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Highlights of recent accounting and regulatory issues December 2011

This document provides highlights of recent accounting and regulatory issues from the FASB, SEC, PCAOB, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and the Board of Governors of the Federal Reserve System (FRB). This bulletin summarizes critical topics, including the state of the banking industry, SEC reporting issues, bank regulator updates, FASB developments and PCAOB updates.
Contents 1 2 2 2 2 3 3 7 7 8 8 8 9 9 A. State of the banking industry B. SEC compliance and reporting matters Update from the Office of the Chief Accountant Avenues for consultation Status of consideration of use of IFRS in U.S. reporting Update from the Division of Corporation Finance Frequent areas of SEC staff comment C. PCAOB matters Standard-setting agenda Inspection findings for financial institutions D. Regulatory Chief Accountants Panel E. FASB update Major projects Troubled debt restructurings

A. State of the banking industry

At a recent industry event, former Senator Evan Bayh provided an update on the banking industry as it relates to the U.S. economy. He expects that recovery from the past three or four years of economic sluggishness will begin to improve, but it will not be a speedy recovery. He cited personal consumption, capital investment, exports and government as the key building blocks to economic improvement, but noted that these underlying agents for growth in our economy are going to be anemic for a long time, ushering in a period of fiscal austerity. In Bayhs opinion, the best way to solve a fiscal problem is through rapid growth, which is unlikely to happen in todays economy. He noted that slower economic growth and financial austerity at the federal level will lead to increased political volatility, and since each party is at odds with the other, finding the middle ground, where progress is usually made, is more difficult. Such intense opposition leads to decision-making gridlock, and progress is only made when there is a crisis, such as the debt ceiling or spiking interest rates. In relation to the banking and financial services industry, Bayh pointed out that with a closely divided Congress and the likelihood that the next presidency could go either way (but he gives a slight advantage to President Obama), the current group of regulators will continue to make decisions. For example, Dodd-Frank will continue to be implemented, and the Consumer Financial Protection Bureau (CFPB) will continue to operate without a head, which means they will be unable to promulgate new rules and regulations. More generally, Bayh expects that in a politically unstable and economically sluggish environment, financial institutions particularly large, complex ones will remain scapegoats for angry voters.

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Despite his gloomy predictions, Bayh ended on an optimistic note, concluding that, over the past 200 years, the American people have overcome numerous significant challenges not unlike the ones the country must tackle today.
B. SEC compliance and reporting matters

Update from the Office of the Chief Accountant In his remarks, James Kroeker, SEC Chief Accountant in the Office of the Chief Accountant (OCA), spoke of the intent of the OCA to be proactive in identifying weaknesses in financial reporting before they become a crisis. In this vein, in addition to filling the role of Deputy Chief Accountant for Policy Support and Market Monitoring in 2010, the OCA is planning the first roundtable in its Financial Reporting Series (FRS). The purpose of this roundtable series, which will include perspectives from investors, financial statement preparers, auditors and others, is to facilitate a discussion of existing pressures or emerging issues in financial reporting. The first roundtable will focus on uncertain measures in financial reporting and whether the appropriate level of information about uncertainty is being provided in current disclosures.

Avenues for consultation Kroeker reminded firms of the various avenues for consulting with OCA and also other divisions of the SEC, such as the Division of Corporation Finance (CorpFin). This includes formal written submissions, as well as informal telephone and no-name inquiries. While informal inquires are accepted, they cannot be relied on as formal positions of the SEC staff. Registrants should expect to be treated professionally in the consultation process and have their matters dealt with in a timely manner, but Kroeker advised registrants to not wait until the day before a filing deadline to make their inquiry. Additionally, if a registrant is consulting with other agencies, such as the FASB, it should advise OCA that such consultations are underway. Status of consideration of use of IFRS in U.S. reporting Kroeker reported on the status of the SECs Work Plan regarding IFRS, including a high-level discussion of the progress reports and related papers issued throughout 2010 and 2011, the most recent being the May 2011 staff paper, Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. issuers. This paper was not a proposal, but was intended to explore a method of bringing IFRS into the U.S. reporting system that had not been fully vetted. The SEC staff has received approximately 130 comments in response to the paper, which expressed a wide array of views. They are now analyzing those comments to inform future recommendations to the Commission. While the SEC staff continues the Work Plan, they plan to issue more progress reports in the near future. They are working aggressively to be able to make a recommendation for the Commissions consideration in 2011. However, Kroeker did state that this timing is dependent on FASB and IASB progress.

The SEC held its inaugural FRS roundtable on Measurement Uncertainty in Financial Reporting on Nov. 8, 2011.

Disclosure consideration for second or junior lien loans Full details of the SEC Work Plan, as well as status updates, reports and other developments are available on the SECs portal: Spotlight on Work Plan for Global Accounting Standards.

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Update from the Division of Corporation Finance Craig Olinger, Deputy Chief Accountant in CorpFin, discussed recent changes within CorpFin. The most notable in the banking industry is the creation of the new AD Office 12 to oversee and review the filings of the 65 largest financial institutions, with the largest investment banks coming into this group in the near future. Additionally, Olinger discussed recent staffing changes, including the ongoing search for a new chief accountant for the Division to replace Wayne Carnall. Frequent areas of SEC staff comment As an introduction to the topic of frequent areas of SEC staff comment on registrant filings, Olinger noted some best practices for resolving issues noted in CorpFin review, which include: Assemble a thorough response, including indication of where revisions have been or will be made to previously filed documents. Do not assume the SEC staff disagrees with the accounting treatment or reporting of the registrant. Call for clarification as needed. Maintain contemporaneous documentation for complex or highly judgmental accounting and reporting matters. Olinger teed up the discussion of frequent areas of comment across all registrant types. Stephanie Hunsaker, Associate Chief Accountant in CorpFin, and John Donohue, Professional Accounting Fellow in OCA, then elaborated on frequent areas of SEC staff comment specific to the banking industry. Those areas of frequent comment are presented in the following pages.

Asset quality issues Although not a new focus area as it relates to financial institutions, CorpFin continues to issue a significant number of comments related to asset quality matters. Hunsaker focused on three broad topics: second lien loans, matters specific to smaller community banks and modifications and troubled debt restructurings (TDRs). Second or junior lien loans In situations where second lien loans were not identified as a separate portfolio segment, investors may need more information to understand the allowance methodology for the second lien loan class. In order to understand potential exposure in this area, CorpFin is asking registrants to elaborate on: What information is available regarding the performing status of the first lien. How that information, or lack thereof, is factored into the allowance for loan loss.
Disclosure consideration for second or junior lien loans Registrants should consider the August 2009 CorpFin Sample Letter Sent to Public Companies on MD&A Disclosure Regarding Provisions and Allowances for Loan Losses, which includes disclosure issues related to second or junior lien loans.

Because trends in first liens delinquency rates differ from those of second liens, SEC staff is requesting expanded disclosure around delinquency trends and charge-off rates of second liens, which generally have lower delinquency rates than first liens, but higher charge-off rates. Smaller community banks Trends show that smaller community banks are continuing to increase allowances for loan loss reserves, while larger institutions are decreasing reserve levels. Disclosure is needed to allow investors to understand the trends and expectations going forward related to the underlying loans and the allowance for loan losses.

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Requests for expanded information regarding appraisals, including timeliness of appraisals, whether adjustments are made to appraisals, and what is done at the institution during interim dates between appraisals. As a related matter, the SEC staff is asking about related chargeoff policies, including timing of charge-offs and how adjustments to appraisals affect charge-off policies. For purchased and credit impaired loans, especially as they relate to failed banks, comments are being issued regarding: how the initial fair value and various loan pools were determined; whether all loans were accounted for, either directly or indirectly, in accordance with FASB Accounting Standards Codification (ASC) 310- 30, Loans and Debt Securities Acquired with Deteriorated Credit Quality; and ongoing accounting policies with respect to adjustments and expectations of cash flows on different loan pools and related impact on the FDIC receivable. Modifications and troubled debt restructurings Transparent disclosures are critical around the types of modification programs a bank employs. Disclosures should be robust regarding those modification programs that result in TDRs and those that do not. Credit loss disclosures The SEC highlighted areas they have commented on related to a companys application of the disclosure requirements resulting from FASB Accounting Standards Update (ASU) 2010-20, Receivables: Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. Credit quality indicators SEC staff has noted that the disclosed indicators are not at the same granular level used internally and should be expanded accordingly. For example, the SEC staff has noted that they have questioned whether a disclosure that only differentiates between performing and nonperforming commercial loans is consistent with managements internal practice. Enhanced disclosures are needed about how indicators relate to likelihood of loss.

Disclosures are not clear if loan-to-values ratios have been updated, as well as the ongoing monitoring policies for such ratios. Credit quality indicators should be disclosed for consumer loans. Charge-off and non-accrual policies Disclosures should be specific to the class level. Disclosing that policies are consistent with bank regulatory requirements is not adequate, as a financial statement user may not know the explicit regulatory requirements. Companies should clearly describe their policies so that financial statement users can compare them to other institutions. In instances where disclosure indicates that loans are charged off when management determines the loan is no longer probable of collection, the SEC staff has questioned managements criteria for determining this judgmental factor. If the period for moving a loan to nonaccrual status exceeds the period for charging off a loan, comments have been issued as to the theory around this policy and whether it is in accordance with U.S. GAAP. The staff has also questioned policies about resuming interest on non-accrual loans once a loan no longer meets the disclosed nonaccrual threshold (for example, they have questioned situations in which the disclosed threshold is 90 days past due and a loan is returned to nonaccrual status when the loan is 89 days past due)

ASU 2010-20 Grant Thorntons New Development Summary ASU enhances credit quality disclosures financing receivables and allowance for credit losses, provides a summary of the disclosure requirements in ASU 2010-20 that generally went into effect for public companies in 2010 and are effective for nonpublic entities in 2011 financial statements.

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Transfers of non-performing assets The SEC is seeing creative structures designed to get loans, especially non-performing loans, off of the entitys balance sheet. Accordingly, CorpFins review has focused on accounting and disclosure concerns of these transactions. Related to accounting guidance, relevant guidance includes variable interest entity (VIE) guidance in ASC 810-10 in evaluating entities used to get loans off-balance sheet. If consolidation of the counterparty (for example, a special purpose vehicle) is not required, either ASC 860, Transfers and Servicing, or ASC 360-20, Real Estate Sales, likely applies. As it pertains to disclosures, disclosures should be tailored to fit each transaction. There is no checklist, but disclosures need to be transparent and complete such that a user of the financial statements can understand the impact on key performance measures.
Disclosure consideration for second or junior lien loans Grant Thornton has issued the following publications on Variable Interest Entities and Transfers and Servicing. Variable interest entity analysis ASC 810, Consolidation, as amended by ASU 2009-17 Transfers of financial assets Implementation guidance on ASC 860, as amended by Statement 166

Transfers to and from held-to-maturity portfolios Mainly as it relates to debt securities, the SEC staff has noted registrants transferring some securities into or out of the heldto-maturity portfolio. In this regard, Donohue stated that ASC 320-10-25, Investments-Debt and Equity Securities, sets a high threshold for not tainting the remaining portfolio. Accordingly, the SEC staff takes a very rigorous approach to evaluating the accounting in this situation. If considering transferring securities out of the held-to-maturity portfolio, consider: Consultation with OCA is highly recommended. In addition to the disclosures in ASC 320-10-50, discuss in the filing the circumstances that changed managements intent with respect to the transferred securities and why that does not taint the remaining portfolio, including references to relevant accounting guidance followed.

Loss contingencies The SEC understands that litigation is a sensitive matter. However, this sensitivity does not relieve a registrant from its obligations to report loss contingencies under ASC 450, Loss Contingencies, and litigation matters under Regulation S-K. Hunsaker reminded the audience of the following considerations: With respect to reasonably possible loss or range of loss: Aggregation of claims is acceptable. With confidence or precision is not a threshold required by ASC 450. Avoid surprising investors. The SEC staff becomes concerned when there are big surprises in registrants filings. For example, making a leap from disclosures stating a matter is immaterial to a large settlement in a subsequent period. The closer to settlement, the more estimable the matter. The evaluation of adequacy of disclosure should be continuous and updated as facts become known. Consideration should also be given to mortgage repurchase litigation matters and potential exposure in that area. For loss contingency disclosures, registrants should use words in the accounting standard in its disclosures to reduce instances of unclear language. Third-party recoveries (such as insurance recoveries) should be a separate asset on the balance sheet. Sovereign debt exposures With respect to sovereign debt, particularly exposure related to European sovereign debt, Donohue mentioned the various areas where disclosure for such exposures is required: Guide III requirement to discuss foreign risk exposure. ASC 320-10-50-1 provides guidance on security types for financial statement disclosure. Disclosures should be gross exposures and not net of other potential recoveries. On the topic of the U.S. debt downgrade, the SEC has not taken a position as to specific application of U.S. GAAP or any impairment required for registrants holding U.S. government obligations.

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Non-GAAP measures The SEC issued Compliance & Disclosure Interpretations on this topic in January 2010, in an attempt to clarify guidance so that management could discuss their business in the same way that they manage it. However, this does not permit use of nonGAAP disclosures that are misleading. Misleading disclosures should not be used in any SEC filing, in a registrants earnings releases or calls, or on its website. A few reminders were given with respect to common comments on non-GAAP measures: A non-GAAP measure continues to be non-GAAP even if calculated based on numbers on the face of the income statement. Pre-tax pre-provision net profit (PPNP) is commonly used in the banking industry, but must be properly labeled as non-GAAP. Additionally, registrants should not refer to a variation of the PPNP calculation as core PPNP. With respect to Basel III capital ratios, since they are not yet required by regulations, they are non-GAAP measures and should be properly disclosed and reconciled as such. Goodwill impairment With the issuance of the revised goodwill standard (ASU 201108, Testing Goodwill for Impairment), the SEC staff expects to see the following changes in registrant disclosures: Updated policy disclosures. MD&A should disclose if qualitative screen is failed and the results of the subsequent quantitative test.

Mortgage servicing rights In cases where a registrant has disclosed a wide range of assumptions used in determining the value of mortgage servicing rights, CorpFin staff have requested more granular disclosures by loan type or interest rate. Fair value measurements and third-party pricing services While raised in the context of PCAOB standard-setting projects, Kroeker did note that in addition to audit work around third-party pricing services, the SEC itself is also examining registrants practices as they relate to use of third-parties in their evaluation of fair value measurements, particularly Level 2 measurements. Kroeker emphasized that while management may certainly utilize the work of a third-party pricing service in its valuation efforts, the ultimate responsibility for complying with U.S. GAAP and maintaining and assessing internal control over financial reporting rests with management. Therefore, management must understand the valuation models, inputs and assumptions the third party is using in order to be responsible for the companys books and records and internal controls. Kroeker was clear that an understanding of the underlying information used by the third-party pricing service is critical to providing appropriate disclosure in the financial statements, as well as in managements discussion and analysis (MD&A).

Additional guidance Grant Thornton has issued a New Development Summary on ASU 2011-08: Qualitative goodwill assessment option FASB issues new guidance to simplify goodwill impairment testing

SEC Regulations Committee This issue was also discussed at the Sept. 27, 2011, joint meeting of The Center for Audit Quality (CAQ) SEC Regulations Committee and the SEC staff. The CAQ has published highlights of that meeting.

Banking industry hot topics

C. PCAOB matters

Standard-setting agenda Kroeker discussed the PCAOB standard-setting agenda. He emphasized that this activity not only impacts auditors but also registrants. In many cases, the proposed or contemplated rulemaking does not consist of details of how to do an audit, but rather standards that are responsive to investors desire for more information about public company audits, particularly coming out of the financial crisis. Kroeker highlighted the following topics. Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards Released in June 2011, this Concept Release explores the following changes related to auditors reporting whether: there should be a separate auditor discussion and analysis (AD&A) to accompany audit reports and whether auditors should have a role auditing managements disclosures contained in MD&A. The comment period for this concept release closed Sept. 30, 2011. Concept Release on Auditor Independence and Audit Firm Rotation Released in August 2011, this Concept Release explores whether audit firm objectivity and independence would be strengthened by certain changes, including term limits on the auditor-client relationship. Comments on the Concept Release are due Dec. 14, 2011.

Audit transparency Released in July 2009, the Concept Release, Requiring the Engagement Partner to Sign the Audit Report explored whether audit partners should be specifically identified in audit reports, in addition to the audit firm. Additionally, it considered how multinational audits are conducted and whether other firms that have a role in an audit should be identified.
The PCAOB released a Proposed Rule, Improving the Transparency of Audits: Proposed Amendments to PCAOB Auditing Standards and Form 2, which supersedes the July 29 concept release noted above. This Proposed Rule would: require registered public accounting firms to disclose the name of the engagement partner in the audit report, rather than requiring the engagement partner to sign the audit report as described in the concept release, and require disclosure in the audit report of other independent public accounting firms and other persons not employed by the auditor that took part in the audit. Comments on the Proposed Rule are due Jan. 9, 2012.

Other planned rulemaking activity Below is a summary of the PCAOBs standard-setting agenda.
Project name Communications with the audit committee Related parties Specialists Fair value measurements (Financial instruments) Principal auditor Confirmations Timing according to PCAOB agenda Reproposal in fourth quarter 2011

Proposed standard in fourth quarter 2011 Proposed standard in first quarter 2012 Proposed standard in first quarter 2012

Proposed standard in first quarter 2012 Final standard or reproposal in second quarter 2012 Proposed standard in third quarter 2012

Quality control standards

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Inspection findings for financial institutions

E. FASB update Major projects

George Wilfert, Deputy Director in the PCAOBs Office of Research and Analysis, and Glenn Tempro, Associate Director in the PCAOBs Division of Registration and Inspections, presented common inspection findings as they relate to audits of banks and savings institutions. First, they highlighted overall inspection observations contained in the Report on Observations of PCAOB Inspectors Related to Audit Risk Areas Affected by the Economic Crisis, published in September 2010. Then, they presented more granular findings as they relate to financial institutions, focusing on the following recurring themes: auditing fair value measurements, litigation and other contingencies arising from mortgage and other loan activities, and auditing the allowance for loan loss.
D. Regulatory Chief Accountants Panel

Robert Storch, FDIC Chief Accountant, Steven Merriett, FRB Assistant Director and Chief Accountant-Supervision, and Kathy Murphy, OCC Chief Accountant, presented on a recent Regulatory Chief Accountants Panel. Murphy began by discussing the topics on which the OCC receives the most questions, which include allowance for loan losses. She noted that overall, the credit quality indicators are stabilizing and improving, particularly for large corporate and credit card portfolios; however, there is still a significant amount of risk with certain portfolios, such as commercial and residential real estate. Another common topic is troubled debt restructuring. Murphy does not expect that there will be significant changes as a result of ASU 2011-02, Receivables: A Creditors Determination of Whether a Restructuring Is a Troubled Debt Restructuring, and believes that the clarifications are consistent with previous interagency guidance. As a result of the new guidance, she indicated that the OCC expects financial institutions to update their TDR policies and include additional analysis and documentation, particularly as it relates to insignificant delays. Murphy also touched upon published data and uses for financial statements, saying since there are so many areas where judgment and estimates are required, the more data a bank has, the more helpful it can be for financial statement purposes. A list of helpful data is available at the OCCs website.

Larry Smith, FASB board member, gave an update on the joint FASB-IASB and FASB-only projects that are in process. Smith spent most of his time on the financial instruments project and leasing, but he also covered consolidations and revenue recognition. For the most up-to-date status of these projects, refer to the information on the FASB Technical Plan and Project Updates page. Of note, Smith indicated the following: The FASB plans to re-expose the proposed leasing and revenue recognition standards. The FASB has not yet discussed whether it will re-expose any components of the financial instruments project. Both Boards are currently working on a revised impairment model. The current thinking is to create a model based on expected credit losses. The model would group loans into three buckets that would capture the deterioration of credit quality in the loan portfolio. The FASB plans to finish its deliberations on classification and measurement and jointly discuss with the IASB the differences in the FASB model and IFRS 9, Financial Instruments (IFRS 9 is a final standard issued by the IASB on classification and measurement). Under the FASBs current thinking, loans and deposits will generally be at amortized cost, debt securities will be at fair value with changes in fair value recognized in net income (FVNI) or fair value with changes in fair value recognized in other comprehensive income (FVOCI), and equity securities will generally be at FVNI. The IASB has completed its redeliberations on hedging, however the FASB does not expect to redeliberate hedging until the Boards discuss their differences in classification and measurement.

Banking industry hot topics

Troubled debt restructurings

In the question and answer session, Smith clarified the effective date of the new disclosures (from ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses) about troubled debt restructurings in ASC 310-10-50-31 through 50-35. In the Codification, the transition for those disclosures currently references the transition and effective date related to ASU 2011-02, therefore some have interpreted that those disclosures are not effective for nonpublic entities until 2012. He clarified that the FASB did not intend to change the effective date of those disclosures for nonpublic entities and that the effective date for nonpublic entities should therefore be the first annual reporting period ending on or after Dec. 15, 2011, (Dec. 31, 2011, for calendar year-end entities). This is consistent with the transition guidance in ASU 2010-20. The FASB staff is reportedly working to clarify this inconsistency.

For more information For more information about the topics covered in this document, contact: Jack Katz National Managing Partner, Financial Services Grant Thornton LLP T 212.542.9660 E jack.katz@us.gt.com Nichole Jordan National Banking and Securities Leader Grant Thornton LLP T 212.624.5310 E nichole.jordan@us.gt.com This Grant Thornton LLP bulletin provides information and comments on current accounting issues and developments. It is not a comprehensive analysis of the subject matter covered and is not intended to provide accounting or other advice or guidance with respect to the matters addressed in the bulletin. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this bulletin. For additional information on topics covered in this bulletin, contact your Grant Thornton LLP adviser. Visit www.GrantThornton.com/ financialservices.

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