TO:
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CHIEF EXECUTIVE OFFICER
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SUBJECT:
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Interest Accruals on Short-term Consumer
Loans - "Rule of 78s" Method
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The FDIC would like to bring to banks' attention an Internal Revenue Service (IRS)
requirement for recognizing interest income on "short-term consumer loans" for federal
income tax purposes.
On August 17, 1997, the IRS published Revenue Procedure (Rev. Proc.) 97-37 (see
IRS Bulletin No. 1997-33), which, among other things, made it clear that the
"Rule of 78s" method of computing interest income on certain "short-term
consumer loans" was no longer acceptable for federal income tax purposes.
Previously, the IRS had permitted the use of the Rule of 78s on such loans as an
administrative exception to the general rule that disallows the Rule of 78s
method of accounting for interest on indebtedness. This exception was only
permitted for amortizing consumer loans that required level payments to be made
on a regular basis at least annually. The loan term could not exceed five years
and a balloon payment could not be due at the end of the loan term.
Effective for tax years ending on or after August 17, 1997, Rev. Proc.
97-37 required interest income on all short-term consumer loans, both
new loans and those currently outstanding, to be recognized using the
constant yield method. For banks that had been using the Rule of 78s,
this meant that they would have to make a mid-year change in the method
of calculating interest income for federal income tax purposes.
During examinations conducted in 1998, FDIC examiners found that
certain banks had not changed from the Rule of 78s to the
constant yield method of accounting for interest income for
federal income tax purposes. Furthermore, many lenders who had
been using the Rule of 78s method of accounting for federal
income tax purposes experienced difficulty in attempting to
comply with Rev. Proc. 97-37.
To address these problems, the IRS modified its guidance
on the Rule of 78s in Rev. Proc. 98-60, which was issued
December 21, 1998 (see IRS Bulletin No. 1998-51). Rev.
Proc. 98-60 states that, as a matter of administrative
convenience, the IRS will permit a taxpayer such as a
bank to use the Rule of 78s method for recognizing
interest income on certain short-term consumer loans "if
the loans were issued prior to the first day of the
taxpayer's first taxable year that begins on or after
January 1, 1999." As an example, banks with a calendar
year fiscal year may continue to recognize revenue for
federal income tax purposes using the Rule of 78s method
on short-term consumer loans (as described in the second
paragraph on the previous page) that were on the books
on or before December 31, 1998. However, these banks
must use the constant yield method of accounting for
interest earned on all short-term consumer loans that
are issued on or after January 1, 1999.
Although these provisions of Rev. Proc. 98-60
provide some relief to institutions that did not
cease to use the Rule of 78s for federal income
tax purposes in 1997, institutions are reminded
that this method of recognizing income on loans
is not acceptable under generally accepted
accounting principles. Accordingly, the Rule of
78s normally should not be used to report
interest income in the quarterly Reports of
Condition and Income (Call Reports) even if it
is used for federal income tax purposes in
accordance with Rev. Proc. 98-60.
The FDIC encourages banks to consult
with their tax advisor concerning the
requirements of Rev. Procs. 98-60 and
97-37. Copies of these revenue
procedures should be available from your
tax advisor or may be obtained on the
Internet at www.irs.ustreas.gov.
For further information on the
provisions of the two revenue
procedures concerning the Rule
of 78s, please contact William
Blanchard of the IRS' Office of
Assistant Chief Counsel
(Financial Institutions and
Products) on 202-622-3950.
Distribution:
FDIC-Supervised
Banks
(Commercial
and
Savings)
NOTE:
Paper
copies
of
FDIC
financial
institution
letters
may
be
obtained
through
the
FDIC's
Public
Information
Center,
801
17th
Street
NW,
Room
100,
Washington,
DC
20434
(800-276-6003
or
(703)
562-2200).
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