that a basis exists to rely on loan data recorded in the loan accounting system, interest income may be tested using computer-assisted audit techniques, the recomputation of accrued amounts for individual accounts, analytical procedures, or some combination thereof. If interest rates were relatively stable during a period and the amounts can be predicted with a sufficient level of precision, interest income can often be tested effectively by using analytical tests by type of loan. The auditor should consider average balances in principal accounts, related yields as compared to averages of rates offered and of rates on existing loans, and other factors and relationships. As discussed in paragraphs 8.201–.206, the effectiveness of such analytical procedures may vary.

8.222 Computer assisted audit techniques. Computer-assisted audit techniques may also be used to perform "exception/limit" checks of individual files for unusual or questionable items meriting further investigation. Examples include identifying unusual interest rates, balances, and payments, or testing the accuracy of delinquency reports.

8.223 Balance sheet classification of loans. Depending on the auditor’s assessment of the risks of material misstatement, the auditor should consider whether any portion of loans is being HFS and, therefore, whether a corresponding valuation allowance or write-down to lower of cost or market value is necessary. Previous loan sale activity, types of loans sold, transactions subsequent to year-end, pending contracts, and management's intentions are factors that should be considered in identifying loans HFS.

8.224 Loan fees and costs. Depending on the auditor’s assessment of risks of material misstatement, the auditor should review and test the propriety of the institution's deferral of loan origination fees and costs in accordance with FASB ASC 310-20, as well as evaluating the impact of not deferring loan costs and fees. The auditor should also consider performing a test of the amortization of net deferred loan fees or costs.

8.225 Undisbursed portion of mortgage loans. Financial institutions sometimes record loans at the gross amount with an offsetting account entitled loans in process (LIP). As funds are disbursed, the LIP account is reduced. Interest or fees on construction loans also may be debited to this account. The LIP account should be cleared when the loan is fully disbursed. LIP detailed ledgers should be reviewed to determine the propriety of accounting, including that for complex interest calculations. Unusual LIP balances, such as debit balances or balances outstanding for an excessive period of time (for example, over a year), may be indicative of problem loans.

8.226 A review of the LIP detailed activity may be performed in connection with the examination of the current-year loan files. Loans selected for testing may be traced to the LIP account. Construction loans selected for testing may be traced to the LIP ledger, and disbursements may be reviewed in connection with the percentage of completion noted on inspection reports. In addition, if loan fees or interest are being capitalized (added to the loan balance) during construction, a review of the LIP ledgers may point out areas of concern. Based on the auditor’s assessment of the risks of material misstatement, the auditor should consider whether to send confirmations to the borrower on any undisbursed loan balances.

8.227 TDRs. The auditor should consider performing procedures to determine whether management has appropriately identified all TDRs, whether the accrual status is appropriate, whether they have been accounted for in conformity with FASB ASC 310-40, and whether management has appropriately measured impairment for TDRs under FASB ASC 310-10. Such tests may include procedures to determine whether possession of collateral has been taken as part of a TDR that is in substance a repossession or foreclosure by the creditor, that is, the creditor receives physical possession of the debtor’s assets regardless of whether formal foreclosure proceedings take place (as discussed in FASB ASC 310-40-40-6 [see paragraph 8.137]). Auditors should also consider whether the entities have appropriate tracking and reporting processes in place to address disclosure requirements applicable to TDRs.

8.228 In addition, auditors should consider reviewing substandard or watch-listed loans that have been renewed at terms similar to the original loan because these loans may involve borrowers that are experiencing some level of financial difficulty and, because of the deterioration in the loan's credit quality, may not otherwise qualify for the terms as offered in the renewal agreement. In these instances, the institution may have granted a concession because the interest rate for such a renewal is not indicative of a market rate, and, therefore, the renewal under such terms is a strong indicator that the loan should be accounted for as a TDR. In such cases, auditors should consider whether the institutions have appropriately documented their conclusions regarding TDR status and appropriately accounted for renewals of this nature. When the practical expedient for collateral dependent loans is not elected, the auditor may also want to review the assumptions of projected cash flows utilized in impairment measurements to determine the reasonableness of the estimates because this will drive the allocated allowance for such loans.

8.229 Valuation. For loans for which there is a market price, the auditor may test fair-value disclosures by reference to third-party market quotations, including information received from brokers or dealers in loans. Fair-value estimates of loans for which there is no market price are highly subjective. There are a variety of methodologies that may be used by institutions to estimate fair values of loans. Most derive a fair value by discounting expected cash flows using appropriate interest rates. Some methodologies are relatively simple, such as methods that derive much of their data from the information used in estimating the allowance for credit losses, and some are relatively complex, such as option pricing models. In accordance with paragraph .06 of AU-C section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures (AICPA, Professional Standards), the objective of the auditor is to obtain sufficient appropriate audit evidence about whether, in the context of the applicable financial reporting framework, accounting estimates including fair value accounting estimates in the financial statements, whether recognized or disclosed, are reasonable and related disclosures in the financial statements are adequate. AU-C section 540 provides relevant guidance. AU-C section 620, Using the Work of an Auditor’s Specialist (AICPA, Professional Standards), addresses the auditor’s responsibilities relating to the work of an individual or organization possessing expertise in a field other than accounting or auditing when that work is used to assist the auditor in obtaining sufficient appropriate audit evidence. AU-C section 620 does not address the auditor’s use of the work of an individual or organization possessing expertise in a field other than accounting or auditing, whose work in that field is used by the entity to assist the entity in preparing the financial statements (a management’s specialist), which is addressed in AU-C section 500.

8.230

Considerations for Audits Performed in Accordance With PCAOB Standards²⁶

PCAOB Staff Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists (AICPA, PCAOB Standards and Related Rules, PCAOB Staff Guidance, sec. 400.02), provides guidance on auditors' responsibilities for auditing fair value measurements of financial instruments and when using the work of specialists under the existing standards of the PCAOB. This alert is focused on specific matters that are likely to increase audit risk related to the fair value of financial instruments in a rapidly changing economic environment. This practice alert highlights certain requirements in the auditing standards related to fair value measurements and disclosures in the financial statements and certain aspects of GAAP that are particularly relevant to the current economic environment.

PCAOB Staff Audit Practice Alert No. 4, Auditor Considerations Regarding Fair Value Measurements, Disclosures, and Other-Than-Temporary Impairments (AICPA, PCAOB Standards and Related Rules, PCAOB Staff Guidance, sec. 400.04), informs auditors about potential implications of recently issued FASB guidance on reviews of interim financial information and annual audits. This alert addresses the following topics: (a) reviews of interim financial information; (b) audits of financial statements, including integrated audits; (c) disclosures; and (d) auditor reporting considerations.

PCAOB Staff Audit Practice Alert No. 7, Auditor Considerations of Litigation and Other Contingencies Arising From Mortgage and Other Loan Activities (AICPA, PCAOB Standards and Related Rules, PCAOB Staff Guidance, sec. 400.07), advises auditors that the potential risks and costs associated with mortgage and foreclosure-related activities or exposures, such as those discussed in the SEC staff letters, could have implications for audits of financial statements or of internal control over financial reporting. These implications might include accounting for litigation or other loss contingencies and the related disclosures.