EXECUTIVE SUMMARY
|
Due to increased regulatory
scrutiny and improved controls
following Sarbanes-Oxley, financial
companies are paying closer attention to
the recognition of fees from loan
origination.
Recognition of fees from
loan origination is subject
to FASB Statement no. 91, which requires
that these fees be netted with
origination costs and the resulting net
fee be deferred and amortized over the
life of the loan, generally using the
effective-interest method.
The straightforward and
mechanical application of the
effective-yield method works well for
ordinary loans but may not comply with
Statement no. 91 in the case of
adjustable-rate and hybrid loans.
Therefore, firms that originated a
substantial number of such loans during
the recent real estate boom should
review their accounting of fee
recognition.
Potential pitfalls for
companies in complying with
Statement no. 91 include relying on
vendor software without thorough
testing, grouping loans without meeting
grouping requirements, relying on manual
spreadsheet computations without proper
controls, having weak controls and not
retaining sufficient loan-level data.
Victor Valdivia, CPA,
Ph.D., is CEO of Hudson River
Analytics Inc. and assistant professor
of accounting at Towson University in
Towson, Md. His e-mail address is
v.valdivia@gmail.com .
|
uring the housing
boom of 2001–2005, lenders earned substantial fees
from loan origination. Such fees are accounted for
according to FASB Statement no. 91,
Accounting for Nonrefundable Fees and
Costs Associated With Originating or Acquiring
Loans and Initial Direct Costs of
Leases. It directs that these fees
are not reflected in earnings as soon as the
lender receives them. Instead, origination fees
are netted with origination costs, and in most
cases the resulting net fee is amortized over the
life of the loan. This amortization is usually
done under the effective-interest method (see
Exhibit 2). Although straightforward in
principle, application of Statement no. 91 can be
difficult and error-prone. Common errors include
the inappropriate use of the straight-line method
instead of the effective-interest method and
errors in amortization computations related to the
use of prepayment estimates or nonstandard loan
types, such as adjustable-rate mortgages (ARMs).
This article focuses on common problems financial
institutions face when implementing Statement no.
91 accounting procedures and systems.
WHY ARE LENDING INSTITUTIONS HAVING
PROBLEMS WITH FASB 91?
Although Statement no. 91 was issued in
1986, a number of restatements have been related
to it in the last few years, including
high-profile ones at Freddie Mac and Fannie Mae.
Reasons for the misstatements have included:
Increased scrutiny of accounting
matters by regulators, partly in response to
investor losses since 2000.
Improved controls following
Sarbanes-Oxley legislation, which identified
deficiencies related to Statement no. 91.
Increased number of ARMs and hybrid
loans during the real estate boom—problematic
because accounting systems originally designed to
handle Statement no. 91 for standard loans are
inadequate to handle nontraditional loan products.
|
Comparing a FASB 91
system calculation’s results against those
in an Excel spreadsheet for a sample of
loans (see formulas in exhibits 2 and 3 ) is useful when
evaluating a system before it is
purchased, as well as at the time of an
audit. |
SIGNS OFT ROUBLE: TOP 10 FASB 91 RED
FLAGS Knowing these common
Statement no. 91 problem areas should help CPAs
identify issues and take appropriate actions:
1. Underestimating the complexities of
Statement no. 91 implementations.
When management underestimates the
statement’s real-life complexities (see, for
example, the case of a hybrid loan in Exhibit 3),
it underallocates resources. The result is
understaffed accounting departments and inadequate
systems. In fact, an investigation of Fannie Mae
by the firms Paul, Weiss, Rifkind, Wharton &
Garrison LLP and the Huron Consulting Group found
that, before its restatement, the “resources
devoted to accounting, financial reporting, and
audit functions were not sufficient to address the
needs of an institution as large and complex as
Fannie Mae,” and that the “accounting systems were
grossly inadequate.”
2. Relying on a vendor’s software to
carry out the correct fee accounting
computations without thoroughly evaluating the
software’s functionality.
Management, not the vendor, is
responsible for the correct accounting treatment.
Therefore, management should verify carefully its
vendor’s software not only for the correct
implementation of the effective-yield method, but
also for compliance with Statement no. 91. This is
particularly important for lenders who originate a
high proportion of ARMs or hybrid loans. An
approach that is particularly useful to verify
vendor software is shown in Exhibit 1. In
practice, it is difficult to ascertain the exact
computations carried out by vendor software.
Running multiple test cases through Microsoft
Excel and comparing the results to those from the
vendor software decrease the likelihood that
amortization computations are carried out
incorrectly by the vendor’s system. See exhibits
2 and 3 for a description of the
functions and formulas that can be used with Excel
to make those comparisons and highlight instances
where Statement no. 91 results can differ from the
effective-interest and straight-line amortization
methods.
|
Effective-Yield Method on a
Standard Fixed-Rate Loan The loan is a
10-year, $100,000 loan at 5% fixed, with a
fee of $3,000 and costs of $2,000.
|
|
| |
Effective-Yield
|
Straight-Line
|
| A
| B |
C | D
| C* |
D* |
Year | Scheduled
Cash (Outflow)/Inflow
| Stated
Interest |
Interest Income
| Amortization
| Interest
Income |
Amortization |
0 |
(99,000) |
|
|
|
|
|
1 |
12,950 |
5,000 |
5,155 |
155 |
5,100 |
100 |
2 |
12,950 |
4,602 |
4,749 |
147 |
4,702 |
100 |
3 |
12,950 |
4,185 |
4,322 |
137 |
4,285 |
100 | 4
|
12,950 |
3,747 |
3,873 | 126
|
3,847 | 100
| …
| … |
… | …
| … |
… | …
| 10
| 12,950
| 617 |
641 |
24 | 717
| 100
|
| |
|
| 1,000
| |
1,000
| The
formulas used to calculate the amounts in
the table are:
A = PMT(Note rate,
remaining amortization term,
remaining principal) B = Note
rate times beginning-of-year
principal
C = Original IRR
times beginning-of-year basis (*)
D = Interest income minus
stated interest = C – B
C* = Stated interest
+ amortization = B + D*
D* = Original net fee
÷ original amortization term
| (*) The
original IRR is the internal rate of
return corresponding to the cash flows in
column A. |
3. Using the straight-line amortization
method without verifying properly that the
results are consistent with Statement no. 91.
For example, Heritage Bankshares, a bank in
Virginia, reported in its 2004 form 10-KSB that
“in misapplying FAS 91, prior to the restatement,
the company amortized deferred net fees/costs
using only the straight-line method instead of
utilizing the level-yield method where
appropriate.”
4. Relying on several manual
computations in the implementation of
Statement no. 91.
For example, spreadsheets with no controls,
auditability functionality or ability to track
management override are commonly used in
amortization computations. Such manual steps
should be replaced with auditable and automated
systems.
FASB Statement no. 91 Requires
Investors to Amortize Also
This article focuses on the
point of view of loan originators who defer
and amortize origination fees. However, FASB
Statement no. 91 also applies to investors
in loans or debt securities purchased at a
premium or discount. For example, if a
company purchases a bond at a premium (or
discount), the premium (or discount) is
amortized over the life of the bond on the
company’s financial statements.
The application of Statement
no. 91 can be very complicated for bonds
with complex cash flows, such as
mortgage-backed securities with underlying
ARM or hybrid loans, tranches in
collateralized mortgage obligations
(CMOs), interest-only (IO) strips or
principal-only (PO) strips, because past
and expected future cash flows of these
securities must be considered to compute
amortization of the premium or discount.
|
5. Having accounting tasks distributed
throughout an institution without sufficient
coordination.
This is a common practice and poses problems
when the institution has weak controls and cannot
enforce its accounting policies. For example, it
may be the responsibility of the operations
department to assign the proper accounting
classification of fees. However, without tight
controls and close coordination with the
accounting department, fees may be categorized
improperly by the operations department and
receive incorrect accounting treatment.
6. Grouping loans by adding their net
fees and amortizing the aggregate net fee,
instead of performing the amortization on the
net fee of each loan separately.
This grouped approach has two main problems.
First, according to Statement no. 91, paragraph
19, loans can be grouped only if the institution
holds a large number of loans having similar
characteristics (loan type, loan size, interest
rate, maturity, location of collateral, date of
origination, expected prepayment rates, etc.).
This is problematic because the accounting
treatment of loans that cannot be placed in a
group may differ from grouped loans. Second, it is
challenging to audit the grouped approach properly
because grouping methodologies are usually very
complex.
| Amortization
Calculation According to FASB 91: A
Hybrid Loan Exhibit 2 shows
effective-yield accounting on a standard
fixed-rate loan, but for hybrid loans
straightforward effective-yield calculations
differ from those under FASB Statement no.
91, as shown in Exhibit 3.
Example. A 10-year
loan for $100,000 has a fixed rate of 5%
for the first two years and a variable
rate of prime plus 1% for the remaining
eight years. At origination, prime is
6.5%. The lender charges fees of $3,000
and incurs $2,000 of related costs.
According to Statement no. 91, the net fee
of $1,000 is deferred and amortized. The
initial loan basis (or carrying amount) is
$99,000. For simplicity, assume that this
loan requires annual payments and there
are no prepayments. See the loan’s
cash flows and stated interest in columns
A and B in Exhibit 3
. If the effective-yield method is
applied mechanically, the interest income
and amortization amounts in columns C and
D are obtained. For comparison, the values
obtained under the straight-line method
are shown in columns C* and D*. Note that
in year 1, under the effective-yield
method, the lender earns an amount in
excess of the net fees, since amortization
of $1,705 exceeds net fees of $1,000.
Statement no. 91, paragraph 18a, corrects
this by limiting amortization; see the
results under Statement no. 91 in columns
C' and D'. Also note that, in this
example, the net fee is recognized
entirely at the end of the first year
rather than over the life of the loan, as
is generally the case under the
effective-interest method. Cases such as
this one, in which the mechanical
application of the effective-interest
method results in the recognition of a
higher amount than the actual fee, occur
when the interest in the initial years is
substantially lower than in later years.
Finally, note the substantial differences
among the three approaches. Thus, applying
the effective-yield method mechanically is
not always in compliance with FASB
Statement no. 91. In particular, lenders
who originate a significant number of ARMs
or hybrid loans should take a close look
at how they compute amortization and
recognize fees from the origination of
such loans. |
7. Using prepayment estimates.
Several difficulties arise in implementing
amortization calculations with prepayment
estimates. First, these estimates are allowed only
for groups of loans (Statement no. 91, paragraph
19). Second, the amortization calculations are
more involved, since an adjustment is necessary
every period to correct for errors in prior
periods’ prepayment estimates. Using prepayments
has additional implementation challenges since the
accounting system must be connected to a
prepayment model, and there are many roadblocks in
implementing this connectivity correctly. For
example, the data interface between the prepayment
model and the amortization system must be
programmed correctly. In addition, care must be
exercised so the beginning-of-period prepayment
estimates (together with beginning-of-period
management assumptions for obtaining such
estimates) are used when computing the
amortization expense for a period.
8. Inappropriate categorization of fees.
Different fees warrant different accounting
treatment under Statement no. 91. In practice,
institutions often lack tight procedures for
ensuring that fees are properly categorized.
Furthermore, it is often necessary to track the
amortization of different fee types separately.
For example, SVB Financial Group, the holding
company for Silicon Valley Bank, reported in its
2005 form 10-K that, prior to its restatement, it
misapplied Statement no. 91 because it had
“misclassified fees on certain letters of credit.”
|
FASB 91 Accounting for a
Hybrid Loan |
| |
|
Effective-Yield
|
Straight-Line
|
FASB 91
|
| A
| B |
C | D
| C* |
D* |
C' | D'
| Year
| Scheduled Cash
(Outflow)/Inflow |
Stated Interest
| Interest
Income |
Amortization |
Interest Income
| Amortization
| Interest
| Amortization
|
0 |
(99,000) |
|
|
|
|
|
|
|
1 |
12,950 |
5,000 |
6,705 |
1,705 |
5,100 |
100 |
6,000 |
1,000 |
2 |
12,950 |
4,602 |
6,282 |
1,680 |
4,702 |
100 |
4,602 |
– |
3 |
12,950 |
6,278 |
5,831 |
(447) |
6,378 |
100 |
6,278 |
– | 4
|
12,950 |
5,677 |
5,258 |
(419) |
5,777 | 100
|
5,677 | –
| …
| … |
… | …
| … |
… | …
| … |
… |
10 |
12,950 |
997 | 906
| (91) |
1,097 |
100 | 997
| –
|
| |
|
| 1,000
| |
1,000 |
| 1,000
| The
formulas used to calculate the amounts in
the table are:
A = PMT(Note rate,
remaining amortization term,
remaining principal) B = Note
rate times beginning-of-year
principal
C = Original IRR
times beginning-of-year basis (*)
D = Interest income minus
stated interest = C – B
C* = Stated interest
+ amortization = B + D*
D* = Original net fee
÷ original amortization term
C' = Stated interest
+ amortization = B + D'
D' = MIN(Interest
income under effective-yield method
– stated interest, original net fee)
= MIN(C – B, original net
fee), and zero after net fee is
amortized completely
| (*) The
original IRR is the internal rate of
return corresponding to the cash flows in
column A. |
9. Lack of loan-level data, and lack of
data in general.
Statement no. 91 calculations require many
loan-level inputs, including historical cash flows
and expected future cash flows for every reporting
period. Institutions, particularly those that
implement grouped amortization methods, often fail
to store relevant loan-level data; this lack of
data makes it difficult for the institution to
adopt loan-level Statement no. 91 computations.
10. Incorrect timing in the recognition
of fees.
Institutions are under pressure to recognize
fees early, rather than defer them, to boost
current earnings. For example, Heritage Bankshares
reported in its 2004 form 10-KSB that prior to its
restatement it “did not consistently defer fees,
resulting in an overstatement of fee income.”
Institutions are also under pressure to report low
earnings volatility and may be tempted to alter
the timing of fee recognition to smooth reported
earnings. In fact, the in-depth investigation of
Fannie Mae mentioned above also revealed that
management misapplied Statement no. 91 “because
compliance with FAS 91 would have resulted in
greater earnings volatility than management had
wanted.” The incentives for early fee recognition
to increase current earnings or to alter the
timing of fee recognition to reduce earnings
volatility are higher in institutions where
management’s compensation depends on reported
results and controls are inadequate. This could be
prevented by improving internal controls and
eliminating the direct dependence of compensation
on reported accounting results. The first
step in avoiding any misapplication is to
recognize applying FASB Statement no. 91 correctly
is not always straightforward. A review of current
implementations may well be warranted,
particularly if prepayment estimates are used and
loans are grouped, or if the institution has
originated a substantial proportion of
nontraditional types of loans such as ARMs, hybrid
loans or loans with an interest-only period. At a
minimum, such a review should test that fees are
indeed deferred and that the straight-line method
is used only in cases allowed by Statement no. 91.
Particular attention should be devoted to testing
amortization calculations for new loan types and
testing controls to ensure that all departments
throughout the institution follow accounting
policies . |