By J.P. LaPointe
Working with a broad range of banking clients provides an expansive overview of common accounting issues that arise with financial institutions. Below are eight significant areas of concern that required additional guidance to clients this year.
Deferring commissions on loan originations
In the current interest rate environment, many institutions are selling fixed-rate first mortgages in the secondary market. As incentive to the loan originators, many institutions are paying commissions for loan originations. As commissions paid have not been significant in recent years, many institutions have not been including these amounts in loan origination cost deferrals. These commission amounts should be deferred as loan origination costs upon origination of the loan. The deferred costs on loans that are intended for sale will become part of the carrying value of the loan and would subsequently be part of the gain or loss on the sale of that loan. Institutions should revisit their cost study to ensure all required components are included.
Mortgage banking derivatives
In conjunction with loans that are intended to be sold in the secondary market, management should consider the impact of mortgage banking derivatives related to loan commitments. Mortgage banking derivatives reflect the fair value of the rate lock commitment intended to be sold in the secondary market, including the value of servicing. The derivative on the commitment should therefore approximate the gain that is expected to be recognized as a result of the sale of the loan. In addition, derivatives on loan commitments that move to loans held for sale would no longer be considered derivatives and would become part of the amortized cost basis of the loans. Management should calculate the derivative related to loan commitments, including loans held for sale, and determine materiality in relation to the financial statements to conclude whether or not they should be recorded.
Mortgage servicing rights recognition
As noted above, many institutions are selling loans in the secondary market and retaining the servicing of those loans. In conjunction with these loan sales, institutions are capitalizing mortgage servicing rights. These servicing rights should be capitalized at fair value; however, as a practical expedient, many institutions are using an arbitrary percentage of the loan balance sold as the capitalized amount. If using this method, management must ensure that this arbitrary percentage is a reasonable estimate of fair value. If not, this can create issues with earnings recognition, as well as issues with potential future period impairment if the mortgage servicing rights are capitalized at an amount that is higher than the fair value.
Estimated life of mortgage servicing rights
Another issue that can cause errors is the estimated life that is used for amortizing mortgage servicing rights. Mortgage servicing rights are to be amortized over the estimated period of servicing income. Some institutions use an expected life of six or seven years to amortize the servicing assets, which factors in early payoffs. However, they are also accelerating the amortization of servicing rights on loans that are paid off early. If your institution uses an expected life in which payoffs are factored in, writing down the servicing rights on paid off loans would only be appropriate if the prepayment speed is exceeding what was used to determine the expected life of the loans.
Investment premiums and discounts
Due to the current low interest rate environment, many institutions are experiencing significant prepayments on mortgage-backed securities. When there are significant prepayments, additional amortization and accretion should be recorded on any related premiums and discounts. Some investment accounting systems will automatically calculate and record the additional amortization or accretion on these prepayments using the level yield method. However, some systems do not have the capability to calculate and record the additional amortization or accretion on the prepayments, which could lead to misstatements of both the balance sheet and the income statement. Methodologies utilized for the amortization of premiums and discounts should be revisited to ensure the appropriate recognition related to accelerated prepayments.
Interest rate swaps
As a result of the prolonged low interest rate environment, many institutions are looking to hedge against rising interest rates. One of the ways that they are doing this is by entering into interest rate swaps. There are risks that are associated with entering into these transactions and management, as well as the board of directors, should understand these risks prior to entering into a swap transaction. In addition, there are accounting issues related to interest rate swaps, including the determination of fair value. It is important for management to understand the assumptions being used in the valuation of the swaps and how the swaps are being recorded. Management will ultimately be taking responsibility for the amounts recorded and the assumptions used in the determination of the fair values.
Reliance on specialists
It’s common for institutions to engage benefits specialists to perform calculations of estimates that require a specific technical expertise, and the results are often taken at face value. However, management must review the results and ensure they understand the assumptions used in the calculations and the overall outcome based on their expectations. For example, if the specialist is preparing a calculation for a post-retirement benefit and the discount rate was reduced from 4.5 percent to 4 percent, one would expect an actuarial loss and related increase in the benefit obligation. If the calculation then reflects an actuarial gain, management should question what other changes were reflected in the calculation that did not result in the expected loss.
Deposit operations segregation of duties
As business goals and objectives are constantly changing, we sometimes lose focus on areas that may not be considered significant at the current time. One of these areas seems to be segregation of duties in the area of deposit operations. There are many risks within the deposit operations area that could be mitigated with proper segregation of duties, which include new account openings, the deposit reconciliation, dormant accounts, file maintenance and customer statement returns. Our engagement teams have seen a significant increase in the number of deficiencies identified in this area during the past year. Controls over deposit operations should be reviewed to ensure adequate segregation of duties, which includes system access and physical access controls.
Operating a financial institution today is complex and comes with many risks. By working closely with your internal and external audit team, you can work on mitigating these risks to ensure that your financial institution is operating as effectively as possible.
J.P. LaPointe, CPA, is audit manager at Wolf & Co., a Boston-based tax and compliance consultant to community banks for over 100 years.