CHICAGO -

Since the recent financial crisis, McGladrey manager Robert McMurray pointed out that many private equity groups and other strategic investors have pushed plenty of money into the specialty finance industry to bring solid returns to their funds.

With increased scrutiny from outside parties during a potential transaction, McMurray emphasized it is vital to ensure that critical accounting policies of target specialty lenders fully comply with relevant accounting guidance and are documented properly.

And McMurray declared the most critical accounting policy and management estimate for most specialty finance companies is the allowance for loan losses.

"There is a wide variety of guidance available on determining the allowance for loan losses, yet some specialty finance companies rely on requirements outlined by the senior lenders or suggestions from their external auditor to make that determination," McMurray stated in a recent white paper McGladrey published titled, "Allowance For Loan Losses Is A Key Due Diligence Issue."

McMurray continued by stating: "Therefore, special scrutiny of that process is vital in any acquisition involving a specialty lender. It should be noted that an allowance for loan losses is not carried over by the acquirer on acquired loans under purchase accounting rules for both business combinations and asset acquisitions."

Back in 2006, McMurray recapped,  federal agencies that regulate banks and credit unions collaborated to issue an Interagency Policy Statement on the Allowance for Loan and Lease Losses (Interagency Policy Statement). The Interagency Policy Statement indicates that management should consider "all significant factors that affect the collectability of the portfolio as of the evaluation date."

McMurray mentioned the Interagency Policy Statement also states that the estimate should be properly supported and documented by the company.

"While the applicability of this guidance is limited to depository institutions supervised by these agencies, it reiterates key concepts of generally accepted accounting principles (GAAP) and serves as useful guidance in applying GAAP," he said.

While historical loss rates generally serve as the starting point for estimating the allowance on homogeneous loans, McMurray recommended that management should also consider qualitative factors that are likely to cause credit losses to differ from historical levels.

Although not an all-encompassing list, McMurray noted the Interagency Policy Statement provides a list of qualitative factors to consider in estimating the allowance, including:

—Changes in lending policies and procedures, such as underwriting standards, collection, charge-off and recovery practices.

—Changes in relevant economic and business conditions (international, national, regional and local).

—Changes in the nature and volume of the portfolio and the term of loans offered.

—Changes in the company's delinquent and nonaccrual loans.

—Changes in the value of collateral for secured loans (such as auto loans).

—Any concentrations of credit.

—Other external factors, which may include competition, or legal and regulatory developments.

"Newly created specialty finance companies or companies without sufficient historical loss rates should use benchmark information or loss rates of other companies with similar types of loans to help establish initial allowance calculations until the company has sufficient loss rate information," McMurray said.

McMurray wrapped up the white paper by suggesting that specialty finance companies should employ a systematic approach to determine the allowance for loan losses as follows:

—Disaggregate the loan portfolio into appropriate homogeneous pools.

—Calculate and document the rationale to support the appropriate historical loss rate and period for each homogeneous pool.

—Evaluate all relevant qualitative factors that may impact the collectability of the portfolio.

—Determine whether any TDRs exist and calculate any necessary impairment specific to TDRs.

—Take an overall look at the allowance and verify its movement is directionally consistent with all factors taken as a whole.

"Potential investors in specialty finance companies should carefully consider if the allowance for loan losses is properly determined by the specialty finance company, in accordance with GAAP, which will provide more meaningful comparisons to other companies in the industry during the due diligence and evaluation phases," McMurray said.

"Additionally, maintaining and documenting a consistent approach will prove to be valuable to specialty finance companies that are seeking to be acquired when external parties come in to evaluate the allowance for loan losses," he went on to say.

The complete white paper McMurray produced for McGladrey can be downloaded here.