What’s New in 10-Ks for US Financial Institutions

What’s New in 10-Ks for US Financial Institutions

Investors’ desks will soon be creaking under the weight of the 10-Ks that companies are about to publish for 2011. Changes in this year’s annual filings will be relatively light, but four new rules and disclosure items are relevant to the credit analysis of financial institutions:
» European sovereign exposures
» Troubled debt restructuring
» Deferred acquisition cost rules for insurers
» Fair value disclosures

SEC raises the bar on reporting European sovereign exposures. On 6 January, the US Securities and Exchange Commission’s (SEC) Division of Corporate Finance issued enhanced disclosure guidance for US public filers with significant exposure to European sovereign debt, which will be effective for 2011 10-Ks. This guidance will provide investors with greater transparency and comparability of exposures.

The SEC noted that disclosures have been inconsistent across US companies, and made clear that US public filers with significant exposure to European sovereign debt should provide more granular disclosure of exposure to each country of concern.

The SEC chose not to specify the countries that should be covered; instead, it indicated that it expects companies to focus on those countries experiencing significant economic, fiscal or political strains such that the likelihood of default would be higher than would be anticipated when such factors do not exist.

Troubled debt restructuring. Last year the US Financial Accounting Standards Board (FASB) issued new rules that clarify when it considers a loan modification or restructuring to be a troubled debt restructuring (TDR). The tightened rules address concerns that investors and standard setters had regarding US banks’ identification of loan modifications for borrowers in financial difficulty.

A TDR occurs when a bank grants to a borrower facing financial difficulties a concession, such as a reduction in interest rate or an extension of a loan’s maturity at a below-market rate. The importance of properly identifying and reporting those loan modifications classified as TDRs has increased since the onset of the financial crisis because of the sheer number of borrowers facing financial problems and the extent and variety of modifications that banks have undertaken in response. The consequences of determining that a modification is a TDR include impairment and increased disclosure.

The new guidance was effective for third-quarter 2011 reporting, and the effect on our rated banks was surprisingly minimal, given the state of the economy. Nevertheless, the rules include new disclosure requirements that are useful to investors. These include qualitative and quantitative information about how TDRs were modified, and the related impact on financial statements, together with details of any payment defaults within 12 months of a loan being classified as a TDR.

New deferred acquisition cost rules for insurers. New accounting rules pertaining to insurance companies’ capitalization of acquisition costs become effective in the first quarter of 2012. The amended rules will address insurers’ currently diverse practices with respect to the capitalization of deferred acquisition costs (DAC), and result in fewer expenses being deferred.

Most firms will adopt the new rules retrospectively, which will involve recalculating DAC assets on balance sheets as if the new rules had been in effect in all prior periods. Doing so will result in better year-to-year profit-and-loss comparability, and cause an immediate write-down of a portion of existing DAC, with a corresponding reduction in equity (net of tax).

Although the new rules will not affect reported equity as of year-end 2011 or earnings for 2011, we expect insurers’ 10-K filings to include discussions of the impact of adoption on equity and expectations of the effect on run-rate earnings. Based on disclosures provided in 10-Qs in second- and third-quarter 2011, the effect will vary significantly among insurers.

Fair value disclosures. The FASB has been gradually expanding fair value disclosures since the financial crisis. Such disclosures in this year’s 10-Ks will provide greater disaggregation of asset/liability type (to the level of asset “class,” such as “asset-backed security” or “municipal debt”), and improved discussion of inputs and valuation techniques for assets and liabilities in Level 2 or Level 3 of the fair-value hierarchy (those assets whose current prices are not available). Further disclosure requirements, including a narrative description of the sensitivity of Level 3 valuations to changes in inputs, will be required beginning with the first quarter’s 10-Q filings.