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The continued viability of an institution depends on its ability to earn an appropriate return on its assets and capital. Good earnings performance enables an institution to fund expansion, remain competitive in the marketplace, and replenish and/or increase capital. Additionally, earnings represent the institution's first line of defense against capital depletion due to credit losses, interest rate risk, and operational risk.

In Farm Credit System (System) institutions, the principal source of earnings is interest income. Accordingly, pricing of the loan portfolio is a key aspect of an institution's earnings management. Institutions must price loan products in a manner sufficient to cover costs and provide the capitalization needed to protect the institution against losses and allow for growth. For detailed information on loan pricing and examining this critical area, refer to the Asset/Liability Management section in this module.

The analysis of earnings requires consideration of several factors, such as earnings level and quality; capital position, quality, and goals; asset quality and degree of credit risk exposure; management performance and earnings philosophy; and the institution's interest rate risk exposure and loan pricing practices. As such, the examiner evaluating earnings must coordinate closely with examiners conducting other aspects of the examination work so that results can be integrated into the final earnings analysis.

Examination Objectives

The fundamental examination objective in the earnings area is to determine the overall adequacy of the institution's present and projected earnings performance. This is accomplished through the following principal objectives:

Evaluate the quantity of earnings in light of all identifiable operational risks;

• Earnings level;
• Composition;
• Stability;
• Portfolio risk; and
• Earnings management.

• Is income sufficient to cover all expenses, including the provision for loan losses?
  
• Is the institution achieving sufficient earnings to meet capital needs and achieve capital goals? The level, quality, and management of capital are key determinants of the necessary level of earnings.
  
• Has the institution achieved its business plan earnings targets? Examiners should identify the causes of variances in actual versus projected performance. Consideration should also be given to whether the institution's earnings targets were reasonable and appropriate to the level of risk.
  
• How do the institution's earnings statistics and ratios compare to a peer group of similar institutions? Care should be taken when using peer data as institutions of similar size may have significantly different portfolio characteristics or unique levels of capital and risk.
  
• What are the current trends in net income and its significant components? What are the underlying causal factors behind any such trends? An analytical review of trends can assist the examiner in identifying areas of weakness which require further evaluation, such as loan pricing problems or high operating expense levels.

• Net Interest Income (NII)--NII (interest income minus interest expense) is the primary source of quality earnings in System institutions. Examiners should identify the specific sources of NII, such as regular accrual loans, restructured loans, cash basis loans, investments, etc., to determine the likelihood of continued interest accruals.
  
• Provisions for Losses--Provisions for losses are charges to income for estimable and probable losses in the institution's assets. System institutions have experienced wide variations in earnings due to large provisions and subsequent reversals of provisions.
  
• Noninterest Income --There are several sources of noninterest income in System institutions, with the most common being financially related services (FRS), fees, patronage, dividends, financial assistance received, and compensation received by associations for servicing bank assets.
  
• Net Gains or Losses--Common examples include gains and losses from sales of other property owned, securities, and other assets. Net gains and losses are typically not a recurring source of income. However, if the institution has demonstrated a steady history of net gains or losses from a common source, examiners should give this due consideration in the earnings analysis.
  
• Noninterest Expenses--Noninterest expense is primarily operating expenses, but could also include other items such as financial assistance provided and Farm Credit System Financial Assistance Corporation debt expense.
  
• Income Taxes--Appropriate tax accruals should be made on a regular basis, and at least with enough frequency to allow for the preparation of accurate income statements. Income taxes are not applicable for Farm Credit Banks, Federal Land Bank Associations, and Federal Land Credit Associations.
  
• Extraordinary Items--Extraordinary items are typically the result of a nonrecurring event. An example may be a one-time adjustment due to an accounting practice change.
  

• Is the institution's allowance for losses adequate? Examiners should identify the reasons for allowance provisions and reversals (e.g., changes in credit risk, the institution's allowance procedures, or accounting practices).
  
• Does the institution generate a significant amount of noninterest income, such as loan fees and financially related services income? Are controls in place to ensure fee and financially related service (FRS) income is collected? Does management determine if FRS programs are profitable?
  
• Has the institution made dividend or patronage payouts? If so, are the amounts reasonable and consistent with the institution's capital position and goals?
  
• Have earnings been impacted by nonoperating gains or losses, such as other property owned disposition or sale of investments? Does the institution expect additional gains/losses in future reporting periods? The impact of nonrecurring items, which are a lower quality source of income, should be considered when evaluating future earnings prospects.
  
• Is the institution complying with all relevant Statements of Financial Accounting Standards (SFAS) which impact earnings? For example:

• Is there consistency between accounting periods in the application of accounting practices?
  

• Have there been any changes in the institution's loan pricing policy or interest rate spreads which have/may impact NII? How are external conditions such as the interest rate environment impacting NII? Rising interest rates may make it more difficult to maintain spreads, while declining rates may make it easier to improve profits by increasing spreads.
  
• How has interest rate risk impacted earnings? What is the potential impact of interest rate risk on future earnings under various interest rate scenarios?
  
• Has planned asset growth been considered when completing financial plans? Earnings will likely need to be increased to meet the associated capital needs and rate of return requirements established by the board.
  
• Has the institution established a favorable earnings trend? Has earnings performance been consistent or erratic? Consideration should be given to the sources of net income to ensure stability from recurring operating sources.
  
• How have external factors or threats, such as laws and regulations, government programs, fiscal and monetary policy, weather, and the competitive environment, affected earnings performance? Has management, through the financial planning process, projected how these factors may impact future earnings? While these factors are largely uncontrollable, management should strategically plan for such events and take steps to either offset the effect or take advantage of likely scenarios.
  
• Based on analysis of the composition of earnings, how much fluctuation has occurred due to nonrecurring sources of earnings? Consider the extent to which things such as net gains or losses and extraordinary items contributed to net income.
  
• Does management anticipate any significant provisions or allowance reversals?
  
• What is the composition of the institution's balance sheet (e.g., high yielding loans/investments versus non- or low yielding nonaccruals, bank investments, or real property)? What impact do non- or low yielding assets have on earnings? The ratio of earning assets/total assets is a useful measure to consider.
  
• Does the institution have any obligation to repay financial assistance? If so, are earnings sufficient to meet such expenses?

• What is the impact of nonearning assets on earnings performance? Are significant future transfers of loans into or out of nonaccrual likely?
  
• Does the institution differentiate loan pricing based on risk? Loans should be priced to compensate for increased risk.
  
• Has the institution accurately identified and recorded known loan losses? Are probable losses accurately estimated and accounted for via provisions to the allowance for losses?
  
• Does the institution continually assess the impact of changes and potential changes in portfolio risk on earnings?

• How effectively have management and the board priced the loan portfolio? Do management information systems provide management with sufficient and timely loan pricing information, such as cost data, loan product data, and competitor rate information? Poor information systems may ignore funding and servicing costs, and encourage dependency on the practice of pricing to meet competition while acting as a precursor to predatory or other unsound pricing practices. Refer to the Asset/Liability Management section for additional loan pricing information.
  
• Does the institution have a sound financial planning and budgeting process? Does management periodically review financial performance in relation to plans? Actual results should be compared to projections, and any significant variances should receive appropriate review by management and the board. The initiation and periodic review of a financial plan and budget for earnings not only provide management with an effective administrative control, but also allow the examiner to gain a more thorough understanding of any unfavorable income and expense performance.
  
• Are the financial plan and budget accurate and realistic projections of expected income and expenditures? The budget should be consistent with the first year of the financial plan. Does management conduct analyses, or "what if" scenarios, to identify the potential impact on earnings from changing operating environments?
  
• Does management determine the costs and profitability of proposed lending and FRS programs prior to implementation? Does management monitor the profitability of such programs on an ongoing basis to enable the board to make sound decisions regarding continuation of such programs?
  
• Are operating expense levels reasonable? Does management adequately monitor and control expenditures? What action is management taking to control costs? Are salary and benefits expenses reasonable? Management's spending philosophy and practices should demonstrate prudence and result in expenditures which are in line with safe business practices. The ratio of operating expenses/average loans is a useful measure when analyzing the level of expenses.
  
• Have expense allocations in jointly operated institutions been adequately supported? Examiners should ensure management adequately documents and monitors expense allocations.
  
• Has interest rate risk (IRR) been accurately identified, measured, and appropriately managed? Examiners should understand the potential impact of IRR on the institution's earnings and ensure management actions in this area are consistent with financial plans and, specifically, earnings objectives.

• Allowance for loan losses;
• Loan portfolio management;
• Loan review;
• Asset/liability management;
• Business planning (including capital planning); and
• Liquidity.

• Earnings are static or declining as a percentage of total assets;
  
• Net income from operations is decreasing as a percentage of total revenues;
  
• The ratio of operating expenses/average loans is increasing or may already be excessive;
  
• The net interest margin is declining;
  
• Loan losses are increasing; and
  
• Items subject to management discretion (such as loan loss reversals) are increasing.

• Changes in loan pricing policies or lending programs;
  
• Shifts in board/management earnings philosophy;
  
• Possible allowance provisions or reversals;
  
• External conditions which may impact interest rates or other income and expense items;
  
• Trends in dividend and patronage income and payouts, and the likelihood they will continue;
  
• Expected nonrecurring sources of income, such as potential gains or losses;
  
• Trends in operating expense levels and potential increases for items such as salaries and benefits or incentive programs;

• Financial assistance repayment obligations;
  
• Impact of changes or errors in accounting practices;
  
• Impact of interest rate risk;
  
• Effect of planned asset growth;
  
• Fluctuation due to nonrecurring sources of income and expense; and
  
• Composition of the balance sheet and planned changes.

• Additional credit risk which may reduce future earnings;
  
• Loan chargeoffs that have not been recorded;
  
• The adequacy of the allowance for losses; and
  
• Adjustments to interest income for loans which require transfer into nonaccrual.