NOTE 1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The Company

National Rural Utilities Cooperative Finance Corporation (“CFC”) is a member-owned cooperative association incorporated under the laws of the District of Columbia in April 1969. CFC’s principal purpose is to provide its members with financing to supplement the loan programs of the Rural Utilities Service (“RUS”) of the United States Department of Agriculture (“USDA”). CFC makes loans to its rural electric members so they can acquire, construct and operate electric distribution systems, generation and transmission (“power supply”) systems and related facilities. CFC also provides its members with credit enhancements in the form of letters of credit and guarantees of debt obligations. As a cooperative, CFC is owned by and exclusively serves its membership, which consists of not-for-profit entities or subsidiaries or affiliates of not-for-profit entities. CFC is exempt from federal income taxes.

National Cooperative Services Corporation (“NCSC”) is a taxable cooperative incorporated in 1981 in the District of Columbia as a member-owned cooperative association. NCSC’s principal purpose is to provide financing to members of CFC, entities eligible to be members of CFC and the for-profit and nonprofit entities that are owned, operated or controlled by or provide significant benefit to certain members of CFC. NCSC’s membership consists of distribution systems, power supply systems and statewide and regional associations that are members of CFC. CFC is the primary source of funding for NCSC and manages NCSC’s business operations under a management agreement that is automatically renewable on an annual basis unless terminated by either party. NCSC pays CFC a fee and, in exchange, CFC reimburses NCSC for loan losses under a guarantee agreement. As a taxable cooperative, NCSC pays income tax based on its reported taxable income and deductions. NCSC is headquartered with CFC in Dulles, Virginia.

Rural Telephone Finance Cooperative (“RTFC”) is a taxable Subchapter T cooperative association originally incorporated in South Dakota in 1987 and reincorporated as a member-owned cooperative association in the District of Columbia in 2005. RTFC’s principal purpose is to provide financing for its rural telecommunications members and their affiliates. RTFC’s membership consists of a combination of not-for-profit and for-profit entities. CFC is the sole lender to and manages the business operations of RTFC through a management agreement that is automatically renewable on an annual basis unless terminated by either party. RTFC pays CFC a fee and, in exchange, CFC reimburses RTFC for loan losses under a guarantee agreement. As permitted under Subchapter T of the Internal Revenue Code, RTFC pays income tax based on its net income, excluding patronage-sourced earnings allocated to its patrons. RTFC is headquartered with CFC in Dulles, Virginia.

Basis of Presentation and Use of Estimates

The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts and related disclosures during the period. Management's most significant estimates and assumptions involve determining the allowance for loan losses and the fair value of financial assets and liabilities. Actual results could differ from these estimates. Certain reclassifications have been made to prior periods to conform to the current presentation.

Risks and Uncertainties

We have considered the impact of the emergence in 2019 and continued spread of a novel strain of coronavirus that causes coronavirus disease 2019 (“COVID-19”), which was declared a global pandemic by the World Health Organization (“WHO”) in March 2020, on our consolidated financial statements. Although the effects of COVID-19 and the response to the virus have negatively impacted financial markets and overall economic conditions, we have been able to navigate the challenges of the pandemic reasonably well. We have been monitoring developments closely, and the future impact of COVID-19 on our operations is highly uncertain and cannot be predicted. The extent of the impact of COVID-19 on our operational and financial performance will depend on certain developments, including, among others, the duration and severity of the COVID-19 pandemic, the ultimate impact on our members, potential further disruption and deterioration in the corporate debt markets and additional, or extended, federal, state and local government orders and regulations that might be imposed in response to the pandemic, all of which are uncertain.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of CFC, variable interest entities (“VIEs”) where CFC is the primary beneficiary and subsidiary entities created and controlled by CFC to hold foreclosed assets. CFC did not have any entities that held foreclosed assets as of May 31, 2020 or May 31, 2019. All intercompany balances and transactions have been eliminated. NCSC and RTFC are VIEs that are required to be consolidated by CFC. Unless stated otherwise, references to “we, “our” or “us” relate to CFC and its consolidated entities.

Variable Interest Entities

A VIE is an entity that has a total equity investment at risk that is not sufficient to finance its activities without additional subordinated financial support provided by another party, or where the group of equity holders does not have: (i) the ability to make decisions about the entity’s activities that most significantly impact its economic performance; (ii) the obligation to absorb the entity’s expected losses; or (iii) the right to receive the entity’s expected residual returns.

NCSC and RTFC meet the definition of VIEs because they do not have sufficient equity investment at risk to finance their activities without additional financial support. When evaluating an entity for possible consolidation, we must determine whether or not we have a variable interest in the entity. If it is determined that we do not have a variable interest in the entity, no further analysis is required and we do not consolidate the entity. If we have a variable interest in the entity, we must evaluate whether we are the primary beneficiary based on an assessment of quantitative and qualitative factors. We are considered the primary beneficiary holder if we have a controlling financial interest in the VIE that provides (i) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. We consolidate the results of NCSC and RTFC with CFC because CFC is the primary beneficiary holder.

Cash and Cash Equivalents

Cash, certificates of deposit, due from banks and other investments with original maturities of less than 90 days are classified as cash and cash equivalents.

Restricted Cash

Restricted cash, which consists primarily of member funds held in escrow for certain specifically designed cooperative programs, totaled $9 million and $8 million as of May 31, 2020 and 2019, respectively.

Investment Securities

We currently hold investments in equity and debt securities. We record purchases and sales of securities on a trade-date basis. The accounting and measurement framework for investment securities differs depending on the security type and the classification.

Our equity securities consist of investments in Federal Agricultural Mortgage Corporation (“Farmer Mac”) Series A common stock and Farmer Mac Series A and Series C non-cumulative preferred stock. We previously had investments in equity securities that were classified as available for sale as of May 31, 2018. The unrealized gains and losses on these securities were recorded in other comprehensive income. Effective with our June 1, 2018 adoption of the financial instrument accounting standard on the recognition and measurement of financial assets and financial liabilities, unrealized gains and losses on equity securities are required to be recorded in earnings. Equity securities are carried at fair value on our consolidated balance sheets with unrealized gains and losses recorded as a component of other non-interest income.

Our debt securities consist of investments in certificates of deposit with maturities greater than 90 days, corporate debt securities, municipality debt securities, commercial mortgage-backed securities (“MBS”) and other asset-backed securities (“ABS”). We currently classify and account for our investments in debt securities as trading. We previously had investments in debt securities that were classified as held to maturity as of May 31, 2019. During the fourth quarter of fiscal year 2020, in light of the extreme volatility and disruptions in the capital and credit markets in early March 2020 resulting from the COVID-19 crisis, we transferred the debt securities in our held-to-maturity investment portfolio to trading, as we revised our objective for the use of our held-to-maturity investment portfolio from previously serving as a supplemental source of liquidity to serving as a readily available source of liquidity. In conjunction with the transfer, recognized an unrealized gain of $1 million in earnings. We report debt securities classified as trading on our consolidated balance sheets at fair value with unrealized gains and losses recorded as a component of other non-interest income. Interest income is generally recognized over the contractual life of the securities based on the effective yield method.

Loans to Members

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are considered as held for investment. Loans held for investment are carried at the outstanding unpaid principal balance, net of unamortized loan origination costs. We classify and account for loans to members as held for investment. Deferred loan origination costs are amortized using the straight-line method, which approximates the effective interest method, into interest income over the life of the loan.

Nonperforming Loans

A loan is considered past due if a full payment of interest and principal is not received within 30 days of its due date. Loans are classified as nonperforming when the collection of interest and principal has become 90 days past due; court proceedings indicate that collection of interest and principal in accordance with the contractual terms is unlikely; or the full and timely collection of interest or principal becomes otherwise due.

Once a loan is classified as nonperforming, we typically place the loan on nonaccrual status and reverse any accrued and unpaid interest recorded during the period in which the loan is classified as nonperforming. We generally apply all cash received during the nonaccrual period to the reduction of principal, thereby foregoing interest income recognition. The decision to return a loan to accrual status is determined on a case-by-case basis.

We fully charge off or write down loans to the estimated net realizable value in the period that it becomes evident that collectability of the full contractual amount is highly unlikely; however, our efforts to recover all charged-off amounts may continue. The determination to write off all or a portion of a loan balance is made based on various factors on a case-by-case basis including, but not limited to, cash flow analysis and the fair value of collateral securing the borrower’s loans.

Impaired Loans

A loan is considered impaired when, based on current information and events, we determine that it is probable that we will be unable to collect all interest and principal amounts due as scheduled in accordance with the contractual terms of the loan agreement, other than an insignificant delay in payment or insignificant shortfall in payment amount. Factors considered in determining impairment may include, but are not limited to:


•	the review of the borrower’s audited financial statements and interim financial statements if available,


•	the borrower’s payment history,


•	communication with the borrower,


•	economic conditions in the borrower’s service territory,


•	pending legal action involving the borrower,


•	restructure agreements between us and the borrower, and


•	estimates of the value of the borrower’s assets that have been pledged as collateral to secure our loans.

We recognize interest income on impaired loans on a case-by-case basis. An impaired loan to a borrower that is nonperforming will typically be placed on nonaccrual status and we will reverse all accrued and unpaid interest. We generally apply all cash received during the nonaccrual period to the reduction of principal, thereby foregoing interest income recognition. Interest income may be recognized on an accrual basis for restructured impaired loans where the borrower is performing and is expected to continue to perform based on agreed-upon terms.

We may modify the terms of a loan to maximize the collection of amounts due when a borrower is experiencing financial difficulties. Concessionary modifications are classified as troubled debt restructurings (“TDRs”) unless the modification results in only an insignificant delay in payments to be received. All of our restructured loans are considered TDRs.

Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of probable credit losses inherent in our loan portfolio, which consists of CFC, NCSC and RTFC loan portfolio segments. Our allowance for loan losses for our portfolio segments consists of a collective allowance for loans that are not individually impaired and a specific allowance for loans identified as individually impaired. We increase or decrease the allowance for loan losses by recording a provision or benefit for loan losses in the statement of operations. We record charge-offs against the allowance for loan losses when management determines that any portion of a loan is uncollectible. We add subsequent recoveries, if any, to the allowance for loan losses.

Collective Allowance

The collective allowance is established, by loan portfolio segment, using an internal model to estimate probable incurred losses as of each balance sheet date. We further stratify our loan portfolio segments and group loans into pools based on member borrower type—distribution, power supply, telecommunications, and statewide and associates—as we consider our members with the same operations to share similar risk characteristics. We delineate each of our loan pools by borrower risk rating and apply loss factors to the outstanding principal balance at the end of each reporting period to determine the collective allowance for loan losses. The loss factors consist of a probability of default, or default rate, and the loss given default, or loss severity or recovery, for each loan pool. We derive the total collective loss estimate by applying the default rate, based on a five-year loss emergence period, and recovery rate, based on our historical experience, to each loan pool. Following is additional information on the key inputs and assumptions used in determining our collective allowance for loan losses.

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Internal Risk Ratings: As part of our credit risk-management process, we regularly evaluate each borrower and loan facility in our loan portfolio and assign an internal risk rating. Our borrower risk rating is intended to reflect probability of default. We engage an independent third party to perform an annual review of a sample of borrowers and loan facilities to corroborate our internally assigned risk ratings. The risk ratings are based on quantitative and qualitative factors, including the general financial condition of the borrower; our judgment of the quality of the borrower’s management; our judgment of the borrower’s competitive position within its service territory and industry; our estimate of the potential impact of proposed regulation and litigation; and other factors specific to individual borrowers or classes of borrowers.

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Loss Emergence Period: The loss emergence period represents the average time between when a loss-triggering event, such as a successful new investment or expansion of services, a severe weather event or deterioration in operations, occurs and the problem loan is charged-off, restructured or otherwise resolved. Our loss emergence period of five years is based on CFC’s historical average loss emergence period.

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Default Rates: Because we have a limited history of defaults to develop reasonable and supportable estimated probability of default rates for our existing loan portfolio, we utilize third-party default data for the utility sector as a proxy to estimate probability of default rates for our loan portfolio segments. The third-party default data provides historical expected default rates, based on credit ratings and remaining maturities of outstanding bonds, for the utility sector. We align our internal borrower risk ratings to the credit ratings provided in the utility default rate table and apply the cumulative default rates for our estimated average loss emergence period of five years to each of our loan pools.

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Recovery Rates: We utilize our internal historical loss experience to estimate loss given default, or the recovery rate, for each of our loan portfolio segments, as we believe it provides a more reliable estimate than third-party loss severity data due to the organizational structure and operating environment of rural utility cooperatives, our lending practice of generally requiring a senior security position on the assets and revenues of borrowers for long-term loans, and the approach we take in working with borrowers that may be experiencing operational or financial issues. The historical recovery rates for each portfolio segment may be adjusted based on management’s consideration and assessment of current conditions and relevant factors, such as recent trends in credit performance, historical variability of recovery rates and additional analysis of long-term loss severity experience, changes in risk-management practices, current and past underwriting standards, specific industry issues and trends and general economic conditions.

Specific Allowance

The specific allowance for individually impaired loans that are not collateral dependent is calculated based on the difference between the recorded investment in the loan and the present value of the expected future cash flows, discounted at the loan’s effective interest rate. If the loan is collateral dependent, we measure the impairment based on the current fair value of the collateral less estimated selling costs. Loans are considered to be collateral dependent if repayment of the loan is expected to be provided solely by the underlying collateral and there are no other available and reliable sources of repayment.

Unadvanced Loan Commitments

Unadvanced commitments represent amounts for which we have approved and executed loan contracts, but the funds have not been advanced. The majority of the unadvanced commitments reported represent amounts that are subject to material adverse change clauses at the time of the loan advance. Prior to making an advance on these facilities, we would confirm there has been no material adverse change in the business or condition, financial or otherwise, of the borrower since the time the loan was approved and confirm the borrower is currently in compliance with loan terms and conditions. The remaining unadvanced commitments relate to line of credit loans that are not subject to a material adverse change clause at the time of each loan advance. As such, we would be required to advance amounts on these committed facilities as long as the borrower is in compliance with the terms and conditions of the loan commitment.

Unadvanced loan commitments related to line of credit loans are typically for periods not to exceed five years and are generally revolving facilities used for working capital and backup liquidity purposes. Historically, we have experienced a very low utilization rate on line of credit loan facilities, whether or not there is a material adverse change clause. Since we generally do not charge a fee on the unadvanced portion of the majority of our loan facilities, our borrowers will typically request long-term facilities to fund construction work plans and other capital expenditures for periods of up to five years and draw down on the facility over that time. In addition, borrowers will typically request an amount in excess of their immediate estimated loan requirements to avoid the expense related to seeking additional loan funding for unexpected items. These factors contribute to our expectation that the majority of the unadvanced loan commitments will expire without being fully drawn upon and that the total unadvanced amount does not necessarily represent future cash funding

requirements.

Reserve for Unadvanced Loan Commitments

We maintain a reserve for unadvanced loan commitments and committed lines of credit. This reserve is included as a component of other liabilities on our consolidated balance sheets, and changes in the reserve are included in other non-interest expense on our consolidated statements of operations. Our estimate of the reserve for potential losses on these commitments takes into consideration various factors, including the existence of a material adverse change clause, the historical utilization of the committed lines of credit, the probability of funding, historical loss experience on unadvanced loan commitments and other inputs along with management judgment consistent with the methodology used to determine our allowance for loan losses.

Fixed Assets

Fixed assets are recorded at cost less accumulated depreciation. We recognize depreciation expense for each category of our depreciable fixed assets on a straight-line basis over the estimated useful life, which ranges from three to 40 years. We recognized depreciation expense of $9 million, $9 million and $8 million in fiscal years 2020, 2019 and 2018, respectively. The following table displays the components of our fixed assets. Our headquarters facility in Loudoun County, Virginia, which is owned by CFC, is included as a component of building and building equipment.



	May 31,
(Dollars in thousands)	2020			2019
Building and building equipment	$	50,087		$	50,167
Furniture and fixtures	6,015			6,012
Computer software and hardware	49,944			71,915
Other	1,051			1,069
Depreciable fixed assets	107,097			129,163
Less: Accumulated depreciation	(59,007		)	(53,695		)
Net depreciable fixed assets	48,090			75,468
Land	23,796			23,796
Software development in progress	17,251			21,363
Fixed assets, net	$	89,137		$	120,627

In the fourth quarter of fiscal year 2020, management made a decision to abandon a project to develop an internal-use loan origination and servicing platform. The project was intended to update our loan platform to provide increased functionality and flexibility and enhance the operational efficiency of our lending, loan servicing and loan accounting processes. As a result of the decision to abandon the project, we wrote off the capitalized amounts related to this project, which were recorded as a component of computer software and hardware and software development in progress, and recognized a non-cash impairment charge of $31 million in the fourth quarter of fiscal year 2020. The impairment charge is reported as a component of other non-interest expense on our consolidated statements of operations.

Assets Held for Sale

An asset is classified as held for sale when (i) management commits to a plan to sell the asset or business; (ii) the asset or business is available for sale in its present condition; (iii) the asset or business is actively marketed for sale at a reasonable price; (iv) the sale is expected to be completed within one year; and (v) it is unlikely significant changes to the plan will be made or that the plan will be withdrawn. Long-lived assets classified as held for sale are initially measured at the lower of their carrying amount or fair value less cost to sell. If the carrying value exceeds the estimated fair value less cost to sell in the period the held for sale criteria are met, an impairment charge is recorded equal to the amount by which the carrying amount exceeds the fair value less cost to sell. Subsequent changes in the long-lived asset’s fair value less cost to sell is reported as an adjustment to the carrying amount to the extent that the adjusted carrying amount does not exceed the carrying amount of the long-lived asset at the time it was initially classified as held for sale.

On March 14, 2018, CFC entered into a purchase and sale agreement (“the agreement”), which was subsequently amended, for the sale of a parcel of land, consisting of approximately 28 acres, located in Loudoun County, Virginia. We designated the property, which had a carrying value of $14 million, as held for sale and reclassified it from fixed assets, net to other assets on our consolidated balance sheet. On July 22, 2019, we closed on the sale of the land and received net proceeds of $22 million, resulting in a gain of $8 million on the sale of this property, which is reported in other non-interest expense on our consolidated statements of operations.

Foreclosed Assets

Foreclosed assets acquired through our lending activities in satisfaction of indebtedness may be held in operating entities created and controlled by CFC and presented separately in our consolidated balance sheets under foreclosed assets, net. These assets are initially recorded at estimated fair value as of the date of acquisition. Subsequent to acquisition, foreclosed assets not classified as held for sale are evaluated for impairment, and the results of operations and any impairment are reported on our consolidated statements of operations under results of operations of foreclosed assets. When foreclosed assets meet the accounting criteria to be classified as held for sale, they are recorded at the lower of cost or fair value less estimated cost to sell at the date of transfer, with the amount at the date of transfer representing the new cost basis. Subsequent changes are recognized in our consolidated statements of operations under results of operations of foreclosed assets. We also review foreclosed assets classified as held for sale each reporting period to determine whether the existing carrying amounts are fully recoverable in comparison to estimated fair values. We did not carry any foreclosed assets on our consolidated balance sheet as of May 31, 2020 or May 31, 2019.

Debt

We report debt at cost net of unamortized issuance costs and discounts or premiums. Issuance costs, discounts and premiums are deferred and amortized into interest expense using the effective interest method or a method approximating the effective interest method over the legal maturity of each bond issue. Short-term borrowings consist of borrowings with an original contractual maturity of one year or less and do not include the current portion of long-term debt. Borrowings with an original contractual maturity of greater than one year are classified as long-term debt.

Derivative Instruments

We are an end user of derivative financial instruments and do not engage in derivative trading. We use derivatives, primarily interest rate swaps and Treasury rate locks, to manage interest rate risk. Derivatives may be privately negotiated contracts, which are often referred to as over-the-counter (“OTC”) derivatives, or they may be listed and traded on an exchange. We generally engage in OTC derivative transactions.

In accordance with the accounting standards for derivatives and hedging activities, we record derivative instruments at fair value as either a derivative asset or derivative liability on our consolidated balance sheets. We report derivative asset and liability amounts on a gross basis based on individual contracts, which does not take into consideration the effects of master netting agreements or collateral netting. Derivatives in a gain position are reported as derivative assets on our consolidated balance sheets, while derivatives in a loss position are reported as derivative liabilities. Accrued interest related to derivatives is reported on our consolidated balance sheets as a component of either accrued interest receivable or accrued interest payable.

If we do not elect hedge accounting treatment, changes in the fair value of derivative instruments, which consist of net accrued periodic derivative cash settlements expense and derivative forward value amounts, are recognized in our consolidated statements of operations under derivative gains (losses). If we elect hedge accounting treatment for derivatives, we formally document, designate and assess the effectiveness of the hedge relationship. Changes in the fair value of derivatives designated as qualifying fair value hedges are recorded in earnings together with offsetting changes in the fair value of the hedged item and any related ineffectiveness. Changes in the fair value of derivatives designated as qualifying cash flow hedges are recorded as a component of other comprehensive income (“OCI”), to the extent that the hedge relationships are effective, and reclassified from accumulated other comprehensive income (“AOCI”) to earnings using the effective interest method over the term of the forecasted transaction. Any ineffectiveness in the hedging relationship is recognized as a component of derivative gains (losses) in our consolidated statement of operations.

We generally do not designate interest rate swaps, which represent the substantial majority of our derivatives, for hedge accounting. Accordingly, changes in the fair value of interest rate swaps are reported in our consolidated statements of operations under derivative gains (losses). Net periodic cash settlements expense related to interest rate swaps are classified as an operating activity in our consolidated statements of cash flows.

We typically designate Treasury rate locks as cash flow hedges of forecasted debt issuances or repricings. Changes in the fair value of treasury locks designated as cash flow hedges are recorded as a component of OCI and reclassified from AOCI into interest expense when the forecasted transaction occurs using the effective interest method. Any ineffectiveness is recognized as a component of derivative gains (losses) in our consolidated statements of operations.

Guarantee Liability

We maintain a guarantee liability that represents our contingent and noncontingent exposure related to guarantees and standby liquidity obligations associated with our members’ debt. The guarantee liability is included in the other liabilities line item on the consolidated balance sheet, and the provision for guarantee liability is reported in non-interest expense as a separate line item on the consolidated statement of operations.

The contingent portion of the guarantee liability represents management’s estimate of our exposure to losses within the guarantee portfolio. The methodology used to estimate the contingent guarantee liability is consistent with the methodology used to determine the allowance for loan losses.

We have recorded a noncontingent guarantee liability for all new or modified guarantees since January 1, 2003. Our noncontingent guarantee liability represents our obligation to stand ready to perform over the term of our guarantees and liquidity obligations that we have entered into or modified since January 1, 2003. Our noncontingent obligation is estimated based on guarantee and liquidity fees charged for guarantees issued, which represents management’s estimate of the fair value of our obligation to stand ready to perform. The fees are deferred and amortized using the straight-line method into interest income over the term of the guarantee.

Fair Value Valuation Processes

We present certain financial instruments at fair value, including equity and debt securities, and derivatives. Fair value is defined as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date (also referred to as an exit price). We have various processes and controls in place to ensure that fair value is reasonably estimated. We consider observable prices in the principal market in our valuations where possible. Fair value estimates were developed at the reporting date and may not necessarily be indicative of amounts that could ultimately be realized in a market transaction at a future date. With the exception of redeeming debt under early redemption provisions, terminating derivative instruments under early-termination provisions and allowing borrowers to prepay their loans, we held and intend to hold all financial instruments to maturity excluding common stock and preferred stock investments that have no stated maturity and our trading debt securities.

Fair Value Hierarchy

The fair value accounting guidance provides a three-level fair value hierarchy for classifying financial instruments. This hierarchy is based on the markets in which the assets or liabilities trade and whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Fair value measurement of a financial asset or liability is assigned a level based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are summarized below:


•	Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities


•	Level 2: Observable market-based inputs, other than quoted prices in active markets for identical assets or liabilities


•	Level 3: Unobservable inputs

The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted prices in active markets or observable market parameters. When quoted prices and observable data in active markets are not fully available, management’s judgment is necessary to estimate fair value. Changes in market conditions, such as reduced liquidity in the capital markets or changes in secondary market activities, may reduce the availability and reliability of quoted prices or observable data used to determine fair value.

Membership Fees

Members are charged a one-time membership fee based on member class. CFC distribution system members, power supply system members and national associations of cooperatives pay a $1,000 membership fee. CFC service organization members pay a $200 membership fee and CFC associates pay a $1,000 fee. RTFC voting members pay a $1,000 membership fee and RTFC associates pay a $100 fee. NCSC members pay a $100 membership fee. Membership fees are accounted for as members’ equity.

Financial Instruments with Off-Balance Sheet Risk

In the normal course of business, we are a party to financial instruments with off-balance sheet risk to meet the financing needs of our member borrowers. These financial instruments include committed lines of credit, standby letters of credit and guarantees of members’ obligations.

Interest Income

Interest income on loans and investments is recognized using the effective interest method. The following table presents interest income, by interest-earning asset category, for fiscal years 2020, 2019 and 2018.



	Year Ended May 31,
(Dollars in thousands)	2020			2019			2018
Interest income by interest-earning asset type:
Long-term fixed-rate loans⁽¹⁾	$	1,043,918		$	1,012,277		$	1,000,492
Long-term variable-rate loans	31,293			41,219			27,152
Line of credit loans	55,140			57,847			38,195
TDR loans⁽²⁾	836			846			889
Other income, net⁽³⁾	(1,304		)	(1,128		)	(1,185		)
Total loans	1,129,883			1,111,061			1,065,543
Cash, time deposits and investment securities	21,403			24,609			11,814
Total interest income	$	1,151,286		$	1,135,670		$	1,077,357

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⁽¹⁾ Includes loan conversion fees, which are generally deferred and recognized as interest income using the effective interest method.

⁽²⁾ Troubled debt restructured (“TDR”) loans.

(3) Consists of late payment fees, commitment fees and net amortization of deferred loan fees and loan origination costs.

Deferred income of $59 million and $58 million as of May 31, 2020 and 2019, respectively, consists primarily of deferred loan conversion fees totaling $53 million and $52 million, respectively. Deferred loan conversion fees are recognized in interest income using the effective interest method.

Interest Expense

The following table presents interest expense, by debt product type, for fiscal years 2020, 2019 and 2018.



	Year Ended May 31,
(Dollars in thousands)	2020		2019		2018
Interest expense by debt product type:⁽¹⁾⁽²⁾
Short-term borrowings	$	77,995	$	92,854	$	50,616
Medium-term notes	125,954		133,797		111,814
Collateral trust bonds	257,396		273,413		336,079
Guaranteed Underwriter Program notes payable	162,929		147,895		140,551
Farmer Mac notes payable	87,617		90,942		56,004
Other notes payable	671		1,237		1,509
Subordinated deferrable debt	51,527		38,628		37,661
Subordinated certificates	57,000		57,443		58,501
Total interest expense	$	821,089	$	836,209	$	792,735

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⁽¹⁾ Includes amortization of debt discounts and debt issuance costs, which are generally deferred and recognized as interest expense using the effective interest method. Issuance costs related to dealer commercial paper, however, are recognized as interest expense immediately as incurred.

⁽²⁾ Includes fees related to funding arrangements, such as up-front fees paid to banks participating in our committed bank revolving line of credit agreements. Depending on the nature of the fee, amounts may be deferred and recognized as interest expense ratably over the term of the arrangement or recognized immediately as incurred.

Early Extinguishment of Debt

We redeem outstanding debt early from time to time to manage liquidity and interest rate risk. When we redeem outstanding debt early, we recognize a gain or loss related to the difference between the amount paid to redeem the debt and the net book value of the extinguished debt as a component of non-interest expense in the gain (loss) on early extinguishment of debt line item.

Income Taxes

While CFC is exempt under Section 501(c)(4) of the Internal Revenue Code, it is subject to tax on unrelated business taxable income. NCSC is a taxable cooperative that pays income tax on the full amount of its reportable taxable income and allowable deductions. RTFC is a taxable cooperative under Subchapter T of the Internal Revenue Code and is not subject to income taxes on income from patronage sources that is allocated to its borrowers, as long as the allocation is properly noticed and at least 20% of the amount allocated is retired in cash prior to filing the applicable tax return.

The income tax benefit (expense) recorded in the consolidated statement of operations represents the income tax benefit (expense) at the applicable combined federal and state income tax rates resulting in a statutory tax rate. The federal statutory tax rate for both NCSC and RTFC was 21% for fiscal year 2020. The federal statutory tax rate for both NCSC and RTFC was 21% for fiscal year 2019 and the federal statutory tax rate for NCSC and RTFC was 29% and 12%, respectively, for fiscal year 2018. Substantially all of the income tax expense recorded in our consolidated statements of operations relates to NCSC. NCSC had a deferred tax asset of $3 million and $2 million as of May 31, 2020 and 2019, respectively, primarily arising from differences in the accounting and tax treatment for derivatives. We believe that it is more likely than not that the deferred tax assets will be realized through taxable earnings.

Recent Accounting Changes and Other Developments

Accounting Standards Adopted in Fiscal Year 2020

Derivatives and Hedging—Targeted Improvements to Accounting for Hedging Activities

In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging—Targeted Improvements to Accounting for Hedging Activities (Topic 815), which expands the types of risk management strategies that qualify for hedge accounting treatment to more closely align the results of hedge accounting with the economics of certain risk-management activities and simplifies certain hedge documentation and assessment requirements. It also eliminates the concept of separately recording hedge ineffectiveness and expands disclosure requirements. The guidance is effective for public entities for fiscal years beginning after December 15, 2018, including interim periods within those years. Early adoption is permitted in any interim period or fiscal year before the effective date. We adopted this guidance on June 1, 2019. Hedge accounting is elective, and we currently apply hedge accounting on a limited basis, specifically when we enter into Treasury rate lock agreements. The adoption of this guidance did not have an impact on our consolidated financial statements or cash flows. If we continue to elect not to apply hedge accounting to our interest rate swaps, the guidance will not have an impact on our consolidated financial statements or liquidity.

Receivables—Nonrefundable Fees and Other Costs

In March 2017, the FASB issued ASU 2017-08, Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20), which shortens the amortization period for the premium on certain callable debt securities to the earliest call date rather the maturity date. The guidance is applicable to any individual debt security, purchased at a premium, with an explicit and noncontingent call feature with a fixed price on a preset date. The guidance does not impact the accounting for purchased callable debt securities held at a discount. The guidance is effective for public entities in fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We adopted this guidance on June 1, 2019. The adoption of this guidance did not have a material impact on our consolidated financial statements or liquidity.

Leases

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which provides new guidance that is intended to improve financial reporting about leasing transactions. The new guidance requires the recognition of a right-of-use asset and lease liability on the consolidated balance sheet by lessees for those leases classified as operating leases under previous guidance. It also requires new disclosures to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases. The guidance is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2018. We adopted this guidance on June 1, 2019. The adoption of this guidance did not have a material impact on our consolidated financial statements or liquidity.

Accounting Standards Adopted Subsequent to Fiscal Year 2020

Fair Value Measurement—Changes to the Disclosure Requirements for Fair Value Measurement

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement—Changes to the Disclosure Requirements for Fair Value Measurement (Topic 820), which eliminates, adds and modifies certain disclosure requirements for fair value measurements as part of its disclosure framework project. The guidance is effective for public entities for fiscal years beginning after December 15, 2019, including interim periods within those years. Early adoption is permitted in any interim period or fiscal year before the effective date. We adopted this guidance on June 1, 2020. The adoption of this guidance did not have a material impact on our consolidated financial statements or liquidity.

Financial Instruments—Credit Losses: Measurement of Credit Losses on Financial Instruments

In June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses: Measurement of Credit Losses on Financial Instruments (Topic 326), which replaces the existing incurred credit loss model and establishes a single credit loss framework based on a current expected credit loss (“CECL”) model for financial assets carried at amortized cost, including loans and held-to-maturity debt securities. CECL requires an entity to estimate credit losses expected over the life of the credit exposure upon initial recognition of that exposure when the financial asset is originated or acquired, which will generally result in earlier recognition of credit losses. The guidance also expands credit quality disclosures and amends the other-than-temporary model for available-for-sale debt securities by requiring the use of an allowance, rather than directly reducing the carrying value of the security. The CECL model is applicable to our loans held-for-investment, unadvanced loan commitments and financial guarantees. Our investment securities are not within the scope of the CECL model because they are classified as trading. We adopted CECL on June 1, 2020, using a modified retrospective approach.

We leveraged our existing probability of default/loss given default model for estimating incurred credit losses and recalibrated this model to serve as the framework for our approach in estimating life-time credit losses for our loan portfolio under CECL. Due to the disruption, rapidly changing conditions and uncertainty caused by the ongoing COVID-19 pandemic, management is continuing to review, assess and refine considerations and judgments related to our qualitative framework under CECL prior to finalizing our estimate of expected credit losses. However, we currently do not believe that the impact at adoption of CECL will have a material impact on our consolidated financial statements. We expect the ultimate impact from our June 1, 2020 adoption of CECL, which we are required to record as a cumulative-effect adjustment to retained earnings, will result in an immaterial decrease in retained earnings and a corresponding increase in our allowance for loan losses. Subsequent to June 1, 2020, expected credit losses for newly recognized loans held for investment, unadvanced loan commitments and financial guarantees, as well as changes in our estimate of expected credit losses on existing financial instruments subject to CECL, will be recognized in earnings. We will be subject to the expanded credit quality disclosure requirements under CECL beginning with the filing of our fiscal year 2021 first quarter Form 10-Q report for the quarterly period ended August 31, 2020.