The staff of the Securities and Exchange Commission has put financial institutions on notice that it is closely scrutinizing disclosures related to loan losses and will take action against delayed recognition.

The staff of the Division of Corporation Finance sent one of its “Dear CFO” letters to an undisclosed number of public companies, then published a sample of the letter on its website so it can be instructive to other entities that may be struggling with how to account for bad loans. The open letter to CFOs reminds them that Regulation S-K requires disclosure in management's discussion and analysis of any known trends, demands, commitments, events or uncertainties that may be material to operations, liquidity or capital. The letter offers several MD&A disclosure suggestions that entities should consider if financial statements will reflect loan losses.

The SEC staff notes the accounting rules around loan loss provisions and allowances haven’t changed in recent years, but the economic scene may have left companies with some new factors to consider. Companies may need to reassess whether the information on which accounting decisions are made is still accurate, and they may need to reconfirm or reevaluate the accounting itself and the related MD&A disclosures, the letter advises.

Companies should look, for example, at their higher-risk loans and provide information that would help investors understand the risk. Investors might want to know the carrying value of higher-risk loans by loan type, the current loan-to-value ratios for each loan type, even further segregated by geographic location if loans are concentrated in a particular region. Disclosures should describe the amount and percentage of refinanced or modified loans by higher-risk loan type, as well as other telling data, such as delinquency statistics and charge-off ratios by loan type.

If a company has changed its practices in how it determines its allowance for loan losses, the SEC staff will be looking for discussion around why the changes occurred and how they affected results. The staff also will look for discussion around declines in collateral value, any activity or transactions undertaken to reduce exposure to credit risk, the reasons behind any changes in key ratios and a host of other details described in the letter.

The letter closes with a not-so-subtle warning. Acknowledging judgment is involved, the staff says, “it would be inconsistent with Generally Accepted Accounting Principles if you were to delay recognizing credit losses that you can estimate based on current information and events. Where we believe a financial institution’s financial statements are inconsistent with GAAP, we will take appropriate action.”