Fifth Third Bank 2009 Annual Report Download - page 20

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
18 Fifth Third Bancorp
CRITICAL ACCOUNTING POLICIES
The Bancorp’s Consolidated Financial Statements are prepared in
accordance with accounting principles generally accepted in the
United States of America. Certain accounting policies require
management to exercise judgment in determining methodologies,
economic assumptions and estimates that may materially affect
the value of the Bancorp’s assets or liabilities and results of
operations and cash flows. The Bancorp's critical accounting
policies include the accounting for allowance for loan and lease
losses, reserve for unfunded commitments, income taxes,
valuation of servicing rights, fair value measurements and
goodwill. No material changes were made to the valuation
techniques or models described below during the year ended
December 31, 2009.
Allowance for Loan and Lease Losses
The Bancorp maintains an allowance to absorb probable loan and
lease losses inherent in the portfolio. The allowance is maintained
at a level the Bancorp considers to be adequate and is based on
ongoing quarterly assessments and evaluations of the collectability
and historical loss experience of loans and leases. Credit losses are
charged and recoveries are credited to the allowance. Provisions
for loan and lease losses are based on the Bancorp’s review of the
historical credit loss experience and such factors that, in
management’s judgment, deserve consideration under existing
economic conditions in estimating probable credit losses. In
determining the appropriate level of the allowance, the Bancorp
estimates losses using a range derived from “base” and
“conservative” estimates. The Bancorp’s strategy for credit risk
management includes a combination of conservative exposure
limits significantly below legal lending limits and conservative
underwriting, documentation and collections standards. The
strategy also emphasizes diversification on a geographic, industry
and customer level, regular credit examinations and quarterly
management reviews of large credit exposures and loans
experiencing deterioration of credit quality.
Larger commercial loans that exhibit probable or observed
credit weakness are subject to individual review. When individual
loans are impaired, allowances are determined based on
management’s estimate of the borrower’s ability to repay the loan
given the availability of collateral and other sources of cash flow,
as well as evaluation of legal options available to the Bancorp. Any
allowances for impaired loans are measured based on the present
value of expected future cash flows discounted at the loan’s
effective interest rate, the fair value of the underlying collateral or
readily observable secondary market values. The Bancorp
evaluates the collectability of both principal and interest when
assessing the need for a loss accrual. Historical loss rates are
applied to commercial loans that are not impaired or are impaired
but smaller than an established threshold and thus not subject to
individual review. The loss rates are derived from a migration
analysis, which tracks the historical net charge-off experience
sustained on loans according to their internal risk grade. The risk
grading system currently utilized for allowance analysis purposes
encompasses ten categories.
Homogenous loans and leases, such as consumer installment,
revolving and residential mortgage loans, are not individually risk
graded. Rather, standard credit scoring systems and delinquency
monitoring are used to assess credit risks. Allowances are
established for each pool of loans based on the expected net
charge-offs. Loss rates are based on the average net charge-off
history by loan category. Historical loss rates for commercial and
consumer loans may be adjusted for significant factors that, in
management’s judgment, are necessary to reflect losses inherent in
the portfolio. Factors that management considers in the analysis
include the effects of the national and local economies; trends in
the nature and volume of delinquencies, charge-offs and
nonaccrual loans; changes in loan mix; credit score migration
comparisons; asset quality trends; risk management and loan
administration; changes in the internal lending policies and credit
standards; collection practices; and examination results from bank
regulatory agencies and the Bancorp’s internal credit examiners.
The Bancorp’s current methodology for determining the
allowance for loan and lease losses is based on historical loss rates,
current credit grades, specific allocation on impaired commercial
credits above specified thresholds and other qualitative
adjustments. Allowances on individual loans and historical loss
rates are reviewed quarterly and adjusted as necessary based on
changing borrower and/or collateral conditions and actual
collection and charge-off experience. An unallocated allowance is
maintained to recognize the imprecision in estimating and
measuring loss when evaluating allowances for individual loans or
pools of loans.
Loans acquired by the Bancorp through a purchase business
combination are recorded at fair value as of the acquisition date.
The Bancorp does not carry over the acquired company’s
allowance for loan and lease losses, nor does the Bancorp add to
its existing allowance for the acquired loans as part of purchase
accounting.
The Bancorp’s primary market areas for lending are the
Midwestern and Southeastern regions of the United States. When
evaluating the adequacy of allowances, consideration is given to
these regional geographic concentrations and the closely
associated effect changing economic conditions have on the
Bancorp’s customers.
Reserve for Unfunded Commitments
The reserve for unfunded commitments is maintained at a level
believed by management to be sufficient to absorb estimated
probable losses related to unfunded credit facilities and is included
in other liabilities in the Consolidated Balance Sheets. The
determination of the adequacy of the reserve is based upon an
evaluation of the unfunded credit facilities, including an
assessment of historical commitment utilization experience, credit
risk grading and historical loss rates based on credit grade
migration. Net adjustments to the reserve for unfunded
commitments are included in other noninterest expense in the
Consolidated Statements of Income.
Income Taxes
The Bancorp estimates income tax expense based on amounts
expected to be owed to the various tax jurisdictions in which the
Bancorp conducts business. On a quarterly basis, management
assesses the reasonableness of its effective tax rate based upon its
current estimate of the amount and components of net income,
tax credits and the applicable statutory tax rates expected for the
full year. The estimated income tax expense is recorded in the
Consolidated Statements of Income.
Deferred income tax assets and liabilities are determined
using the balance sheet method and are reported in other assets
and accrued taxes, interest and expenses, respectively in the
Consolidated Balance Sheets. Under this method, the net deferred
tax asset or liability is based on the tax effects of the differences
between the book and tax basis of assets and liabilities, and
recognizes enacted changes in tax rates and laws. Deferred tax
assets are recognized to the extent they exist and are subject to a
valuation allowance based on management’s judgment that
realization is more-likely-than-not. This analysis is performed on a
quarterly basis and includes an evaluation of all positive and
negative evidence to determine whether realization is more-likely-
than-not.
Accrued taxes represent the net estimated amount due to
taxing jurisdictions and are reported in accrued taxes, interest and
expenses in the Consolidated Balance Sheets. The Bancorp