Remarks before the 2015 AICPA Conference on Current SEC and PCAOB Developments

Christopher M. Rickli, Professional Accounting Fellow, Office of the Chief Accountant

AICPA National Conference on Current SEC and PCAOB Developments
Washington, DC

Dec. 9, 2015

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.

Introduction

Good morning. I would like to speak with you today about two topics: the allowance for loan losses and consolidation.

Staff Accounting Bulletin No. 102 reminders

The GAAP objective of the allowance for loan losses is to capture management’s best estimate of probable incurred credit losses as of the reporting date.[1] For financial services companies, the allowance for loan losses represents one of the most significant estimates in the financial statements. For auditors, the risk of material misstatement for the allowance for loan losses often represents a significant risk due to the degree of complexity and judgment involved in the measurement of the allowance.

We continue to observe a number of PCAOB[2] inspection findings in the area of the allowance for loan losses. When addressing issues in this area, I believe it is helpful to reflect not only on the auditor’s responsibilities for auditing the estimate, but also management’s responsibilities in developing the estimate.

SAB 102[3] establishes expectations for management related to the development, documentation, and application of a systematic methodology[4] for determining allowance for loan loss estimates in accordance with GAAP. I would like to highlight a few excerpts concerning data reliability and documenting adjustments.

Data-reliability

SAB 102 speaks to the expectation that management provide written documentation on certain decisions, strategies, and processes for its allowance for loan loss methodology.[5] One of these processes relates to the accumulation of relevant, sufficient, and reliable data on which to base the allowance estimate.[6] Source data is subjected to management’s selected methods and judgments to ultimately arrive at a recorded estimate.

SAB 102 provides for tailoring aspects of the allowance process to the size and complexity of the registrant and its loan portfolio.[7] However, I believe, as a general rule, an allowance for loan loss process that would meet the expectations of SAB 102 would include effective internal accounting controls designed to ensure the use of relevant, reliable, and sufficient data to develop the estimate.

While management reviews certainly have a place in the process of developing an accounting estimate, transaction level controls would typically be needed in order to satisfy SAB 102’s expectations surrounding data relevance and reliability. Registrants should consider the sufficiency of controls and documentation related to the aggregation and evaluation of the data itself to assert the relevance, sufficiency, and reliability of the data used.

Documentation of adjustments

Another area that I would like to focus on is documenting allowance adjustments. Adjustments are often recorded to capture factors not already included in the entity’s loss estimation model. These factors could include changes in risk selection and underwriting standards, lending policies, and certain economic trends and conditions. SAB 102 establishes an expectation that entities consider these types of factors and determine and document which factors were used in the analysis, and how those factors affected the loss measurements.[8]

In order to meet these expectations, it would likely be important that the entity have an adequate understanding of the data currently being used in the loss estimation model, as well as the methods and judgments being applied to that data to ultimately arrive at an estimate. This would likely be important in order to establish the starting point for the allowance calculation, and in turn be able to evaluate the necessity and reasonableness of proposed adjustments.

In situations where adjustments are recorded, SAB 102 establishes the expectation that management maintain sufficient, objective evidence to support the amount of the adjustment, and explain why the adjustment is necessary.[9]

Consolidation – Risk Retention

Let me turn now to a second topic: consolidation questions related to certain special-purpose entities. In 2014, several federal agencies adopted final rules to implement the Dodd-Frank credit risk retention requirements for asset-backed securities.[10] Over the past several months, OCA has received accounting consultations related to the application of Topic 810[11] to a registrant’s involvement with a so-called collateralized manager vehicle, or CMV. CMVs are designed to sponsor various types of securitization transactions.

In one particular fact pattern, the CMV itself was required to hold an ownership interest in the underlying securitization to which it acted as a sponsor. The registrant made an initial equity contribution to the CMV, and obtained one of three seats on the CMV’s board of directors. The remaining equity capital was funded by third party investors, several of which were individually significant.

The registrant also entered into a services agreement to provide certain support functions to the CMV, including middle and back office operations, investment research, and other administrative activities.

An aspect of the registrant’s consolidation analysis related to whether the CMV was a voting interest entity under Topic 810. The analysis focused heavily on the ownership of the CMV and the role of the CMV’s board of directors. The equity holders of the CMV, as represented by the board of directors, had power over the most significant activities of the CMV, including the development of the investment strategy, the hiring and firing of service providers, and the appointment of individuals to the CMV’s investment committee. Based on these factors, we did not object to the conclusion that the CMV was a voting interest entity under Topic 810.

We understand that many variations of this type of entity exist in the marketplace. Therefore, it is possible that several of the most significant factors to the analysis may vary greatly from CMV to CMV, and therefore may result in different accounting conclusions.  As a result, it would not be appropriate to analogize our conclusions to other fact patterns that involve a CMV.

I would also like to note that our conclusions did not extend beyond the registrant’s GAAP accounting analysis. A critical part of the registrant’s legal analysis would likely include whether the CMV would qualify as a legal sponsor. This is a legal question and was not addressed as part of the accounting consultation. To the extent there is uncertainty related to legal questions, entities should consult with their primary regulator.

Thank you.