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Getting a Handle on Loan Fees

Although straightforward in principle, application of Statement No. 91 can be difficult and error-prone when it comes to treating loan origin fees.

August 2007
from Journal of Accountancy

During 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. FASB says origination fees are not reflected in earnings as soon as the lender receives them. Instead, the 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.

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.

Signs of Trouble: 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, 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. 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.

READER NOTE: For useful exhibits and resources, read full article here.

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.

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.

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.”

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.

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Victor Valdivia, CPA, Ph.D., is CEO of Hudson River Analytics Inc. and assistant professor of accounting at Towson University in Towson, Md. His views as expressed in this article do not necessary reflect the views of the AICPA or the Journal of Accountancy.