Protecting the Currency of the Realm: The Integrity of Financial Reporting

The incoming NCUA
Chair faces many challenges. Restoring financial integrity to the call
report process is an immediate one. In a dramatically increased
uncertain world, the new Chair can be sure of two things: first, losses
and therefore asset values, will be hard to estimate for quite some
time; and second, capturing these elusive values thru the call report
process will continue to be problematic.

New approaches and better action steps to handle both valuation and
accounting treatment of loss estimates are needed. To date, NCUA has
handled neither well. There will, however, be opportunities to improve
the current situation and define new approaches in the months ahead.

The immediate issue is understanding how the uncertainty and muddied waters now surrounding the call reports occurred.

Call Reports: A Crucial Public Record

The integrity of financial reporting is the foundation of confidence in
all institutions, but especially in credit unions. Credit unions are
required to post their statements monthly for members; corporates must
file and publicly release the 5310 regulatory call reports monthly. The
quarterly 5300 credit union call reports are also public documents.

These reports are the first, and in many cases, the only data that are used to understand the "state of the industry."

Not only are members expected to refer to and use this data to monitor
their own institution, but the data provides the first level of
performance analysis by credit unions and regulators as well as lenders
and other vendors that serve the industry. Peer comparisons, not single
firm data, are an integral part of this process. The press, Congress,
commentators and analysts all rely on this public data to monitor how
credit unions are doing—as well as make daily regulatory decisions and
even more lasting legislative recommendations or reports.

Reporting Has Been Compromised

Now this system of reporting has been severely compromised. From the
December 2008 year-end 5300 reports, and for as long as the next eight
quarterly reports, it will be virtually impossible to look at a single
filing and be able to tell how a credit union or a peer group is
performing. In addition, the monthly corporate reports since yearend
December 2008 have been in a state of constant revision or suspension
because of the lack of critical information from US Central.

The Source of the Problem

NCUA in its oversight of the call report system has made two separate errors.

The first is requiring certainty when reporting events where numerical
precision is impossible. The most dramatic example of this effort is
the various estimates of NCUSIF losses accompanied by mandatory
write-downs. There are similar examples where natural person credit
unions have been required to post loan loss allowances two or three
times current delinquencies based on an examiner’s own mandated model
of the loan portfolio.

This error arises from a misunderstanding of what modeling does, or as
what one writer has stated, "All models are wrong, some are useful."

But the more dangerous result is faulty conclusions. Jim Collins, in
his book "How the Mighty Fall," describes this outcome: 'The greatest
danger comes not in ignoring clear and unassailable facts, but in
misinterpreting ambiguous
data in situations when you face severe or catastrophic consequences if
the ambiguity resolves itself in a way that’s not in your favor (page
70)."

The second error is in being uncertain when certainty is required in
financial reporting. NCUA told credit unions that they could account
for the insurance fund loss announced in January 2009 in any manner
their CPA firm approved. The CPA community could not agree on a single
standard for reporting this common obligation and authorized multiple
ways to recognize this event's impact on income statements and balance
sheets. This has resulted in a complete absence of consistency in how
this universal regulatory event is reported and multiple versions of
call reports for the same period!

For example, at least 1,400 credit unions have re-filed their December
2008 call reports after the corporate actions were announced on January
28, 2009. Of this number, 1,396 show multiple differences in data.
These credit unions manage $369 billion, or 45 percent, of the
industry's assets. Because the insurance expense was not in the call
report as a separate account code, at least four expense categories
were used to report the entry, including member insurance (a310) and
operating fees (a320) which both affect expense ratio calculations.
Gain or loss on investments (a420) and other non-operating
income/expense (a440) were also used to report the insurance deposit
write-down.

In addition, these re-filings show adjustments in other accounts. These
changes were not included in the FOIA file NCUA made available publicle
until an updated file was released last week, five months after the
intiial data release. Credit unions did not uniformly report these
events in the first quarter March 2009 call report either. Some
recognized the entire insurance expense, including their WesCorp
capital write-down (WesCorp was conserved on March 20, 2009). Other
credit unions did nothing, preferring to wait until September 2009 when
NCUA said it would announce this year's premium.

Subsequent to these events and myriad reporting practices, the
corporate stabilization bill was passed and NCUA came out in June 2009
with additional accounting requirements, one of which was to mandate
that there would be no restatement of prior period reports!

All of this uncertainty could have been avoided if NCUA had required a
single reporting requirement for an event that affected every insured
credit union. Any one of the several alternatives were compatible with
standard accounting requirements; by not requiring certainty, the
consistency of call report cycles for at least two years have been
compromised. NCUA is responsible for the integrity of this process.
 
Inaccurate Data Leads to Poor Decisions

Credit unions in the first quarter of 2009 recorded one of their
strongest financial outcomes. Yet the press headlined it like this:
"Worst quarter ever." In fact, by the end of the first quarter, credit
unions had expensed over $6 billion of the $7 billion combined NCUSIF
and WesCorp estimated losses. This outcome, a demonstration of credit
union resilience, was hidden. Instead, hyperbole and the tabloid values
of reporting in which bad news drives out good, dominated the analysis
of credit unions’ collective financial condition.

With these two cycles of varying call report data and the September
2009 restatements of prior write downs, it will be impossible to look
at a single period call report and tell how an individual credit union
or a group, such as California credit unions, are doing without
extended inter-period analysis.

Just one example: approximately $3 billion of the deposit write down
was reported in December 2008 year-end re-filed reports. This amount
will be "recaptured" in September 2009. How can a comparison of the
full year 2009 be done with 2008 results? Which 2008 results are to be
used? Depending on which data set a commentator uses, the effect on net
income could be as high as $6 billion when comparing the two periods'
results.

The Absence of Audited Statements

This call report ambiguity is heightened by the still yet to be
finalized audits of the NCUSIF and US Central for 2008. The same firm,
Deloitte Touche does both audits. Corporate Credit Unions have been
given interim statements and direction that at one point declared US
Central completely devoid of capital; later they were informed that US
Central still had almost $2.0 billion in capital.

Delays in audited statements are not positive signs. They either
reflect significant disagreement between the auditor and the client or
an accounting situation that is not resolvable. Neither reason for the
delays is encouraging; this external check and balance on any
organization's (NCUA in both cases) reporting is sorely needed.

The delay also suggests the difficulties that make audited statements a
drawn out process is the same for NCUA as it was for the fired
corporate managers. NCUA's taking control of the books did not change
the nature of the underlying uncertainty. Multiple delays merely
heighten suspicion that NCUA is just seeking a loss number more aligned
with their views.

The absence of financial integrity isn't merely about the ability to
understand individual or collective financial performance. Financial
institutions, in fact the entire system, rely on trust by all
participants. In good or bad times, the integrity of financial
reporting, especially call reports, is fundamental to sustaining
confidence. Without consistent reporting, individual bias and opinion
can drive decisions that are not in everyone's best interest.

The issue is not easily resolvable. Can the new Chair set a new course
and set of standards and put these goals on the agenda? Is there a way
to reset the measures so all reporting asterisks can be dropped? Can
these changes be done in consultation with the industry? Finally, can
our cooperative values help restore reporting integrity and do so in a
way that differentiates our industry?

While there are no easy answers, a joint effort to find a solution
could help restore credit union confidence in the regulator, not to
mention the industry's reporting.