[Federal Register: September 7, 2000 (Volume 65, Number 174)]
[Notices]
[Page 54268-54276]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr07se00-91]
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FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL
Policy Statement on Allowance for Loan and Lease Losses
Methodologies and Documentation for Banks and Savings Institutions
AGENCY: Federal Financial Institutions Examination Council.
ACTION: Proposed Policy Statement; request for comment.
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SUMMARY: The Federal Financial Institutions Examination Council (FFIEC)
\1\ is requesting comments on a proposed Policy Statement on Allowance
for Loan and Lease Losses (ALLL) Methodologies and Documentation for
Banks and Savings Institutions (Policy Statement). This proposed Policy
Statement is intended to provide guidance on the design and
implementation of ALLL methodologies and supporting documentation
practices.
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\1\ The FFIEC consists of representatives from the Board of
Governors of the Federal Reserve System (FRB), the Federal Deposit
Insurance Corporation (FDIC), the Office of the Comptroller of the
Currency (OCC), the Office of Thrift Supervision (OTS) (referred to
as the ``banking agencies''), and the National Credit Union
Administration. However, this guidance is not directed to credit
unions.
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DATES: Comments must be received by November 6, 2000.
ADDRESSES: Comments should be directed to Keith J. Todd, Executive
Secretary, Federal Financial Institutions Examination Council, 2000 K
Street, N.W., Suite 310, Washington, DC 20006, fax number: (202) 872-
7501. Comments will be available for public inspection during regular
business hours at the above address. Appointments to inspect comments
are encouraged and can be arranged by calling the FFIEC at (202) 872-
7500.
FOR FURTHER INFORMATION CONTACT:
FDIC: Carol L. Liquori, Examination Specialist, Division of
Supervision, (202) 898-7289, or Doris L. Marsh, Examination Specialist,
Division of Supervision, (202) 898-8905, FDIC, 550 17th Street, N.W.,
Washington, DC 20429.
FRB: Linda V. Griffith, Supervisory Financial Analyst, (202) 452-
3506, or Arthur Lindo, Supervisory Financial Analyst, (202) 452-2695,
Division of Banking Supervision and Regulation, Board of Governors of
the Federal Reserve System, 20th Street and Constitution Avenue, N.W.,
Washington, DC 20551.
OCC: Richard Shack, Senior Accountant, Chief Accountant's Office,
Core Policy Division, (202) 874-5411, or Louise A. Francis, National
Bank Examiner, Chief Accountant's Office, Core Policy Division, (202)
874-1306, Office of the Comptroller of the Currency, 250 E Street,
S.W., Washington, DC 20219.
OTS: William Magrini, Policy Analyst, Policy Division, (202) 906-
5744, or Harrison E. Greene, Jr., Securities Accountant, Accounting
Policy Division, (202) 906-7933, Office of Thrift Supervision, 1700 G
Street, N.W., Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
I. Background
On March 10, 1999, the Federal Deposit Insurance Corporation, the
Federal Reserve Board, the Office of the Comptroller of the Currency,
the Office of Thrift Supervision, and the Securities and Exchange
Commission (together, the Agencies) issued a joint letter to financial
institutions on the allowance for loan and lease losses (the Joint
Letter). In the Joint Letter, the Agencies agreed to establish a Joint
Working Group to study ALLL issues and to assist financial institutions
by providing them with improved guidance on this topic. The Agencies
agreed that the Joint Working Group would develop and issue parallel
guidance for two key areas regarding the ALLL:
Appropriate methodologies and supporting documentation,
and
Enhanced disclosures.
This proposed Policy Statement represents the banking agencies'
[[Page 54269]]
guidance to banks and savings institutions relating to methodologies
and supporting documentation for the ALLL. The Securities and Exchange
Commission staff is planning to provide parallel guidance on this topic
for public companies in a future Staff Accounting Bulletin.\2\
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\2\ The American Institute of Certified Public Accountants is
developing more specific guidance on the accounting for loan losses
and the techniques for measuring probable incurred loss in a loan
portfolio. This guidance is expected to be released in final form in
2001.
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This Policy Statement clarifies the banking agencies' expectations
regarding methodologies and documentation support for the ALLL from a
generally accepted accounting principles (GAAP) perspective. For
financial reporting purposes, including regulatory reporting, the
provision for loan and lease losses and the ALLL must be determined in
accordance with GAAP and supervisory guidance. GAAP requires that an
institution maintain written documentation to support the amounts of
the ALLL and the provision for loan and lease losses reported in the
financial statements.
The proposal is not intended to change existing accounting guidance
in, or modify the documentation requirements of, GAAP or guidance
provided in the relevant joint interagency statements issued by the
Agencies. It is intended to supplement, not replace, the guidance the
banking agencies provided in their Interagency Policy Statement on the
Allowance for Loan and Lease Losses, which was issued in December 1993.
It is also intended to supplement guidance the banking agencies
provided in their interagency guidelines establishing standards for
safety and soundness that were issued in 1995 and 1996 pursuant to
Section 39 of the Federal Deposit Insurance Act (FDI Act).\3\ Under the
guidelines for asset quality, each institution should estimate and
establish a sufficient ALLL supported by adequate documentation. The
proposed Policy Statement does not address or change current guidance
regarding loan charge-offs; therefore, institutions should continue to
follow existing regulatory guidance that addresses the timing of
charge-offs.
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\3\ Institutions should refer to the guidelines adopted by their
primary federal regulator as follows: For national banks, Appendix A
to Part 30; for state member banks, Appendix D to Part 208; for
state nonmember banks, Appendix A to Part 364; for savings
associations, Appendix A to Part 570.
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The guidance in this Policy Statement recognizes that institutions
should adopt methodologies and documentation practices that are
appropriate for their size and complexity. For smaller institutions
with fewer and less complex loan products, the amount of supporting
documentation for the ALLL may be less exhaustive than for larger
institutions.
Recognizing that a primary mission of the banking agencies is to
support a safe and sound banking system, examiners will continue to
evaluate the overall adequacy of the ALLL, including the adequacy of
supporting documentation, to ensure that it is appropriate. While the
proposed Policy Statement generally does not provide guidance to
examiners in conducting safety and soundness examinations, examiners
may criticize institutions that fail to document and maintain an
adequate ALLL in accordance with this Policy Statement and other
banking agency guidance. In such cases, institution management may be
cited for engaging in unsafe and unsound banking practices and may be
subject to further supervisory action.
II. Principal Elements of the Policy Statement
The proposed Policy Statement clarifies that the board of directors
of each institution is responsible for ensuring that controls are in
place to determine the appropriate level of the ALLL. It also
emphasizes the banking agencies' long-standing position that
institutions should maintain and support the ALLL with documentation
that is consistent with their stated policies and procedures, GAAP, and
applicable supervisory guidance.
The proposed Policy Statement provides guidance on significant
aspects of ALLL methodologies and documentation practices.
Specifically, the proposal provides guidance on maintaining and
documenting policies and procedures that are appropriately tailored to
the size and complexity of the institution and its loan portfolio. The
proposed Policy Statement notes that it is critical for an
institution's ALLL methodology to incorporate management's current
judgments about the credit quality of the loan portfolio. The
methodology must be a thorough, disciplined, and consistently applied
process that is reviewed and approved by the institution's board of
directors.
The proposal also discusses the methodology and documentation
needed to support ALLL estimates prepared in accordance with GAAP,
which requires loss estimates based upon reviews of individual loans
and groups of loans. After determining the allowance on individually
reviewed loans and groups of loans, the proposal states that management
should consolidate these loss estimates and summarize the amount to be
reported in the financial statements for the ALLL. To verify that the
ALLL methodology is effective and conforms to GAAP and supervisory
guidance, a review of the methodology and its application should be
completed by external or internal auditors or some other party
unrelated to the ALLL process, as appropriate for the size and
complexity of the institution.
The proposal includes illustrations of implementation practices
that institutions may find useful for enhancing their own ALLL
practices, an appendix that provides examples of certain key aspects of
ALLL guidance, a summary of applicable GAAP guidance, and a
bibliographical list of relevant GAAP guidance, joint interagency
statements, and other literature on ALLL issues.
III. Comments
Comment is requested on all aspects of the proposed Policy
Statement.
IV. Paperwork Reduction Act
In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.
chapter 35), the banking agencies have reviewed the proposed Policy
Statement and determined that it does not add any collections of
information pursuant to the Act.
V. Proposed Policy Statement
The text of the proposed Policy Statement follows:
Policy Statement on Allowance for Loan and Lease Losses Methodologies
and Documentation for Banks and Savings Institutions
Boards of directors of banks and savings institutions are
responsible for ensuring that their institutions have controls in
place to consistently determine the allowance for loan and lease
losses (ALLL) in accordance with the institutions' stated policies
and procedures, generally accepted accounting principles (GAAP), and
ALLL supervisory guidance.\4\ To fulfill this responsibility, boards
of directors instruct management to develop and maintain an
appropriate, systematic, and consistently applied process to
determine the amounts of the ALLL and provisions for loan losses.
Management should create and implement suitable policies and
procedures to communicate the ALLL process internally to all
applicable personnel. By creating an environment that encourages
personnel to follow these policies
[[Page 54270]]
and procedures, management improves procedural discipline and
compliance.
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\4\ A bibliography is attached that lists applicable ALLL GAAP
guidance, interagency policy statements, and other reference
materials that may assist in understanding and implementing an ALLL
in accordance with GAAP. See Appendix B for additional information
on applying GAAP to determine the ALLL.
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The determination of the amounts of the ALLL and provisions for
loan and lease losses should be based on management's current
judgments about the credit quality of the loan portfolio, and should
consider all known relevant internal and external factors that
affect loan collectibility as of the reporting date. The ALLL
methodology, the associated policies and procedures, and the amounts
to be reported each period for the provision for loan and lease
losses and ALLL should be reviewed and approved by the board of
directors. To ensure the methodology remains appropriate for the
institution, the board of directors should have the methodology
periodically validated and, if appropriate, revised. The board of
directors' audit committee \5\ should oversee and monitor the
internal controls over the ALLL determination process.\6\
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\5\ While all institutions are encouraged to establish audit
committees, small institutions without audit committees should have
the board of directors assume this responsibility.
\6\ Institutions and their auditors should refer to Statement on
Auditing Standards No. 61, Communication With Audit Committees (as
amended by Statement on Auditing Standards No. 90, Audit Committee
Communications), which requires certain discussions between the
auditor and the audit committee. These discussions should include
items, such as accounting policies and estimates, judgments, and
uncertainties, that have a significant impact on the accounting
information included in the financial statements.
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The banking agencies' \7\ have long-standing examination
policies that call for examiners to review an institution's lending
and loan review functions and recommend improvements, if needed.
Additionally, in 1995 and 1996, the banking agencies adopted
interagency guidelines establishing standards for safety and
soundness, pursuant to Section 39 of the Federal Deposit Insurance
Act (FDI Act).\8\ The interagency asset quality guidelines and the
guidance in this paper assist an institution in estimating and
establishing a sufficient ALLL supported by adequate documentation,
as required under the FDI Act. Additionally, the guidelines require
operational and managerial standards that are appropriate for an
institution's size and the nature and scope of its activities.
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\7\ The banking agencies are the Federal Deposit Insurance
Corporation, the Federal Reserve Board, the Office of the
Comptroller of the Currency, and the Office of Thrift Supervision.
\8\ Institutions should refer to the guidelines adopted by their
primary federal regulator as follows: For national banks, Appendix A
to Part 30; for state member banks, Appendix D to Part 208; for
state nonmember banks, Appendix A to Part 364; for savings
associations, Appendix A to Part 570.
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For financial reporting purposes, including regulatory
reporting, the provision for loan and lease losses and the ALLL must
be determined in accordance with GAAP. GAAP requires that allowances
be well documented, with clear explanations of the supporting
analyses and rationale. This Policy Statement describes but does not
increase the documentation requirements already existing within
GAAP. Failure to maintain, analyze, or support an adequate ALLL in
accordance with GAAP and supervisory guidance is generally an unsafe
and unsound banking practice.
This guidance applies equally to all institutions, regardless of
the size. Because of their less complex lending activities and
products, smaller institutions may find it more efficient to combine
a number of procedures (e.g., information gathering, documentation,
and internal approval processes) while continuing to ensure the
institution has a consistent and appropriate methodology. Thus, much
of the documentation that a larger institution might retain in
support of the allowance may be combined into fewer supporting
documents in a smaller institution. For example, simplified
documentation can include spreadsheets, check lists, and other
summary documents that many institutions currently use.
Illustrations A and C provide specific examples of how smaller
institutions may determine and document portions of their loan loss
allowance.
Documentation Standards
Appropriate written supporting documentation facilitates review
of the ALLL process and reported amounts, builds discipline into the
ALLL determination process, and improves the process for estimating
loan and lease losses by helping to ensure that all relevant factors
are appropriately considered in the ALLL analysis. An institution
should document the relationship between the findings of its
detailed review of the loan portfolio and the amount of the ALLL and
the provision for loan and lease losses reported in each period.\9\
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\9\ This position is fully described for public companies in the
Securities and Exchange Commission's (SEC) Financial Reporting
Release No. 28 (FRR 28), in which the SEC indicates that the books
and records of public companies engaged in lending activities should
include documentation of the rationale supporting each period's
determination that the ALLL and provision amounts reported were
adequate.
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At a minimum, institutions should maintain written supporting
documentation for the following decisions, strategies, and
processes:
(1) Policies and procedures:
(a) Over the systems and controls that maintain an appropriate
ALLL and
(b) Over the ALLL methodology,
(2) Loan grading system or process,
(3) Summary or ``roll-up'' of the ALLL balance,
(4) Validation of the ALLL methodology, and
(5) Justification for periodic adjustments to the ALLL process.
The following sections of this Policy Statement provide guidance
on significant aspects of ALLL methodologies and documentation
practices. Specifically, the paper provides guidance on:
(1) Policies and Procedures,
(2) Methodology,
(3) ALLL Under Financial Accounting Standards Board (FASB)
Statement of Financial Accounting Standards No. 114, Accounting by
Creditors for Impairment of a Loan (FAS 114),
(4) ALLL Under FASB Statement of Financial Accounting Standards
No. 5, Accounting for Contingencies (FAS 5),
(5) Consolidating the Loss Estimates, and
(6) Validating the ALLL Methodology.
Policies and Procedures
Financial institutions utilize a wide range of policies,
procedures, and control systems in their ALLL process. Sound
policies should be appropriately tailored to the size and complexity
of the institution and its loan portfolio.
An institution's written policies and procedures for the systems
and controls that maintain an appropriate ALLL should address but
not be limited to:
(1) The roles and responsibilities of the institution's
departments and personnel (including the lending function, credit
review, financial reporting, internal audit, senior management,
audit committee, board of directors, and others, as applicable) who
determine the ALLL to be reported in the financial statements;
(2) The institution's accounting policies for loans and loan
losses, including the policies for charge-offs and recoveries and
for estimating the fair value of collateral, where applicable;
(3) The description of the institution's systematic methodology,
which should be consistent with the institution's accounting
policies for determining its ALLL; \10\ and
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\10\ Further explanation is presented in the Methodology section
that appears below.
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(4) The system of internal controls used to ensure that the ALLL
process is maintained in accordance with GAAP and supervisory
guidance.
An internal control system for the ALLL estimation process
should:
(1) Include measures to ensure the reliability and integrity of
information and compliance with laws, regulations, and internal
policies and procedures;
(2) Ensure that the institution's financial statements
(including regulatory reports) are prepared in accordance with GAAP
and ALLL supervisory guidance; \11\ and
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\11\ 11 In addition to the supporting documentation requirements
for financial institutions, as described in interagency asset
quality guidelines, public companies are required to comply with the
books and records provisions of the Securities Exchange Act of 1934
(Exchange Act). Under Sections 13(b)(2)-(7) of the Exchange Act,
registrants must make and keep books, records, and accounts, which,
in reasonable detail, accurately and fairly reflect the transactions
and dispositions of assets of the registrant. Registrants also must
maintain internal accounting controls that are sufficient to provide
reasonable assurances that, among other things, transactions are
recorded as necessary to permit the preparation of financial
statements in conformity with GAAP. See also SEC Staff Accounting
Bulletin No. 99, Materiality.
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(3) Include a well-defined loan review process containing:
(a) An effective loan grading system that is consistently
applied, identifies differing risk characteristics and loan quality
problems accurately and in a timely manner, and prompts appropriate
administrative actions;
(b) Sufficient internal controls to ensure that all relevant
loan review information is
[[Page 54271]]
appropriately considered in estimating losses. This includes
maintaining appropriate reports, details of reviews performed, and
identification of personnel involved; and
(c) Clear formal communication and coordination between an
institution's credit administration function, financial reporting
group, management, board of directors, and others who are involved
in the ALLL determination process (e.g., written policies and
procedures, management reports, audit programs, and committee
minutes).
Methodology
An ALLL methodology is a system that an institution designs and
implements to reasonably estimate loan and lease losses as of the
financial statement date. It is critical that ALLL methodologies
incorporate management's current judgments about the credit quality
of the loan portfolio through a disciplined and consistently applied
process.
An institution's ALLL methodology is influenced by institution-
specific factors, such as an institution's size, organizational
structure, business environment and strategy, management style, loan
portfolio characteristics, loan administration procedures, and
management information systems. However, there are certain common
elements an institution should incorporate in its ALLL methodology.
A summary of common elements is provided in Appendix B.\12\
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\12\ Also, refer to paragraph 7.05 of the American Institute of
Certified Public Accountants' (AICPA) Audit and Accounting Guide,
Banks and Savings Institutions, 1999 edition (AICPA Audit Guide).
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Documentation of ALLL Methodology in Written Policies and
Procedures
An institution's formal policies and procedures should describe
the primary elements of the institution's ALLL methodology. Such
elements would include portfolio segmentation, impairment
measurement, and loss rate determination. Specifically, written
policies and procedures should describe the methodology:
(1) For segmenting the portfolio:
(a) How the segmentation process is performed (i.e., by loan
type, industry, risk rates, etc.),
(b) When a loan grading system is used to segment the portfolio:
(i) The definitions of each loan grade,
(ii) A reconciliation of the internal loan grades to supervisory
loan grades, and
(iii) The delineation of responsibilities for the loan grading
system.
(2) For determining and measuring impairment under FAS 114:
(a) The methods used to identify loans to be analyzed
individually;
(b) For individually reviewed loans that are impaired, how the
amount of any impairment is determined and measured, including:
(i) Procedures describing the impairment measurement techniques
available and
(ii) Steps performed to determine which technique is most
appropriate in a given situation.
(c) The methods used to determine whether and how loans
individually evaluated under FAS 114, but not considered to be
individually impaired, should be grouped with other loans that share
common characteristics for impairment evaluation under FAS 5.
(3) For determining and measuring impairment by applying loss
rates to loan balances under FAS 5:
(a) How loans with similar characteristics are grouped to be
evaluated for loan collectibility (such as loan type, past-due
status, and risk);
(b) How historical loss rates are determined and what factors
are considered when establishing appropriate time frames over which
to evaluate loss experience; and
(c) Descriptions of qualitative factors (e.g., changes in
economic conditions) that may affect loss rates or other loss
measurements.
The supporting documents for the ALLL may be integrated in an
institution's credit files, loan review reports or worksheets, board
of directors' and committee meeting minutes, computer reports, or
other appropriate documents and files.
ALLL Under FAS 114
An institution's ALLL methodology related to FAS 114 loans
begins with the use of its normal loan review procedures to identify
whether a loan is impaired as defined by the accounting standard.
Institutions should document:
(1) The method and process for identifying loans to be evaluated
under FAS 114 and
(2) The analysis that resulted in an impairment decision for
each loan and the determination of the impairment measurement method
to be used (i.e., present value of expected future cash flows, fair
value of collateral less costs to sell, or the loan's observable
market price).
Once an institution has determined which of the three available
measurement methods to use for an impaired loan under FAS 114, it
should maintain supporting documentation as follows:
(1) When using the present value of expected future cash flows
method:
(a) The amount and timing of cash flows,
(b) The effective interest rate used to discount the cash flows,
and
(c) The basis for the determination of cash flows, including
consideration of current environmental factors and other information
reflecting past events and current conditions.
(2) When using the fair value of collateral method:
(a) How fair value was determined, including the use of
appraisals, valuation assumptions, and calculations,
(b) The supporting rationale for adjustments to appraised
values, if any,
(c) The determination of costs to sell, if applicable, and
(d) Appraisal quality and expertise of the appraiser.
(3) When using the observable market price of a loan method:
(a) The amount, source, and date of the observable market price.
Illustration A describes a practice used by a small financial
institution to document its FAS 114 measurement of impairment using
a comprehensive worksheet.\13\ Q&A #1 and #2 in Appendix A provide
examples of applying and documenting impairment measurement methods
under FAS 114.
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\13\ The referenced ``gray box'' illustrations are presented to
assist institutions in evaluating how to implement the guidance
provided in this document. The methods described in the
illustrations may not be suitable for all institutions and are not
considered required processes or actions. For additional
descriptions of key aspects of ALLL guidance, a series of ALLL
Questions and Answers (Q&As) are included in Appendix A of this
paper.
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Begin Text Box--Illustration A (Documenting an ALLL Under FAS
114, Comprehensive worksheet for the impairment measurement
process): A small institution utilizes a comprehensive worksheet for
each loan being reviewed individually under FAS 114. Each worksheet
includes a description of why the loan was selected for individual
review, the impairment measurement technique used, the measurement
calculation, a comparison to the current loan balance, and the
amount of the ALLL for that loan. The rationale for the impairment
measurement technique used (e.g., present value of expected future
cash flows, observable market price of the loan, fair value of the
collateral) is also described on the worksheet. End Text Box
Some loans that are evaluated individually for impairment under
FAS 114 may be fully collateralized and therefore require no ALLL.
Q&A #3 in Appendix A presents an example of an institution whose
loan portfolio includes fully collateralized loans and describes the
documentation maintained to support the conclusion that no ALLL was
needed for those loans.
ALLL Under FAS 5
Segmenting the Portfolio
For loans evaluated on a group basis under FAS 5, management
should segment the loan portfolio by identifying risk
characteristics that are common to groups of loans. Institutions
decide how to segment their loan portfolios based on many factors,
which vary with their business strategies as well as their
information system capabilities. Smaller institutions that are
involved in less complex activities often segment the portfolio into
broad loan categories. This method of segmenting the portfolio is
likely to be appropriate in only the smallest of institutions
offering a narrow range of loan products. Larger institutions
typically offer a more diverse and complex mix of loan products.
Such institutions may start by segmenting the portfolio into major
loan types but typically have more detailed information available
that allows them to further segregate the portfolio into product
line segments based on the risk characteristics of each portfolio
segment. Regardless of the method used, documentation should be
maintained to support that the loans in each segment have similar
attributes or characteristics.
As economic and other business conditions change, institutions
often modify their business strategies, which may result in
adjustments to the way in which they segment their loan portfolio
for purposes of estimating loan losses. Illustration B presents an
example in which an institution refined its segmentation method to
more effectively
[[Page 54272]]
consider risk factors and maintains documentation to support this
change.
Begin Text Box--Illustration B (Documenting Segmenting
Practices, Documenting a refinement in a segmentation method): An
institution with a significant portfolio of consumer loans performed
a review of its ALLL methodology. The institution had determined its
ALLL based upon historical loss rates in the overall consumer
portfolio. The ALLL methodology was validated by comparing actual
loss rates (charge-offs) for the past two years to the estimated
loss rates. During this process, the institution decided to evaluate
loss rates on an individual product basis (e.g., auto loans,
unsecured loans, or home equity loans). This analysis disclosed
significant differences in the loss rates on different products.
With this additional information, the methodology was amended in the
current period to segment the portfolio by product, resulting in a
better estimation of the loan losses associated with the portfolio.
To support this change in segmentation practice, the credit review
committee records contain the analysis that was used as a basis for
the change and the written report describing the need for the
change. End Text Box
Institutions use a variety of documents to support the
segmentation of their portfolios. Some of these documents include:
(1) Loan trial balances by categories and types of loans,
(2) Management reports about the mix of loans in the portfolio,
(3) Delinquency and nonaccrual reports, and
(4) A summary presentation of the results of an internal or
external loan grading review.
Reports generated to assess the profitability of a loan product
line may be useful in identifying areas in which to further segment
the portfolio.
Estimating Loss on Groups of Loans
Based on the segmentation of the portfolio, an institution
estimates the loan and lease losses to determine the appropriate
level of the FAS 5 portion of the ALLL.\14\ For those segments that
require an ALLL, the institution estimates the loan and lease
losses, on at least a quarterly basis, based upon its ongoing loan
review process and analysis of loan performance. The institution
should follow a systematic and consistently applied approach to
select the most appropriate loss measurement methods and support its
conclusions and rationale with written documentation. Regardless of
the method used to determine loss rates, an institution should
demonstrate and document that the loss rates used to estimate the
ALLL for each segment are determined in accordance with GAAP as of
the financial statement date.\15\
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\14\ An example of a loan segment that does not generally
require an ALLL includes loans that are fully secured by deposits
maintained at the lending institution.
\15\ Refer to paragraph 8(b) of FAS 5. Also, the AICPA is
currently developing a Statement of Position that will provide more
specific guidance on accounting for loan losses.
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One method of estimating loan losses for groups of loans is
through the application of loss rates to the groups' aggregate loan
balances. Such loss rates typically reflect historical loan loss
experience for each group of loans, adjusted for relevant
environmental factors (e.g., industry, geographical, economic, and
political factors) over a defined period of time. If an institution
does not have loss experience of its own, it may be appropriate to
reference the loss experience of other institutions, provided that
the institution demonstrates that the attributes of the loans in its
portfolio segment are similar to those of the loans included in the
portfolio of the institution providing the loss experience.\16\
Institutions should maintain supporting documentation for the
technique used to develop their loss rates, including the period of
time over which the losses were incurred. Institutions that
determine losses based upon a range of loss should maintain
documentation to support the identified range of loss and the
rationale used for determining which estimate is the best estimate
within the range of loan losses. An example of how a small
institution performs a comprehensive historical loss analysis is
provided as the first item in Illustration C.
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\16\ Refer to paragraph 23 of FAS 5.
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Begin Text Box--Illustration C (Documenting Setting Loss Rates,
First Illustration, Comprehensive historical loss analysis in a
small institution): A small institution determines its historical
loss rates based on annual loss rates over a three-year historical
period. The analysis is conducted by type of loan and is further
segmented by originating branch office. The analysis considers
charge-offs and recoveries in determining the loss rate. The
institution also considers the loss rates for each loan grade and
compares them to historical losses on similarly rated loans in
arriving at the historical loss factor. The institution maintains
supporting documentation for its loss factor analysis, including
historical losses by type of loan, originating branch office, and
loan grade for the three-year period.
(Second Illustration, Adjustment of historical rates for changes
in local economic conditions): An institution develops a factor to
adjust historical loss rates for its assessment of the impact of
changes in the local economy. For example, when analyzing the loss
rate on commercial real estate loans, the assessment identifies
changes in recent commercial building occupancy rates. The
institution generally finds the occupancy statistics to be a good
indicator of probable losses on these types of loans. The
institution maintains documentation that summarizes the relationship
between current occupancy rates and its loss experience. End Text
Box
Before employing a loss estimation model, an institution should
evaluate and modify, as needed, the model's assumptions to ensure
that the resulting loss estimate is consistent with GAAP.
Institutions that use loss estimation models typically document the
evaluation, the conclusions regarding the appropriateness of
estimating loan losses with a model or other loss estimation tool,
and the support for adjustments to the model or its results.
To adjust historical loss rates for current conditions,
institutions should consider environmental factors and then document
which factors were used in the analysis. Factors that should be
considered in adjusting historical loss rates include the following:
\17\
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\17\ Refer to paragraph 7.13 in the AICPA Audit Guide.
---------------------------------------------------------------------------
(1) Levels of and trends in delinquencies and impaired loans;
(2) Levels of and trends in charge-offs and recoveries;
(3) Trends in volume and terms of loans;
(4) Effects of any changes in risk selection and underwriting
standards, and other changes in lending policies, procedures, and
practices;
(5) Experience, ability, and depth of lending management and
other relevant staff;
(6) National and local economic trends and conditions, and
industry conditions; and
(7) Effects of changes in credit concentrations.
For any adjustment of historical loss rates, the institution
should document that the adjustment is necessary to reflect current
information, events, circumstances, and conditions in the loss
rates. The second item in Illustration C provides an example of how
an institution adjusts its commercial real estate historical loss
rates for changes in local economic conditions. Q&A #4 in Appendix A
provides an example of maintaining supporting documentation for
adjustments to portfolio segment loss rates for an environmental
factor related to an economic downturn in the borrower's primary
industry. Q&A #5 in Appendix A describes one institution's process
for determining and documenting an ALLL for loans that are not
individually impaired but have characteristics indicating there are
loan losses on a group basis.
Consolidating the Loss Estimates
To verify that ALLL balances are presented fairly in accordance
with GAAP and are auditable, management should prepare a document
that summarizes the amount to be reported in the financial
statements for the ALLL. The board of directors should review and
approve this summary.
Common elements in such summaries include:
(1) An estimate of the probable loss or range of loss incurred
for each category evaluated (e.g., individually evaluated impaired
loans, homogeneous pools, and other groups of loans that are
collectively evaluated for impairment);
(2) The aggregate probable loss estimated using the
institution's methodology;
(3) A summary of the current ALLL balance;
(4) The amount, if any, by which the ALLL is to be adjusted;
\18\ and
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\18\ Subsequent to adjustments, there should be no material
differences between the consolidated loss estimate, as determined by
the methodology, and the final ALLL balance reported in the
financial statements.
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(5) Depending on the level of detail that supports the ALLL
analysis, detailed subschedules of loss estimates that reconcile to
the summary schedule.
[[Page 54273]]
Illustration D describes how institutions may document their
estimated ALLL by adding comprehensive explanations to their summary
schedules.
Begin Text Box--Illustration D (Consolidating Estimates,
Descriptive comments added to the consolidated ALLL summary
schedule): To simplify the supporting documentation process and to
eliminate redundancy, some institutions include detailed supporting
information on their summary schedules. For example, in the summary
schedule that presents FAS 114 allowances, some institutions
describe their policy for selecting loans for evaluation under FAS
114. Institutions identify which FAS 114 impairment measurement
method was used for each individually reviewed impaired loan. Other
items include brief descriptions of loss factors for particular
segments of the loan portfolio, the basis for adjustments to loss
rates, and explanations of changes in ALLL amounts from period to
period. End Text Box
Generally, an institution's review and approval process for the
ALLL relies upon the data provided in these consolidated summaries.
There may be instances in which individuals or committees that
review the ALLL methodology and resulting allowance balance identify
adjustments that need to be made to the loss estimates to provide a
better estimate of loan losses. These changes may be due to
information not known at the time of the initial loss estimate
(e.g., information that surfaces after determining and adjusting, as
necessary, historical loss rates, or a recent decline in the
marketability of property after conducting a FAS 114 valuation based
upon the fair value of collateral). It is important that these
adjustments are consistent with GAAP and are reviewed and approved
by appropriate personnel. Additionally, the summary should provide
each subsequent reviewer with an understanding of the support behind
these adjustments. Therefore, management should document the nature
of any adjustments and the underlying rationale for making the
changes. This documentation should be provided to those making the
final determination of the ALLL amount. Q&A #6 in Appendix A
addresses the documentation of the final amount of the ALLL.
Validating the ALLL Methodology
To verify that the ALLL methodology is effective and conforms to
GAAP and supervisory guidance, an institution's directors should
establish internal control procedures, appropriate for the size and
complexity of the institution. These procedures should include an
independent review of the methodology and its application.
In practice, financial institutions employ numerous procedures
when validating the reasonableness of their ALLL methodology and
determining whether there may be deficiencies in their overall
methodology or loan grading process. Examples are:
(1) A review of trends in loan volume, delinquencies,
restructurings, and concentrations.
(2) A review of previous charge-off and recovery history,
including an evaluation of the timeliness of the entries to record
both the charge-offs and the recoveries.
(3) A review by an independent party, such as an independent
loan review committee, external auditors, or internal audit staff.
This often involves the independent party reviewing, on a test
basis, source documents and underlying assumptions to determine that
the established methodology develops reasonable loss estimates.
(4) An evaluation of the appraisal process of the underlying
collateral. This may be accomplished by periodically comparing the
appraised value to the actual sales price on selected properties
sold.
Supporting Documentation for the Validation Process
Management usually supports the validation process with the
workpapers from the review of the ALLL function. Additional
documentation often includes the summary findings of the independent
third party reviewer. The institution's board of directors, or its
designee, reviews the findings and acknowledges its review in its
meeting minutes. If the methodology is changed based upon the
findings of the validation process, documentation that describes and
supports the changes should be maintained.
Appendix A.--ALLL Questions and Answers
Q&A #1--ALLL Under FAS 114--Measuring and Documenting Impairment
Facts: Approximately one-third of Institution A's commercial
loan portfolio consists of large balance, non-homogeneous loans. Due
to their large individual balances, these loans meet the criteria
under Institution A's policies and procedures for individual review
for impairment under FAS 114. Upon review of the large balance
loans, Institution A determines that certain of the loans are
impaired as defined by FAS 114.
Question: For the commercial loans reviewed under FAS 114 that
are individually impaired, how should Institution A measure and
document the impairment on those loans? Can it use an impairment
measurement method other than the methods allowed by FAS 114?
Interpretive Response: For those loans that are reviewed
individually under FAS 114 and considered individually impaired,
Institution A must use one of the methods for measuring impairment
that is specified by FAS 114 (that is, the present value of expected
future cash flows, the loan's observable market price, or the fair
value of collateral). Accordingly, in the circumstances described
above, for the loans considered individually impaired under FAS 114,
it would not be appropriate for Institution A to choose a
measurement method not prescribed by FAS 114. For example, it would
not be appropriate to measure loan impairment by applying a loss
rate to each loan based on the average historical loss percentage
for all of its commercial loans for the past five years.
Institution A should maintain written documentation to support
its measurement of loan impairment under FAS 114. If it uses the
present value of expected future cash flows to measure impairment of
a loan, it should document the amount and timing of cash flows, the
effective interest rate used to discount the cash flows, and the
basis for the determination of cash flows, including consideration
of current environmental factors and other information reflecting
past events and current conditions. When using the fair value of
collateral to measure impairment, Institution A should document how
it determined the fair value, including the use of appraisals,
valuation assumptions and calculations, the supporting rationale for
adjustments to appraised values, if any, and the determination of
costs to sell, if applicable. Similarly, Institution A should
document the amount, source, and date of the observable market price
of a loan, if that method of measuring loan impairment is used.
Q&A #2--ALLL Under FAS 114--Measuring Impairment for a Collateral
Dependent Loan
Facts: Institution B has a $10 million loan outstanding to
Company X that is secured by real estate, which Institution B
individually evaluates under FAS 114 due to the loan's size. Company
X is delinquent in its loan payments under the terms of the loan
agreement. Accordingly, Institution B determines that its loan to
Company X is impaired, as defined by FAS 114. Because the loan is
collateral dependent, Institution B measures impairment of the loan
based on the fair value of the collateral. Institution B determines
that the most recent valuation of the collateral was performed by an
appraiser eighteen months ago and, at that time, the estimated value
of the collateral (fair value less costs to sell) was $12 million.
Institution B believes that many of the assumptions that were
used to value the collateral eighteen months ago do not reflect
current market conditions and, therefore, the appraiser's valuation
does not approximate current fair value of the collateral. Several
buildings, which are comparable to the real estate collateral, were
recently completed in the area, increasing vacancy rates, decreasing
lease rates, and attracting several tenants away from the borrower.
Accordingly, credit review personnel at Institution B adjust certain
of the valuation assumptions to better reflect the current market
conditions as they relate to the loan's collateral. After adjusting
the collateral valuation assumptions, the credit review department
determines that the current estimated fair value of the collateral,
less costs to sell, is $8 million. Given that the recorded
investment in the loan is $10 million, Institution B concludes that
the loan is impaired by $2 million and records an allowance for loan
losses of $2 million.
Question: What type of documentation should Institution B
maintain to support its determination of the allowance for loan
losses of $2 million for the loan to Company X?
Interpretive Response: Institution B should document that it
measured impairment of the loan to Company X by using the fair value
of the loan's collateral, less costs to sell, which it estimated to
be $8 million. This documentation should include the institution's
rationale and basis for the $8 million valuation, including the
revised valuation assumptions it used, the valuation calculation,
and the determination of costs to sell, if applicable. Because
Institution B
[[Page 54274]]
arrived at the valuation of $8 million by modifying an earlier
appraisal, it should document its rationale and basis for the
changes it made to the valuation assumptions that resulted in the
collateral value declining from $12 million eighteen months ago to
$8 million in the current period.\19\
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\19\ In accordance with the FFIEC's Federal Register Notice,
Implementation Issues Arising from FASB No. 114, ``Accounting by
Creditors for Impairment of a Loan,'' published February 10, 1995
(60 FR 7966, February 10, 1995), impaired, collateral-dependent
loans must be reported at the fair value of collateral, less costs
to sell, in regulatory reports. This treatment is to be applied to
all collateral-dependent loans, regardless of type of collateral.
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Q&A #3--ALLL Under FAS 114--Fully Collateralized Loans
Facts: Institution C has $10 million in loans that are fully
collateralized by highly rated debt securities with readily
determinable market values. The loan agreement for each of these
loans requires the borrower to provide qualifying collateral
sufficient to maintain a loan-to-value ratio with sufficient margin
to absorb volatility in the securities' market prices. Institution
C's collateral department has physical control of the debt
securities through safekeeping arrangements. In addition,
Institution C perfected its security interest in the collateral when
the funds were originally distributed. On a quarterly basis,
Institution C's credit administration function determines the market
value of the collateral for each loan using two independent market
quotes and compares the collateral value to the loan carrying value.
If there are any collateral deficiencies, Institution C notifies the
borrower and requests that the borrower immediately remedy the
deficiency. Due in part to its efficient operation, Institution C
has historically not incurred any material losses on these loans.
Institution C believes these loans are fully-collateralized and
therefore does not maintain any ALLL balance for these loans.
Question: What documentation does Institution C maintain to
adequately support its determination that no allowance is needed for
this group of loans?
Interpretive Response: Institution C's management summary of the
ALLL includes documentation indicating that, in accordance with the
institution's ALLL policy, the collateral protection on these loans
has been verified by the institution, no probable loss has been
incurred, and no ALLL is necessary. Documentation in Institution C's
loan files includes the two independent market quotes obtained each
quarter for each loan's collateral amount, the documents evidencing
the perfection of the security interest in the collateral, and other
relevant supporting documents. Additionally, Institution C's ALLL
policy includes a discussion of how to determine when a loan is
considered ``fully collateralized'' and does not require an ALLL.
The policy requires the following factors, at a minimum, to be
considered and the institution's findings concerning these factors
to be fully documented:
(1) Volatility of the market value of the collateral
(2) Recency and reliability of the appraisal or other valuation
(3) Recency of the bank or other third party inspection of the
collateral
(4) Historical losses on similar loans
(5) Confidence in the bank's lien or security position including
appropriate:
(a) Type of security perfection (e.g., physical possession of
collateral or secured filing)
(b) Filing of security perfection (i.e., correct documents and
with the appropriate officials), and
(c) Relationship to other liens.
Q&A #4--ALLL Under FAS 5--Adjusting Loss Rates
Facts: Institution D's lending area includes a metropolitan area
that is financially dependent upon the profitability of a number of
manufacturing businesses. These businesses use highly specialized
equipment and significant quantities of rare metals in the
manufacturing process. Due to increased low-cost foreign
competition, several of the parts suppliers servicing these
manufacturing firms declared bankruptcy. The foreign suppliers have
subsequently increased prices and the manufacturing firms have
suffered from increased equipment maintenance costs and smaller
profit margins. Additionally, the cost of the rare metals used in
the manufacturing process increased and has now stabilized at double
last year's price. Due to these events, the manufacturing businesses
are experiencing financial difficulties and have recently announced
downsizing plans.
Although Institution D has yet to confirm an increase in its
loss experience as a result of these events, management knows that
the institution lends to a significant number of businesses and
individuals whose repayment ability depends upon the long-term
viability of the manufacturing businesses. Institution D's
management has identified particular segments of its commercial and
consumer customer bases that include borrowers highly dependent upon
sales or salary from the manufacturing businesses. Institution D's
management performs an analysis of the affected portfolio segments
to adjust its historical loss rates used to determine the ALLL.
Question: How should Institution D document its support for the
loss rate adjustments that result from considering these
manufacturing firms' financial downturns?
Interpretive Response: Institution D should document its
identification of the particular segments of its commercial and
consumer loan portfolio for which it is probable that the
manufacturing business' financial downturn has resulted in loan
losses. In addition, Institution D should document its analysis that
resulted in the adjustments to the loss rates for the affected
portfolio segments. As part of its documentation, Institution D
maintains copies of the documents supporting the analysis, including
relevant newspaper articles, economic reports, and economic data.
Because Institution D has had similar situations in the past,
its supporting documentation also includes an analysis of how the
current situation compares to the institution's previous loss
experiences in similar circumstances. A summary of the amount and
rationale for the adjustment factor is presented to the audit
committee and board for their review and approval prior to the
issuance of the financial statements.
Q&A #5--ALLL Under FAS 5--Estimating Losses on Loans Individually
Reviewed for Impairment but Not Considered Individually Impaired
Facts: Institution E has outstanding loans of $2 million to
Company Y and $1 million to Company Z, both of which are paying as
agreed upon in the loan documents. The institution's ALLL policy
specifies that all loans greater than $750,000 must be individually
reviewed for impairment under FAS 114. Company Y's financial
statements reflect a strong net worth, good profits, and ongoing
ability to meet debt service requirements. In contrast, recent
information indicates Company Z's profitability is declining and its
cash flow is tight. Accordingly, this loan is rated substandard
under the institution's loan grading system. Despite its concern,
management believes Company Z will resolve its problems and
determines that neither loan is individually impaired as defined by
FAS 114.
Institution E segments its loan portfolio to estimate loan
losses under FAS 5. Two of its loan portfolio segments are Segment 1
and Segment 2. The loan to Company Y has risk characteristics
similar to the loans included in Segment 1 and the loan to Company Z
has risk characteristics similar to the loans included in Segment
2.\20\
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\20\ These groups of loans do not include any loans that have
been individually reviewed for impairment under FAS 114 and
determined to be impaired as defined by FAS 114.
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Question: How does Institution E adequately support and document
an ALLL under FAS 5 for these loans that were individually reviewed
for impairment but are not considered individually impaired?
Interpretive Response: In its determination of the ALLL under
FAS 5, Institution E includes its loans to Company Y and Company Z
in the groups of loans with similar characteristics (i.e., Segment 1
for Company Y's loan and Segment 2 for Company Z's loan).
Management's analyses of Segment 1 and Segment 2 indicates that it
is probable that each segment includes some losses, even though the
losses cannot be identified to one or more specific loans.
Management estimates that the use of its historical loss rates for
these two segments, with adjustments for changes in environmental
factors, such as current local economic conditions, provides a
reasonable estimate of the institution's probable loan losses in
these segments.
Institution E documents its decision to include its loans to
Company Y and Company Z in its determination of its ALLL under FAS
5. It also documents the specific characteristics of the loans that
were the basis for grouping these loans with other loans in Segment
1 and Segment 2, respectively. Institution E maintains documentation
to support its method of estimating loan losses for Segment 1 and
[[Page 54275]]
Segment 2, including the average loss rate used, the analysis of
historical losses by loan type and by internal risk rating, and
support for any adjustments to its historical loss rates. The
institution also maintains copies of the economic and other reports
that provided source data.
Q&A #6--Consolidating the Loss Estimates--Documenting the Reported ALLL
Facts: Institution F determines its ALLL using an established
systematic process. The accounting department prepares supporting
schedules that include the amount of each of the components of the
ALLL, as well as the total ALLL amount, for review by senior
management and the Credit Committee. Members of senior management
and the Credit Committee meet to discuss the ALLL. During these
discussions, they identify changes to be made to certain of the ALLL
estimates. As a result of the adjustments made by management, the
total amount of the ALLL changes. The supporting schedules are not
updated to reflect the adjustments made by senior management and the
Credit Committee. When performing their audit of the financial
statements, the independent accountants are provided with the
original ALLL supporting schedules that were reviewed by management
and the Credit Committee, as well as a verbal explanation of the
changes made by management and the Credit Committee when they met to
discuss the loan loss allowance.
Question: Are Institution F's documentation practices related to
the balance of its loan loss allowance appropriate?
Interpretive Response: No. An institution must maintain
supporting documentation for the loan loss allowance amount reported
in its financial statements. An institution should document not only
the determination of the ALLL using its methodology, but also any
subsequent adjustments to the amount of the ALLL and the rationale
for those adjustments, such as adjustments made by management or
board committees as in the circumstances described above.
Appendix B--Application of GAAP
An ALLL recorded pursuant to GAAP is an institution's best
estimate of the probable amount of loans and lease-financing
receivables that it will be unable to collect based on current
information and events.\21\ A creditor should record an ALLL when
the criteria for accrual of a loss contingency as set forth in GAAP
have been met. Estimating the amount of an ALLL involves a high
degree of management judgment and is inevitably imprecise.
Accordingly, an institution may determine that the amount of loss
falls within a range. An institution should record its best estimate
within the range of loan losses.\22\
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\21\ This Appendix provides guidance on the ALLL and does not
address allowances for credit losses for off-balance sheet
instruments (e.g., loan commitments, guarantees, and standby letters
of credit). Institutions should record liabilities for these
exposures in accordance with GAAP. Further guidance on this topic is
presented in the American Institute of Certified Public Accountants'
Audit and Accounting Guide, Banks and Savings Institutions (AICPA
Audit Guide). Additionally, this Appendix does not address
allowances or accounting for assets or portions of assets sold with
recourse, which is described in Statement of Financial Accounting
Standards No. 125, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities (FAS 125).
\22\ Refer to FASB Interpretation No. 14, Reasonable Estimation
of the Amount of a Loss, and Emerging Issues Task Force Topick No.
D-80, Application of FASB Statements No. 5 and No. 114 to a Loan
Portfolio (EITF Topic D-80).
---------------------------------------------------------------------------
Under GAAP, Statement of Financial Accounting Standards No. 5,
Accounting for Contingencies (FAS 5), provides the basic guidance
for recognition of a loss contingency, such as the collectibility of
loans (receivables), when it is probable that a loss has been
incurred and the amount can be reasonably estimated. Statement of
Financial Accounting Standards No. 114, Accounting by Creditors for
Impairment of a Loan (FAS 114) provides more specific guidance about
the measurement and disclosure of impairment for certain types of
loans.\23\ Specifically, FAS 114 applies to loans that are
identified for evaluation on an individual basis. Loans are
considered impaired when, based on current information and events,
it is probable that the creditor will be unable to collect all
interest and principal payments due according to the contractual
terms of the loan agreement.
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\23\ EITF Topic D-80 includes additional guidance on the
requirements of FAS 5 and FAS 114 and how they relate to each other.
The AICPA is currently developing a Statement of Position (SOP) that
will provide more specific guidance on accounting for loan losses.
---------------------------------------------------------------------------
For individually impaired loans, FAS 114 provides guidance on
the acceptable methods to measure impairment. Specifically, FAS 114
states that when a loan is impaired, a creditor should measure
impairment based on the present value of expected future principal
and interest cash flows discounted at the loan's effective interest
rate, except that as a practical expedient, a creditor may measure
impairment based on a loan's observable market price or the fair
value of collateral, if the loan is collateral dependent. When
developing the estimate of expected future cash flows for a loan, an
institution should consider all available information reflecting
past events and current conditions, including the effect of existing
environmental factors. The following Illustration provides an
example of an institution estimating a loan's impairment when the
loan has been partially charged-off.
Begin Text Box--Illustration (Interaction of FAS 114 With an
Adversely Classified Loan, Partial Charge-Off, and the Overall
ALLL): An institution determined that a collateral dependent loan,
which it identified for evaluation, was impaired. In accordance with
FAS 114, the institution established an ALLL for the amount that the
recorded investment in the loan exceeded the fair value of the
underlying collateral, less costs to sell. Consistent with relevant
regulatory guidance, the institution classified a portion of the
recorded investment as ``Loss'' and the remaining recorded
investment as ``Substandard.'' For this loan, the amount classified
``Loss,'' which was deemed to be the confirmed loss, was less than
the impairment amount (as determined under FAS 114). The institution
charged off the ``Loss'' portion of the loan. After the charge-off,
the portion of the ALLL related to this ``Substandard'' loan (1)
reflects an appropriate measure of impairment under FAS 114, and (2)
is included in the aggregate FAS 114 ALLL for all loans that were
identified for evaluation and individually considered impaired. The
aggregate FAS 114 ALLL is included in the institution's overall
ALLL. End Text Box
Large groups of smaller-balance homogeneous loans that are
collectively evaluated for impairment are not included in the scope
of FAS 114.\24\ Such groups of loans may include, but are not
limited to, credit card, residential mortgage, and consumer
installment loans. FAS 5 addresses the accounting for impairment of
these loans. Also, FAS 5 provides the accounting guidance for
impairment of loans that are not identified for evaluation on an
individual basis and loans that are individually evaluated but are
not individually considered impaired.
---------------------------------------------------------------------------
\24\ In addition, FAS 114 does not apply to loans measured at
fair value or at the lower of cost or fair value, leases, or debt
securities.
---------------------------------------------------------------------------
Institutions should ensure that they do not layer their loan
loss allowances. Layering is the inappropriate practice of recording
in the ALLL more than one amount for the same probable loan loss.
Layering can happen when an institution includes a loan in one
segment, determines its best estimate of loss for that loan either
individually or on a group basis (after taking into account all
appropriate environmental factors, conditions, and events), and then
includes the loan in another group, which receives an additional
ALLL amount.\25\
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\25\ According to the Federal Financial Institutions Examination
Council's Federal Register Notice, Implementation Issues Arising
from FASB Statement No. 114, Accounting by Creditors for Impairment
of a Loan, published February 10, 1995, institution-specific issues
should be reviewed when estimating loan losses under FAS 114. This
analysis should be conducted as part of the evaluation of each
individual loan reviewed under FAS 114 to avoid potential ALLL
layering.
---------------------------------------------------------------------------
There are certain common elements an institution should
incorporate in its loan loss allowance methodology. Generally, an
institution's methodology should: \26\
---------------------------------------------------------------------------
\26\ Refer to paragraph 7.05 of the AICPA Audit Guide.
---------------------------------------------------------------------------
(1) Include a detailed analysis of the loan portfolio, performed
on a regular basis;
(2) Consider all loans (whether on an individual or group
basis);
(3) Identify loans to be evaluated for impairment on an
individual basis under FAS 114 and segment the remainder of the
portfolio into groups of loans with similar risk characteristics for
evaluation and analysis under FAS 5;
(4) Consider all known relevant internal and external factors
that may affect loan collectibility;
(5) Be applied consistently but, when appropriate, be modified
for new factors affecting collectibility;
(6) Consider the particular risks inherent in different kinds of
lending;
[[Page 54276]]
(7) Consider collateral values (less costs to sell), where
applicable;
(8) Require that analyses, estimates, reviews and other ALLL
methodology functions be performed by competent and well-trained
personnel;
(9) Be based on current and reliable data;
(10) Be well documented with clear explanations of the
supporting analyses and rationale; and
(11) Include a systematic and logical method to consolidate the
loss estimates and ensure the ALLL balance is recorded in accordance
with GAAP.
A systematic methodology that is properly designed and
implemented should result in an institution's best estimate of the
ALLL. Accordingly, institutions should adjust their ALLL balance,
either upward or downward, in each period for material differences
between the results of the systematic determination process and the
unadjusted ALLL balance in the general ledger.\27\
---------------------------------------------------------------------------
\27\ Institutions should refer to the guidance on materiality in
SEC Staff Accounting Bulletin No. 99, Materiality.
---------------------------------------------------------------------------
Bibliography
GAAP and Auditing Guidance
American Institute of Certified Public Accountants' Audit and
Accounting Guide, Banks and Savings Institutions, 1999 edition
Auditing Standards Board Statement on Auditing Standards No. 61,
Communication With Audit Committees (AICPA, Professional Standards,
vol. 1, AU sec. 380)
Emerging Issues Task Force Topic No. D-80, Application of FASB
Statements No. 5 and No. 114 to a Loan Portfolio (EITF Topic D-80
and attachments), discussed on May 19-20, 1999
Financial Accounting Standards Board Interpretation No. 14,
Reasonable Estimation of the Amount of a Loss (An Interpretation of
FASB Statement No. 5)
Financial Accounting Standards Board Statement of Financial
Accounting Standards No. 5, Accounting for Contingencies
Financial Accounting Standards Board Statement of Financial
Accounting Standards No. 114, Accounting by Creditors for Impairment
of A Loan (An Amendment of FASB Statements No. 5 and 15)
Financial Accounting Standards Board Statement of Financial
Accounting Standards No. 118, Accounting by Creditors for Impairment
of a Loan--Income Recognition and Disclosures (An Amendment of FASB
Statement No. 114)
Financial Accounting Standards Board Statement of Financial
Accounting Standards No. 125, Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities
Regulatory Guidance
Federal Deposit Insurance Act, Section 39, Standards for Safety and
Soundness (12 U.S.C. 1831p-1)
Federal Financial Institutions Examination Council's Instructions
for Preparation of Consolidated Reports of Condition and Income
Interagency Guidelines Establishing Standards for Safety and
Soundness, established in 1995 and 1996, as amended on October 15,
1998
Interagency Policy Statement on the Allowance for Loan and Lease
Losses (ALLL), December 21, 1993
Joint Interagency Statement (regarding the ALLL), November 24, 1998
Joint Interagency Letter to Financial Institutions (regarding the
ALLL), March 10, 1999
Joint Interagency Letter to Financial Institutions (regarding the
ALLL), July 12, 1999
Securities and Exchange Commission Financial Reporting Release No.
28, Accounting for Loan Losses by Registrants Engaged in Lending
Activities, December 1, 1986
Securities and Exchange Commission Securities Act Industry Guide 3,
Statistical Disclosure by Bank Holding Companies
Securities and Exchange Commission Staff Accounting Bulletin No. 99,
Materiality, August 1999
Securities Exchange Act of 1934, Section 13(b)(2)-(7) (15 U.S.C.
78m(b)(2)-(7))
United States General Accounting Office Report to Congressional
Committees, Depository Institutions: Divergent Loan Loss Methods
Undermine Usefulness of Financial Reports, (GAO/AIMD-95-8), October
1994
Dated: August 30, 2000.
Joanne M. Giese,
Assistant Executive Secretary, Federal Financial Institutions
Examination Council.
[FR Doc. 00-22719 Filed 9-6-00; 8:45 am]
BILLING CODE 6210-01-P (25%), 6714-01-P (25%) 6720-01-P (25%), 4810-33-
P (25%)