CASH, PREPAIDS, OREO, OTHER ASSETS/LIABILITIES, OFF-BALANCE SHEET

Question 1

3.4. CASH DUE FROM BANKS

What is included in cash? (Hint: UCC)

Answer 1

• US and foreign coin and currency
• Clearings (checks, drafts, notes, and other items that
represent instructions for processing financial
transactions)
• Cash items - checks or other items in the process of
collection payable in cash upon presentation

Question 2

3.4. CASH DUE FROM BANKS

What are the purposes Due From Banks are used for?

Answer 2

• To facilitate the collection of cash items and cash
letters,
• Transfer and settlement of security transactions,
• Transfer of participation-loan funds,
• Purchase or sale of Federal funds, and for many other
purposes

Question 3

3.5. PREMISES & EQUIPMENT

What does premises include?

Answer 3

• Premises include the cost, less accumulated
depreciation, of land and buildings actually owned
and occupied (or to be occupied) by the bank, its
branches, and consolidated subsidiaries.
• Bank premises also include leasehold improvements.
> Leasehold improvements comprise two types of accounts:
&raquo_space; Buildings constructed on leased property,
&raquo_space; Capitalized disbursements directly related to leased quarters such

Question 4

3.5. PREMISES & EQUIPMENT

How are fixed assets reported?

Answer 4

• Reported at original cost and are depreciated over their estimated useful life,
• Except for land which is not a depreciable asset.

Question 5

3.5. PREMISES & EQUIPMENT
Any lease entered into by a Lessee bank, which at its inception meets one or more of the four following criteria must be accounted for as a property acquisition financed with a debt obligation (i.e., as a capitalized lease). What is the criteria?

Answer 5

• Ownership of the property is transferred to the lessee at the end of the lease term.
• The lease contains a bargain purchase option
• The lease term represents at least 75% of the estimated economic life of the leased property
• The present value of the minimum lease payments at the beginning of the lease term is 90% or more of the fair value of the leased property to the lessor at the inception date, less any related investment tax credit retained by or expected to be realized by the lessor.

Question 6

3.5. PREMISES & EQUIPMENT

If a lease meets none of the criteria required to qualify as a capitalized lease, how is it reported?

Answer 6

• If the criteria for qualifying for a capital lease is not met, the lease should be accounted for as an operating lease.
• Normally, rental payments should be charged to expense over the term of the operating lease as they become payable.

Question 7

3.5. PREMISES & EQUIPMENT

What does a sale-leaseback transaction involve?

Answer 7

• The sale of property by the owner and a lease of the property back to the seller.
• If a bank sells premises or fixed assets and leases back the property, the lease shall be treated as a capital lease if it meets any one of the four criteria for capitalization.
• Otherwise, the lease shall be accounted for as an operating lease

Question 8

3.5. PREMISES & EQUIPMENT

When must a loss be recognized with a sale-leaseback transaction?

Answer 8

• A loss must be recognized immediately for any excess of net book value over fair value at the time of sale.
• In the event a bank sells a property for an amount less than its fair value, (for example, in order to obtain more favorable lease terms), the difference between the sale proceeds and fair value represents an additional loss that must be deferred and amortized over the life of the lease.
• Any gain resulting from a sale-leaseback transaction is generally deferred and amortized over the life of the lease.
• The general rule on deferral does not permit the recognition of all or a part of the gain in income, at the time of sale.
• Exceptions to the general rule do permit full or partial recognition of a gain at the time of the sale if the leaseback covers less than substantially all of the property that was sold or if the total gain exceeds the minimum lease payments.

Question 9

3.6 OREO

How is Other Real Estate Owned (OREO) booked?

Answer 9

• Should be booked at time of foreclosure at the fair value of the property less cost to sell; the excess should be reported as a recovery of prior charge-off or current earnings, as appropriate.
• If partial satisfaction of loan, loan should be reduced by fair value of property less costs to sell.
• Legal and other direct expenses incurred by the bank in foreclosure should be included in expenses when they are incurred.

Question 10

3.6 OREO

List the 5 methods of accounting for the disposition of OREO under FAS 66?

Answer 10

• Full Accrual Method (most favorable method for bank)
• Installment Method (second most favorable for bank)
• Cost Recovery Method (weak borrower)
• Reduced-Profit Method (rarely used)
• Deposit Method
Note: If a profit occurs in the sale of bank financed other real estate, each method sets forth the manner in which the profit is to be recognized. Regardless of which method is used, any losses on the disposition of real estate should be recognized immediately.

Question 11

3.6 OREO

What are the three major phases of the ORE life cycle?

Answer 11

•  Acquisition
    >>  FAS 15 and FAS144
•  Holding period
    >>  FAS 34 and FAS 67
•  Disposition
    >>  FAS 66

Question 12

3.6 OREO

Where are Other Real Estate Reserves included in capital?

Answer 12

• Not included in either Tier 1 or Tier 2 Capital, nor recognized in leverage or RBC
• Valuation allowances must be made on an asset-by-asset basis and are netted from the asset’s cost to determine the gross amount for classification.
• General reserves should be viewed as a contra-asset to other real estate and netted from the “OREO” category in the statement of condition.
• To the degree general reserves adequately cover the risks inherent in the other real estate portfolio as a whole, the amount of other real estate assets classified Loss will not need to be deducted from Tier 1 capital

Question 13

3.6 OREO

Explain the Full Accrual Method of accounting for the disposition of OREO under FAS 66.

Answer 13

• Full Accrual Method (most favorable method for bank)
&raquo_space; Disposition is recorded as a sale,
&raquo_space; The asset resulting from the seller’s financing of the transaction is reported as a loan, and
&raquo_space; Profit is recognized immediately in full although 4 conditions have to be met:
a. Sale consummated
b. Receivable is not subject to future subordination
c. Usual risks and rewards of ownership have been transferred
d. Buyer’s down payment and periodic payments are adequate to demonstrate a commitment to pay for the property
&raquo_space; An adequate down payment can be anywhere from 5 to 25 percent, depending on loan type.
&raquo_space; Periodic payments are contractual payments that must be sufficient to repay the loan over customary terms for the type of property.

Question 14

3.6 OREO

Explain the Installment Method of accounting for the disposition of OREO under FAS 66.

Answer 14

• Installment Method (second most favorable for bank)
&raquo_space; Sale has been consummated;
&raquo_space; There is corresponding loan;
&raquo_space; Profits are recorded as the bank receives payments;
&raquo_space; Interest income is recognized on an accrual basis;
&raquo_space; Used when down payment is not adequate for full accrual method, but recovery of cost of property is reasonably assured;
&raquo_space; Factors that should be considered for recovery assurance include:
a. Down payment size
b. LTV ratios
c. Projected cash flow from property
d. Recourse provisions
e. Guarantees
f. Pledging additional collateral

Question 15

3.6 OREO

Explain the Cost Recovery Method of accounting for the disposition of OREO under FAS 66

Answer 15

• Cost Recovery Method ( WEAK BORROWER)
&raquo_space; Sale has been consummated, and
&raquo_space; There is a corresponding loan, although
&raquo_space; income recognition is deferred, and
&raquo_space; May apply when dispositions do not qualify under full accrual or installment methods.
&raquo_space; Principal payments are applied as a reduction of the loan balance, and
&raquo_space; Interest increases the unrecognized gross profit.
&raquo_space; No profit or interest income is recognized until the aggregate payments exceed the recorded amount of the loan.
&raquo_space; The loan is maintained on nonaccrual status while this method is used.
&raquo_space; This is used when down payment is adequate

Question 16

3.6 OREO

Explain the Reduced Profit Method of accounting for the disposition of OREO under FAS 66.

Answer 16

• Reduced-Profit Method
&raquo_space; Sale has been consummated, and
&raquo_space; there is a corresponding loan.
&raquo_space; Method is appropriate in those situations where the bank receives an adequate down payment, however,
&raquo_space; The loan amortization schedule does not meet the requirements of the full accrual method.
&raquo_space; Profits recognized as payments are received; however,
&raquo_space; Profit recognition (or apportionment method) is based on the present value of the lowest level of periodic payments required under the loan agreement. (rarely used) is inadequate

Question 17

3.6 OREO

Explain the Deposit Method of accounting for the disposition of OREO under FAS 66.

Answer 17

• Deposit Method
&raquo_space; Used in situations where a sale of real estate has not been consummated.
&raquo_space; An example of this method is when an ORE property is under a rent to own agreement between the bank and a renter.
&raquo_space; This method may also be used as an alternate for the cost recovery method.
&raquo_space; Continues to be reported as other real estate.
&raquo_space; Payments received from the borrower are reported as a liability until sufficient payments or other events have occurred which allow the use of one of the other methods.
&raquo_space; No profit or interest income is recognized

Question 18

3.7. OTHER ASSET & LIABILITIES

What are some examples of Other Liabilities?

Answer 18

• Mortgages Payable - Mortgages, liens and other encumbrances on premises which the bank is legally obligated to pay
• Capital Lease Outstanding - Leases that transfer all the benefit and risks of property ownership be accounted for by the lessee as the acquisition of an asset and incurrence of a liability.
• Accrued Taxes and Expenses - Accrued taxes and expenses which represent charges to income for expenses not immediately payable, but which have yielded benefits in the current period.
• Bankers Acceptances - Acceptance executed by a bank or by others acting as its agent
• Servicing Liabilities - Contracts to service assets for which the benefit of servicing is not expected to adequately compensate the servicer for performance.
• All Other Miscellaneous Liabilities - Examples include dividends payable, net deferred tax liabilities, etc.

Question 19

3.7. OTHER ASSET & LIABILITIES

What are examples of Other Assets?

Answer 19

• Prepaid Expenses - premiums paid for insurance, maintenance contracts, and advance rental payments for rentals/premises
• Accrued Income Accounts - Income earned but not received (for accrual accounting) - Overstatement = Loss.
• Banker’s Acceptances - bill of exchange drawn on and accepted by a bank for payment by that bank at a specific time
• Servicing Assets - contractual obligation to provide servicing for mortgage loans, credit card receivables, or other financial assets for another.
• Suspense Accounts - temporary accounts such as teller, interoffice, and bookkeeping differences with debit balances. Outdated items should be classified Loss.
• Cash Items not in the Process of Collection - Checks returned by other banks, checks not posted by bookkeepers, and other unpaid items.
• Tax Assets (a.k.a future tax benefits, deferred tax assets, prepaid income tax) - arise from temporary differences or operating loss or other carryforwards. Loss carryforwards should only be recognized when the realization of the benefit is more likely to occur than not.
• Bank Owned Life Insurance - If policy held to term, it can provide attractive tax - equivalent yields to help offset the rising cost of providing employee benefits. Management should employ a sound pre-purchase analysis, ongoing monitoring, reliable accounting, and accurate assessment of risk-based capital requirements.
• Goodwill and Other Identifiable Assets-Goodwill is an unidentifiable asset acquired in business combinations or where change of control has occurred. Other intangible assets are distinguished from goodwill when they are identifiable.
• All other miscellaneous assets - Examples include repossessed property, reimbursable insurance claims, etc.

Question 20

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

How are derivative contracts reported?

Answer 20

FAS 133 provides that derivative contracts must be reported at fair value on the balance sheet.

Question 21

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

How are allowances for off-balance sheet items reported?

Answer 21

Allowances for off-balance sheet items should be made to “Other liabilities.”

Question 22

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

What are letters of credit and what are the four types?

Answer 22

• A conditional commitment (except when prepaid by the account party) on the bank’s part to provide payment on drafts drawn in accordance with the document terms.
• Four basic types of letters of credit are:
> Travelers,
> Those sold for cash,
> commercial, and
> Standby

Question 23

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

What are travelers letters of credit?

Answer 23

• A travelers letter of credit is addressed by the bank to its correspondents authorizing drafts by the person named in accordance with specified terms
• These letters are generally sold for cash.

Question 24

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

What are Sold for Cash letters of credit?

Answer 24

• When a letter of credit is sold for cash, the bank receives funds from the account party at the time of issuance
• This letter is not reported as a contingent liability, but rather as a demand deposit.

Question 25

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

What are commercial letters of credit?

Answer 25

• A commercial letter of credit is issued specifically to facilitate trade or commerce
• Generally, drafts will be drawn when the underlying transaction is consummated as intended.
• Commercial letters of credit not sold for cash do, however, represent contingent liabilities and should be accorded examination treatment as such
• Refer to the International Banking section of this Manual for further details on commercial letters of credit

Question 26

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

What are standby letter of credit?

Answer 26

• A standby letter of credit (SBLC) is an irrevocable commitment on the part of the issuing bank to make payment to a designated beneficiary.
• It obligates the bank to guarantee or stand as surety for the benefit of a third party.
• SBLCs can be either financial-oriented, where the account party is to make payment to the beneficiary, or performance-oriented, where a service is to be performed by the account party.
• SBLCs are issued for a variety of purposes:
> to improve the credit ratings for issuers of industrial development revenue bonds and commercial paper;
> to provide back-up facilities for loans granted by third parties;
> to assure performance under construction and employment contracts;
> to ensure the account party satisfies financial obligations payable to major suppliers or under tax shelter programs.

Question 27

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

What is a loan commitment?

Answer 27

• A written agreement, signed by the borrower and lender, detailing terms and conditions under which a loan of up to a specified amount will be made.
• The commitment will have an expiration date and, for agreeing to make the accommodation, the bank may require a fee to be paid and/or require the maintenance of a stipulated compensating balance by the customer.
• A commitment can be irrevocable, like an SBLC facility, operating as an unconditional guarantee by the bank to lend when called upon to do so by the customer.
• Commitments are conditioned on the maintenance of a satisfactory financial standing by the customer and the absence of default in other covenants
• A bank may also enter into an agreement to purchase loans from another institution, which should be reflected as off-balance sheet items, until the sale is consummated.

Question 28

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

How are unused portions of loan commitments reported?

Answer 28

Unused portions of loan commitments that are not considered derivatives should continue to be reported as off-balance sheet items.

Question 29

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES
Asset-backed commercial paper programs are usually carried out through a bankruptcy-remote, special-purpose entity, which generally is sponsored and administered by a bank to provide funding to its corporate customers, how should they be reported?

Answer 29

A bank should report the credit enhancements and liquidity facilities it provides to the programs as off-balance sheet liabilities.

Question 30

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

Define Category I contingent liabilities.

Answer 30

Those which will give rise to a concomitant increase in bank assets if the contingencies convert into actual liabilities.
• Letters of Credit
• Unfunded Commitments
• Revolving Underwriting Facilities (RUF)
• Banker’s Acceptances
• Loans Sold without Recourse
Such contingencies should be evaluated for credit risk and if appropriate, listed for Special Mention or subjected to adverse classification.

Question 31

3.8. OFF-BALANCE SHEET ITEMS & DERIVATIVES

Define Category II contingent liabilities.

Answer 31

Category II contingent liabilities normally depends solely on the probability of the contingencies becoming direct liabilities.
• Litigation
• Trust Activities
• Reserve Premium Accounts
• Consigned Items & Other Non-Ledger Control Accounts
> Safekeeping
> Rental safe deposit box facilities,
> Purchase & sales of investments for customers,
> Sale of travelers checks,
> Sale of US Savings Bonds, and
> Collection department service