Loan originations - originate the accounting better

A great example of substance over form, FAS 91 can be difficult and error-prone. Common errors include the use of the SLM method instead of the effective-interest method and errors in amortization computations related to the use of prepayment estimates or nonstandard loan types. Below are fice such common mistakes we often make

FAS 91 – we can review this at quarter close .
Many a time managements underestimates the statement’s real-life complexities, thereby under-allocating resources. This is particularly important for lenders who originate a high proportion of ARMs or hybrid loans.

A Vendors software can take care of my FAS 91
Most of us accountants purchase a vendor software to take care of the accounting without verifying whether the vendor software would actually take care of the complex accounting needs of the loan transactions. Management should verify carefully its vendor’s software not only for the correct implementation of the effective-yield method, but also for compliance with Statement no. 91.

The application of Statement no. 91 can be very complicated for bonds with complex cash flows, such as mortgage-backed securities with underlying ARM or hybrid loans, tranches in collateralized mortgage obligations (CMOs), interest-only (IO) strips or principal-only (PO) strips, because past and expected future cash flows of these securities must be considered to compute amortization of the premium or discount.

Blame it on operations!
This is a common practice and poses problems more often than not. In many organizations, it may be the responsibility of the loan-operations department to assign the proper accounting classification of fees in the software. However, without tight controls and close coordination with finance, fees may be categorized improperly by the operations department and receive incorrect accounting treatment.

Prepayment estimates – we will cross the bridge when it comes to it
Several difficulties arise in implementing amortization calculations with prepayment estimates. First, these estimates are allowed only for groups of loans (Statement no. 91, paragraph 19). Second, the amortization calculations are more involved, since an adjustment is necessary every period to correct for errors in prior periods’ prepayment estimates.
Using prepayments has additional implementation challenges since the accounting system must be updated to a prepayment model, and there are many roadblocks in implementing this connectivity correctly.

Incorrect timing in the recognition of fees.
Organizations are at times are under pressure to recognize fees early, rather than defer them, to boost current earnings.
On the contrary many organizations are also under pressure to report low earnings volatility and may be tempted to alter the timing of fee recognition to smooth reported earnings. As FAS 91 can sometimes create earning volatility, managements may be forced to alter the timing of the amortization to make the recognition to be more in line with advance investor forecasts handed over.

A well defined internal controls backed with preventive IT controls can help many a organisations in dealing with a simple accounting treatment.