Annual Report - CoBank

Critical Accounting EstimatesManagement’s discussion and analysis of the financialcondition and results of operations are based on the Bank’sconsolidated financial statements, which we prepare inaccordance with accounting principles generally accepted inthe United States of America. In preparing these financialstatements, we make estimates and assumptions. Our financialposition and results of operations are affected by theseestimates and assumptions, which are integral tounderstanding reported results.Note 2 to the accompanying consolidated financialstatements contains a summary of our significant accountingpolicies. We consider certain of these policies to be critical tothe presentation of our financial condition, as they require usto make complex or subjective judgments that affect the valueof certain assets and liabilities. Some of these estimates relateto matters that are inherently uncertain. Most accountingpolicies are not, however, considered critical. Our criticalaccounting policies relate to determining the level of ourreserve for credit exposure and the valuation of financialinstruments with no ready markets (primarily derivatives andcertain investment securities). Management has reviewedthese critical accounting policies with the Audit Committee ofthe Board of Directors.Certain of the statements below contain forward-lookingstatements, which are more fully discussed on page 63.Reserve for Credit ExposureOur allowance for loan losses reflects an adjustment tothe value of our total loan and finance lease portfolio forinherent credit losses related to outstanding balances. Weprovide line of credit financing to customers to cover shorttermand variable needs, the usage of which, particularly forfarm supply and grain marketing customers, is influenced byvolatility in agricultural commodity prices. As a result, wehave significant unfunded commitments for which wemaintain a separate reserve. This reserve is reported as aliability on the Bank’s consolidated balance sheet. We refer tothe combined amounts of the allowance for loan losses and thereserve for unfunded commitments as the “reserve for creditexposure.”Our reserve for credit exposure reflects our assessment ofthe risk of probable and estimable loss related to outstandingbalances and unfunded commitments in our loan and financelease portfolio. The reserve for credit exposure is maintainedat a level consistent with this assessment, considering suchfactors as loss experience, portfolio quality, portfolioconcentrations, current production conditions, and economicand environmental factors specific to our business segments.The reserve for credit exposure is based on our regularevaluation of our loan and finance lease portfolio. Weestablish the reserve for credit exposure via a process thatbegins with estimates of probable loss within the portfolio.Our methodology consists of analysis of specific individualcredits and evaluation of the remaining portfolio. We evaluatesignificant individual credit exposures, including adverselyclassified loans, based upon the borrower’s overall financialcondition, resources, payment record and projected viability.We also evaluate the prospects for support from anyfinancially viable guarantors and the estimated net realizablevalue of any collateral. Senior-level committees approvespecific credit and reserve-related activities. The Audit andRisk Committees of the Board of Directors review andapprove the reserve for credit exposure prior to final approvalby the Board of Directors.Our determination of the reserve for credit exposure issensitive to the assigned risk ratings and probabilities ofdefault, as well as assumptions surrounding loss given default.Changes in these components underlying this criticalaccounting estimate could increase or decrease our provisionfor loan losses. Such a change would increase or decrease netincome and the related allowance for loan losses and reservefor unfunded commitments, which could have a material effecton the Bank’s financial position and results of operations.To analyze the impact of assumptions on our provisionexpense and the related reserve for credit exposure, wechanged a critical assumption to reflect the impact ofdeterioration or improvement in loan quality. In the event that10 percent of loans (calculated on a pro-rata basis across allrisk ratings), excluding loans to Associations and guaranteedloans, experienced downgrades or upgrades of one risk ratingcategory, the provision for loan losses and related reserve forcredit exposure would have increased or decreased by$7.9 million at December 31, 2011.Valuation of Financial Instruments with No ReadyMarketsWe use fair value measurements to record fair valueadjustments to certain financial instruments and to determinefair value disclosures. All of our investment securities andderivative instruments are reported at their estimated fair valueon the accompanying consolidated balance sheets.As discussed in Note 12 to the accompanyingconsolidated financial statements, we maximize the use ofobservable inputs when measuring fair value. Observableinputs reflect market-derived or market-based informationobtained from independent sources, while unobservable inputsprimarily reflect our estimates about market data.The fair value of our investment securities is determinedby a third-party pricing service that uses valuation models toestimate current market prices. Inputs and assumptions relatedto these models are typically observable in the marketplace.Such models incorporate prepayment assumptions andunderlying mortgage- or asset-backed collateral information togenerate cash flows that are discounted using appropriatebenchmark interest rate curves and volatilities. These thirdpartyvaluation models also incorporate information regardingbroker/dealer quotes, available trade information, historicalcash flows, credit ratings, and other market information. Suchvaluations represent an estimated exit price, or price to bereceived by a seller in active markets to sell the investmentsecurities to a willing participant.CoBank 2011 Annual Report60