RMA SPRING CONFERENCE LOAN REVIEW AND CREDIT QUALITY FROM THE AUDITORS POINT OF VIEW.

RMASPRING CONFERENCE

LOAN REVIEW AND CREDIT QUALITY FROM THE

AUDITORS POINT OF VIEW

Presenting Panel

Cynthia A. Dopjera, ShareholderBrian P. Holle, Advisory Manager

Kevin C. Horton, Assurance Principal

Topics for Discussion:

Underwriting Observations in 2013

Borrower Financial Statements – Fraud Indicators and Methods to Assist in Analyzing Financial Statements

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Community Banks $100MM - $2.5B Houston & Southeast Texas

Most Frequent Loan Policy Exceptions from 2013 Reviews (regardless of loan origination/vintage):

High Loan to Value (LTV)

Financial Statements (FS) below standard

Waive personal guarantees

Extended amortization schedule


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New Loans Underwritten since 4Q2012:

43% are CRE

19% are CRE owner occupied

28% are C&I loans


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CRE Lending Underwriting:

Sponsor/guarantor Global Cash Flow (GCF) Analysis 40% of CRE subject to GCF Analysis 33% of CRE did not need GCF Analysis 27% of CRE needed GCF, but was not performed

GCF Analysis Consistency Complete documentation challenges Sponsor guarantor GCF trends


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CRE and C&I Underwriting – Common Technical Challenges:

Not documenting/verifying guarantor personal liquidity

Excessive reliance on pro-forma future CF estimates for DSCR

Failing to consider borrower’s debt service requirements from other lenders in DSCR

Relying on non-recurring cash flows to support DSCR

Not accounting for AR exceptions/carve-outs in borrowing base agreements

Not establishing any financial ratio covenants


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What is Fraudulent Financial Reporting?

Common Types of Schemes

Indicators of Financial Statement Fraud

Methods to Assist in Analyzing Financial Statements


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What is Fraudulent Financial Reporting?

Manipulation, falsification, or alteration of accounting records or supporting documentation from which financial statements are prepared

Misrepresentation in, or intentional omissions from, the financial statements of events, transactions, or other significant information

Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure within financial statements


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Common Types of Schemes:

Improper Revenue Recognition

Overstatement of Assets

Understatement of Liabilities (including contingent liabilities)


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Indicators of Financial Statement Fraud:

Complex business arrangements or structures; including related party activity

Frequent changes in auditors

History of inability to generate cash flows from operations while reporting earnings and growth

Unusual rapid revenue and/or profit growth


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Methods to Assist in Analyzing Financial Statements:

Beneish M-Score Model

Ratio Analysis

Vertical and Horizontal Analysis

Altman Z-Score


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Beneish M-Score Model:

Professor Messod Beneish published an empirical equation using eight ratios to detect earnings manipulation

M stands for manipulation

M-Score model is based on eight values determined from the financial statements of the company DSRI – Days’ Sales Receivables Index GMI – Gross Margin Index AQI – Asset Quality Index SGI – Sales Growth Index DEPI – Depreciation Index SGAI – Sales, General and Administrative Expense Index LVI – Leverage Index TATA – Total Accruals to Total Assets


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Beneish M-Score Model – (continued):

An M Score> -2.22 indicates a strong likelihood of the company being a manipulator


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Beneish M-Scorehttp://investexcel.net

Parameters GlossaryYear 2008 2009 SGA Selling, General and Administrative ExpensesNet Sales 93823 93685 CA Current AssetsCost of Goods 52155 49193 DSRI Days Sales in Receivables IndexNet Receivables 1174 1373 GMI Gross Margin IndexCurrent Assets 73717 67991 AQI Asset Quality IndexProperty, Plant and Equipment 2532 2058 SGI Sales Growth IndexDepreciation 1696 1716 DEPI Depreciation IndexTotal Assets 86291 84832 SGAI Sales, General and Administrative Expenses IndexSGA Expense 32426 33013 LVGI Leverage IndexNet Income 5741 9888 TATA Total Accruals to Total AssetsCash Flow from Operations 8416 2877Current Liabilities 26297 26275Long-term Debt 1232 1470

Derived VariablesOther L/T Assets [TA-(CA+PPE)] 10042 14783DSRI 0.854GMI 1.069AQI 0.668SGI 1.001DEPI 1.134SGAI 0.981TATA -0.031LVGI 0.975

M-score5 variable model -3.16 if M > -2.22, firm is likely to be a manipulator8 variable model -2.83

Notes5 variable equationM = -6.065+ .823 DSRI + .906 GMI + .593 AQI + .717 SGI + .107 DEPI8 variable equationM = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892 SGI + .115 DEPI -.172 SGAI + 4.679 Accrual to TA - .327 Leverage

Vertical & Horizontal Analysis -Balance Sheet


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Vertical & Horizontal Analysis -Income Statement


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Ratios:


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Formula Example MeaningCurrent Ratio Current Assets

Current Liabilities1.35 There is 1.35 in current

assets to pay every $1.00 in current liabilities.

Quick Ratio Cash + Accounts ReceivableCurrent Liabilities

0.49 There is $0.49 in quickassets (liquid) to payevery $1.00 in currentliabilities.

Debt to Equity Ratio Total LiabilitiesEquity

0.45 The creditors have put $0.45in the business for every $1.00the owners have put in.

Gross Profit Margin Gross ProfitSales

30.7% For every $1.00 of salesthere is $0.307 in gross profit.

Pre-Tax ProfitMargin

Profit Before TaxesSales

0.15% For every $1.00 of salesthere is $0.00015 in pre-taxprofit.

Ratios – (continued):


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Formula Example MeaningSales to Assets Sales

Total Assets1.98 There is $1.98 in sales for

every $1.00 in assets employedin the business.

Return to Assets Profit Before TaxesEquity

0.3% There is $0.003 in profit for every $1.00 in assets employedin the business.

Inventory Turnover Cost of Goods SoldInventory

4x On average, the inventoryturns over 4 times a year.

Inventory Days 365 DaysInventory Turnover

91 days On average, the inventoryturns over every 91 days.

Accounts Receivable SalesAccounts Receivable

10.9x On average, the accounts receivable turn over 10.9times a year.

Turnover Collection Period

365 DaysAccounts Receivable Turnover

33 days On average, the accountsreceivable turn over every 33days.

Altman Z-Score:

Developed by Professor Edward Altman

Indicator of a company’s financial solvency

Z-Score is based on five ratios; each ratio is weighted Return on total assets Sales to total assets Equity to debt Working capital to total assets Retained earnings to total assets

A Z-Score of 1.81 or below indicates possible future insolvency


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Weighting Weighted Ratio Formula Factor Ratio

Return on Earnings Before Total Assets Interest and Taxes / x3.3 Total Assets

Sales to Net Sales /Total Assets Total Assets x.0999

Equity to Debt Market Value of Equity / Total Liabilities x0.6

Working Capital Working Capital / to Total Assets Total Assets x1.2

Retained Earnings Retained Earnings / to Total Assets Total Assets x1.4

Total of all Weighted Ratios -= Z-Score

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RMA SPRING CONFERENCE LOAN REVIEW AND CREDIT QUALITY FROM THE AUDITORS POINT OF VIEW.

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