by Tanta on 1/19/2008 10:00:00 AM

We get a lot of questions about accounting issues these days. People are concerned about accrual accounting, particularly as it relates to Option ARMs or negative amortization and the income treatment of accrued but unpaid interest. This issue always butts up against the question of how mortgage holders reserve against losses on loans, or determine the extent to which capitalized interest is or is not ultimately collectable. We've also posted some news stories regarding the uproar over SFAS 114 treatment of modified mortgages, which really get down into the weeds in terms of mortgage accounting and which are, therefore, hard to follow without a basic understanding of general mortgage asset accounting. Finally, a number of people have been asking, as we keep seeing more and more reports of write-downs at banks and investment banks, how long this writing-down is going to go on, and how it is really calculated.

Some of you--bless your lovely hearts--may be entirely innocent of any background in accounting. You may be struggling to follow the conversation in part because you make the common civilian error of forgetting that bank accounting is "backwards." To you, a loan is a liability and a deposit account is an asset. To the bank, the loan is an asset and the deposit account is a liability. It does get more complicated than that, but it never makes any sense at all until you do get past that point.

Some of you, I know, come from the "real economy," or "widget-accounting," and you are stuggling with accounting concepts that make sense to you in terms of widget makers (or retailers), like inventory and receivables and warehouses, but become puzzling when they are applied to financial accounting. Some of you may be small business owners who work on a cash basis, not an accrual basis, so you may find financial accounting even more impenetrable.

I, who was never allowed into the accounting department unescorted am not an accountant, quite often struggle to make these things clear. Fortunately, our regular commenter Lama, who is a real accountant, has offered us a splendid GuestNerd post which walks us through the basics of accrual accounting, reserves, income, and asset valuation. I have added a few comments of my own, strictly from a banking perspective. Another of our regulars, the mighty bacon dreamz, has contributed illustrations to support Lama's text. I think you will find them enlightening.

Lama On Accrual Accounting and Reserves:

To understand how "other amortization" works, I guess you first need to know how accrual accounting works. Most individuals calculate their taxes based on cash basis accounting. You recognize income when you receive the cash (or check); you recognize expenses when you pay cash. Companies with simple cash transactions and not much equipment or inventory do not vary much if they use cash or accrual accounting (think newsstands, maybe a small consulting company).

Accrual accounting means you recognize revenue when earned, expenses when incurred. A gas station would not incur an expense when they purchase gas for resale. That station would incur the expense at the time the gas was sold. That’s because the gas’ cost was a cost to produce the sale. In the time between the purchase and subsequent sale, the company holds the gas as inventory as an asset on its balance sheet.

Another concept to keep in mind is that every asset on a balance sheet has a base and a reserve. The base asset value is the easy part. If someone borrows $100,000, you have a schedule with the $100,000 on it. The loan cost you $100,000 to make. If someone owes you the $100,000 and $5,000 accrued (unpaid) interest, now your schedule will have $105,000 as a current loan value.

Making a loan on the accrual basis means the lender is earning income based on what he is owed, not based on how much cash he receives, but how much the borrower owes. If there’s a $100,000 loan at 5%, the borrower owes $5,000 after one year. If the borrower pays $6,000, the loan balance is $99,000 with $5,000 paying interest and $1,000 paying principal. If the borrower pays $4,000, the loan balance is now $101,000, with $5,000 paying interest and $1,000 increasing the amount of the loan. That’s all there is to calculating the base asset. This is in keeping with every related principle of accrual accounting and has been done the same way since The Mortgage Pig wore short pants.

Now the reserve or fuzzy area. A reserve is the amount by which you will devalue the amount you record as the base asset. There are 3 basic ways to calculate a reserve. It’s possible to use any combination of 1, 2 or 3 within a portfolio. On debt instruments a company intends to hold (until maturity or involuntary termination), the reserve will be based on both Net Present Value of cash flows and collectability. The most accurate method is to specifically identify impaired assets. If you only think you’ll collect $90,000 NPV, the value is $90,000. Repeat the same for each loan. One might have a value of $0. [Tanta: this involves a credit analyst reviewing each loan at each reporting period, generally quarterly, to determine whether or to what extent it is impaired. You will find this method used on commercial portfolios, where there are fewer units of much larger loans which may not be homogenous or easily comparable to each other.]

The second method is a percent reduction of loan values based on historical experience. Say, if instruments of a certain type typically devalue by 5%, you’d apply that to the assets in the classification. Split the classified loans into as much detail as you think appropriate (there’s some detail in this area we don’t need today). [Tanta: this is the method typically used for loans classified as residential 1-4 family mortgages. In any but the tiniest portfolios, there are too many units to examine individually, and the guidelines and underlying collateral for residential 1-4 family are (supposed to be) homogenous enough that classification or grouping of loans for analytical purposes is considered sound practice as well as obviously efficient practice.]

The third type of reserve is called a general reserve. It is simply an educated guess applied to the entire portfolio. A manager might apply this on top of the other two types. This is also known as wetting your thumb and checking which way the wind is blowing. Years ago, the chairman of the SEC decried general reserves as “Cookie Jar” reserves and “Rainy Day Funds” and their use substantially diminished. Oh, in case you do some research on your own, Reserves = Allowances. [Tanta: in the context of banking, you will find loan reserves referred to as Allowances for Loan and Lease Losses or ALLL.]

The loan balance you see on the balance sheet or support schedule is the net of the base less reserves.

So, how does this affect Income? In accounting, everything is a transaction. Hence the Debits and Credits, which are just names. Your credit card company says “we’ll credit your account.” That means they are posting a credit to their Assets account “Loans." Assets are Debit accounts, so increases in Assets are Debits, decreases are Credits. Revenue is a Credit account, so increases in Revenue are Credits, decreases are Debits.

Reserves for Loans Losses is a Contra-Asset account. Contra-assets are credit accounts that piggyback off Asset accounts. That is to say, an increase to the Reserve is a decrease (credit) to the net Asset. The sister account to Loan Reserves on the Income Statement is the expense called "Provision for Credit/Loan Losses." To balance the journal entry, you post a debit to the expense, increasing it. So, in our example loan above, the base Asset is still $100,000 and the Contra-asset is $10,000, net $90,000. Expenses in the Income Statement will take the other side of the journal entry and increase (debit) for $10,000. In theory, there could be income from a reduction of the allowance account. I don’t see that happening these days. [Tanta: that would be the “cookie jar” problem: the temptation to over-reserve in very good times, which reduces current income to just “good,” in order to reduce those unnecessary reserves in future bad quarters, which would increase income in those quarters from bad to “good” (or just “acceptable,”) and therefore make the income over time appear more stable, which makes Wall Street analysts happy. It is not likely that anyone intentionally over-reserves in bad times, since it’s hard to withstand the effect that has on current income, whatever it might do for future quarters. I certainly do not believe that banks and thrifts were over-reserving during the boom, and as each quarter’s reports come out we see they are steadily increasing ALLL. This does not look like “smoothing” income to me.]

Something very likely to happen is that, in addition to principal, jingle mail senders will not be paying interest. If the bank can foresee a future default on our loan’s interest payments of $2,000, then they record a liability for $2,000 (not a reserve to an asset) and record a debit to Interest Income for $2,000 in the current year, reducing revenue.

Now, our total Net Income is reduced by $10,000 + $2,000, $12,000. Unless and until Cash is loaned or received, there is no effect on Cash.

It’s clear that there is some estimating and guessing done within the reserve calculations and bank managers are going to do all in their power to avoid restatements as none of them ever could have known (enter specific affecting crisis here). So if you want some moral outrage, don’t vent it on the accrual method, vent it against the reserves (more specifically, the people who estimate them). [Tanta: this is why I keep saying that the accounting treatment we are seeing for OAs is not "accounting games." The issue isn't the accounting rules for non-cash income; the issue is what assumptions went into estimating how much of that deferred interest is ultimately collectable.]

Lama On Asset Valuation:

First of all, most assets are required to be valued at the lower of cost or market (assuming a market exists). Usually, the more liquid an asset, the closer the market value will be to cost. Cash is the logical extreme as cost always equals market. Then you have Accounts Receivable which is usually proximate. Next, Inventory can closely trace the actual cost. That is, it should, but companies buy things they can’t sell, they redesign products they make, causing component inventory to be worth little to the company. Even items that have value to someone else might be valued at very little because there’s too much cost involved in finding a buyer and transportation. I once audited a company that had hundreds of thousands of titanium pipes valued at cost. Well, they had no use and no customer for them. The best offer they got was from the original vendor, 15% of cost. That was my number. So it goes onto Capital/Fixed Assets. Here, market value is usually not important. Heavy equipment that might make lots of money frequently has a low resale value and huge transportation costs if it was sold.

Our debt instruments are, by their nature, very liquid. If the holder is interested in selling, they should be valued at market. If you don’t like the current market price, then the instruments are not for sale . . . ok, you don’t mark them to market, you mark them to discounted cash flows. This is where the “mark to make believe” has been and is happening.

[Tanta: banks and thrifts in the mortgage business have two categories of mortgage assets: HFS (held for sale) and HTM (held to maturity). The former is “inventory” and the latter is “portfolio investment.” HFS is marked to market. As Lama says, if you aren’t marking to a market price, then apparently you aren’t really trying to sell anything here (home sellers, take notes on this part). Eventually, if you cannot (or will not) sell your HFS pipeline, you will need to transfer it to HTM (if you have the capital necessary to hold loans to maturity), and at that point you record the loan at the lower of cost or market. In this case there is an original “write-down” of the asset if current market value is less than cost. After that, further write-downs will be necessary at each reporting period, as Lama indicates above, if the assets become impaired (or more impaired than they were when you originally put them on the books). So what we are reading in the news about write-downs of mortgages and mortgage-related assets these days involve a combination of mark-to-market adjustments (for anything in “inventory” or being taken out of HFS to HTM) and impairments of assets that have deteriorated since the asset value was originally recorded. No one is allowed to take a “once and for all” write-down of a mortgage asset; ALLL is based on your best projections of realized losses in the next 12 months (adjusted each quarter). Theoretically, every loan you own is subject to further write-down each quarter if in fact your estimate of collectability continues to deteriorate.]