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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis. All posts prior to September, 2007 are in the public domain, but after September 4, 2007, only subscribers to The Analyst's Accounting Observer will see all posts going forward. Only selected, occasional posts will be released to the public domain from September 4 forward.
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| Comerica's Call
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Location: Blogs AAO Weblog (Public) |
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| Posted by: Jack Ciesielski |
7/19/2005 6:07 AM |
The single most important figure in a financial institution's balance sheet - the one that can most directly affect its earnings and financial status - is the allowance for loan and lease losses. Want a referesher course in how it should be developed, and how not to do it? See Accounting & Auditing Enforcement Release No. 2278, issued on Friday. It's a cease-and-desist order issued to Comerica, Inc.; since they've remedied their wrongs, a cease-and-desist order is a kind of exercise in finger-wagging at the recipient. But it leaves a record of what went wrong, too, providing free lessons for those that don't want to repeat the mistakes of others.
What went wrong for Comerica? The firm had three chief subsidiaries, one of which was Comerica Bank-California. This was the one where the firm botched its allowance for loan and lease losses ("ALLL" from here on in). For each sub, Comerica developed standard, specific and unallocated reserves. While there was a lack of documentation on why certain loans were assigned specific loan grades or reserves, it's their handling of the unallocated reserves that really got Comerica in the soup.
The unallocated reserves were "were intended to cover potential losses on categories of loan portfolios that had been identified as having specific loss characteristics that had not otherwise been considered. Comerica determined its unallocated reserve by first setting a separate range of minimum and maximum reserve percentages for each portfolio category, based on industry, geographic, and economic factors. Comerica used the same percentages for all three of its subsidiaries, notwithstanding the different factors that might have applied to the loan portfolios of Comerica Bank-Texas, Comerica Bank-Michigan, and Comerica Bank-California." [Emphasis added. Why should the factors be the same for a California bank as for one in Michigan? It's not clear why the bank went that route, but the SEC didn't really push the point in the AAER, bringing no more light on the matter.] A minimum and maximum range was figured for the unallocated reserve for each of the subsidiary banks, and from there, the firm's chief credit officer would select a point within each sub's range on the way to developing the preliminary consolidated ALLL reserve. "...Within a few days after the end of each quarter, a group of Comerica's senior officers would meet to review the adequacy of the ALLL, as reflected in the preliminary Credit Loss Reserve binder. At this meeting, Comerica's management would, as described above, determine the final unallocated reserve and the final quarterly ALLL figure. The results of the quarterly meeting were reflected in the final Credit Loss Reserve binder, but meeting minutes were not maintained." Which leads one to wonder: what factors did the management consider in deciding what the final reserve should be? Simply Wall Street estimates? Can't tell.
Where it got messy: the Comerica Bank-California process wasn't documented well enough and there wasn't much of a link between the credit quality review process and the ALLL figures in the Call Reports filed with the Federal Reserve Bank. In late 2001 and early 2002, the Federal Reserve Bank of San Francisco notified Comerica Bank-California that it was concerned about the adequacy of the ALLL given the decline in the bank's portfolio; on July 31, 2002, examiners from the Federal Reserve bank informed Comerica management that they had identified additional reserve adjustments. Despite ongoing discussions, on August 12, 2002, Comerica filed its second quarter 10-Q with an understated ALLL and an earnings overstatement of nearly 15%.
On September 18, the Federal Reserve Bank of San Francisco ordered Comerica Bank-California to restate its second quarter Call Report to reflect $40 million of increased ALLL. On October 2, Comerica filed an amended 10-Q incorporating the same adjustments. The stock dropped 20%. Ouch!
In sum: Comerica's methodology was not systematic in capturing reasonably estimable losses in a particular quarter; the timing of their reviews was mid-quarter, and they sometimes didn't capture a deterioration in the second half of a quarter until the following period. Wrong periodicity, in accounting-speak. And that resulted in filing financials that were not presented in accordance with GAAP, ones that were not based on adequate books and records with good internal controls over their preparation.
Cease and desist!
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