Q&A: CPA Veteran Talks ALLL Funding
Industry CPA veteran Michael Sacher has been providing expertise to credit unions on accounting and finance, internal control, asset liability management and governance issues for 30 years. After spending seven years as partner in charge of the Los Angeles office of McGladrey & Pullen's credit union division, Sacher struck out on his own in 2008, forming Sacher Consulting.
An expert in allowance for loan and lease loss accounting and troubled debt restructuring, Sacher's skills were in high demand in 2009.
Credit Union Times: How has ALLL methodology changed in the past few years?
Michael Sacher: The severe economic conditions of the past few years have rendered the "conventional" approach to allowance methodology inadequate. That approach, which relied heavily on a backwards looking historical loss ratio no longer provides an accurate or reasonable estimate of loan impairment. The historical loss ratio approach worked well when the environment was stable, and loan quality was exceptionally strong. In the current environment, other "qualitative & environmental" factors must be considered that may not be (probably are not) reflected in this historic approach.
CU Times: You've been featured often on the credit union speaking circuit this year, discussing ALLL issues. Have you seen some progress in improved awareness of the issue?
Sacher: There has absolutely been progress this year. CFOs and CEOs understand that the allowance is, by far, the most significant estimate within the financial reporting structure, and that proper governance procedures required a major focus on this important accounting area as a result of current economic conditions.
CU Times: What aren't credit unions doing properly in their ALLL accounting that concerns you most?
Sacher: It's important to note that many credit unions have significantly updated and improved their ALL methodology over the past two years. It is clear that the industry has a much larger Allowance cushion today reflective of the updated methodology. The most common mistakes I see involve credit unions in the so-called "sand states" that haven't updated their loan to value analytics or obtained refreshed credit scores. I'm also concerned about credit unions that haven't begun to carefully analyze the exposure in their business loan portfolio. And finally, I'm still seeing a lot of confusion on accounting for restructured/workout loans.
If I were on the board or supervisory committee of a credit union, I'd be asking the following questions with regard to the allowance:
Do we have updated analytics on the current market value of real estate securing our loan portfolio?
Do we obtain updated credit scores of our borrowers on a regular basis?
What steps are we taking to evaluate loss exposure on business loans?
What is the relationship between the current balance of the allowance as compared to estimated charge-offs for the next 12 months? Is there at least a one-year cushion?
Are we properly accounting for troubled-debt restructures?
Has the allowance policy been updated, reviewed by an outside party, and has a formal presentation been made to the board of directors on allowance methodology?
CU Times: Any trends in loan categories that are experiencing increasing ALLL percentages? Is there another asset bubble burst lurking on credit union balance sheets?
Sacher: There has been a lot of talk about exposure within the commercial loan sector, though the losses experienced by credit unions thus far have been minor. However, the same lessons we learned with respect to residential real estate impairment apply to commercial loans. Generally accepted accounting principles require the allowance to be established when impairment conditions can be identified, which is usually possible well in advance of the loan becoming delinquent. Credit unions need to ensure that have identified these "impairment indicators" so they are able to record the impairment in a timely manner.
CU Times: Based on the economic forecasting you've seen for the next few years, will ALLL ratios continue to rise, stay the same, or fall?
Sacher: I hope the negative impact of playing catch-up over the past year is behind us and that the amount of provision expense to be recognized will stabilize and soon begin to decline. A lot depends on economic factors that are hard to predict, such as how fast unemployment begins to decline, whether we see another wave of foreclosures, and what happens to the commercial loan sector.