Federal Deposit
Insurance Corporation

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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

July 2, 2001.
AGENCY: Federal Financial Institutions Examination Council.

ACTION: Notice of final interagency policy statement.

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SUMMARY: The Federal Financial Institutions Examination Council
(FFIEC), on behalf of 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), and the Office of
Thrift Supervision (OTS) (collectively referred to as the ``banking
agencies''), is adopting an interagency Policy Statement on Allowance
for Loan and Lease Losses (ALLL) Methodologies and Documentation for
Banks and Savings Institutions (Policy Statement). The National Credit
Union Administration (NCUA), also a member of the FFIEC, is currently
reviewing this policy and may issue similar guidance specifically
directed toward credit unions. This Policy Statement is intended to
provide guidance on the design and implementation of ALLL methodologies
and supporting documentation practices.

EFFECTIVE DATE: The Policy Statement is effective immediately.

FOR FURTHER INFORMATION CONTACT:
FRB: Linda V. Griffith, Supervisory Financial Analyst, (202) 452-
3506, Division of Banking Supervision and Regulation, Board of
Governors of the Federal Reserve System, 20th Street and Constitution
Avenue, NW., Washington, DC 20551.
FDIC: Doris L. Marsh, Examination Specialist, Division of
Supervision, (202) 898-8905, FDIC, 550 17th Street, NW., Washington, DC
20429.
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, SW.,
Washington, DC 20219.
OTS: William Magrini, Senior Project Manager, 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, NW., Washington, DC 20552.

[[Page 35630]]

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 Policy Statement represents the banking agencies' guidance to
banks and savings institutions relating to methodologies and supporting
documentation for the ALLL. The Securities and Exchange Commission
staff has issued parallel guidance on this topic for public companies
in Staff Accounting Bulletin No. 102.\1\
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\1\ In addition, the American Institute of Certified Public
Accountants (AICPA) is developing guidance on the accounting for
loan losses and the techniques for measuring probable incurred
losses in a loan portfolio.
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This Policy Statement clarifies the banking agencies' expectations
regarding methodologies and documentation support for the ALLL. For
financial reporting purposes, including regulatory reporting, the
provision for loan and lease losses and the ALLL must be determined in
accordance with generally accepted accounting principles (GAAP). 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 Policy Statement does not 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).\2\ Under the
guidelines for asset quality, each institution should estimate and
establish a sufficient ALLL supported by adequate documentation. This
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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\2\ 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 institutions with fewer
and less complex loan products, the amount of supporting documentation
for the ALLL may be less exhaustive than for institutions with more
complex loan products or portfolios.
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
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. The Proposed Policy Statement

The FFIEC sought public comment on a proposed policy statement on
ALLL methodologies and documentation practices for banks and savings
institutions on September 7, 2000 (65 FR 54268). The proposal indicated
that the purpose of the policy statement was to provide financial
institutions with enhanced guidance on appropriate ALLL methodologies
and documentation practices.
The proposed Policy Statement explained 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
emphasized 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 proposal described significant aspects of ALLL methodologies
and documentation practices. Specifically, the proposal provided
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 proposal stated that an
institution's ALLL methodology must be a thorough, disciplined, and
consistently applied process that incorporates management's current
judgments about the credit quality of the loan portfolio.
The proposal also discussed 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. The proposal stated that after determining the
allowance on individually reviewed loans and groups of loans,
management should consolidate those loss estimates and summarize the
amount to be reported in the financial statements for the ALLL. To
verify that the ALLL methodology is appropriate and conforms to GAAP
and supervisory guidance, a party who is independent from the ALLL
estimation process should review the methodology and its application in
a manner appropriate to the size and complexity of the institution.
The proposal included illustrations of implementation practices
that institutions may find useful for enhancing their own ALLL
practices; an appendix that provided 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. Discussion of Public Comments

A. General Comments

The FFIEC received 31 letters commenting on the proposed policy
statement. Twenty financial organizations submitted comments, whose
size (based upon total assets) ranged from $18 million to $450 billion.
The other letters were primarily submitted by industry trade groups and
the accounting profession.
Two of the commenters fully supported the guidance in the proposed
policy statement. Thirteen commenters opposed issuance of the policy
statement. The commenters who oppose

[[Page 35631]]

the guidance expressed two primary concerns. First, they believe
institutions, particularly smaller institutions, will need to
unnecessarily increase resources dedicated to ensure compliance with
the guidance. Second, they thought that issuance of the policy
statement may be premature given the ALLL guidance expected to be
developed by the AICPA. The other commenters generally supported the
guidance with certain modifications.
The two commenters who supported the proposed policy statement in
the form it was issued believe that they are already in compliance with
the proposal's requirements. They understood that the guidance did not
attempt to expand current GAAP requirements and allowed institutions to
continue to use judgment in implementing loan loss estimation
methodologies that are appropriate to individual institutions.
The banking agencies believe that institutions currently complying
with GAAP should not need to dedicate additional resources to create or
support the ALLL included in their regulatory reports. The banking
agencies have expected institutions to follow GAAP, as it applies to
the ALLL, for regulatory reporting purposes for a number of years. The
proposal is consistent with existing GAAP, which requires that
allowances be well documented, with clear explanations of the
supporting analysis and rationale. The banking agencies encourage
institutions to carefully evaluate their current ALLL methodologies and
supporting documentation practices as well as other credit risk
management practices and reports before making significant changes to
their current practices or creating new processes, reports, or other
supporting documents in order to follow this guidance.
Some commenters suggested the Policy Statement should include the
banking agencies' views on the ALLL guidance being developed by the
AICPA. While the attached Policy Statement mentions that the AICPA is
developing guidance on the ALLL, a description of that project's scope
or a summary of its anticipated guidance is outside the scope of this
Policy Statement. Furthermore, the AICPA continues to develop its
guidance, and the Agencies are closely monitoring and actively
contributing to that process.
Several commenting financial institutions indicated that following
the guidance may prompt a reduction in the ALLL level at their
institutions. However, as noted above, institutions are already
required to follow GAAP when determining the ALLL and the guidance does
not change existing GAAP; therefore, following this Policy Statement
should not result in adjustments to the ALLL by institutions following
GAAP.
Several commenters suggested that documentation requirements for
small or noncomplex institutions should be substantially different than
the guidance for larger or more complex institutions. The guidance in
the policy statement includes a broad description of the steps taken
during the ALLL estimation process that must be documented. The types
of documentation described in the examples illustrate that management
has considerable flexibility in determining the appropriate level and
type of supporting documentation given the type of loans and associated
credit risks being evaluated. Additionally, the guidance specifically
states that institutions with less complex products or portfolios may
consider combining some of the procedures outlined in the proposed
guidance. Furthermore, when appropriate, these institutions may utilize
documentation that is already being generated for other purposes to
support their ALLLs. The banking agencies believe these suggestions
will assist these institutions in supporting their ALLLs without any
unnecessary burden.
A number of the commenters suggested that the guidance in the
policy statement should clarify the banking agencies' position on the
term ``unallocated'' ALLLs. The guidance recognizes that, regardless of
the terminology that an institution uses to label portions of its ALLL,
the entire ALLL should be determined in accordance with GAAP and
supported with adequate documentation.

B. Changes to the Proposal in Response to Comments

One issue that was raised by some commenters was concern that the
Policy Statement would confuse the distinction between current GAAP
requirements and what would be considered best practices in corporate
governance. They believe that some of the documentation requirements
contained in the proposed policy statement are not requirements of
GAAP. In response to these comments, a footnote was added to the Policy
Statement to clarify how the Policy Statement describes, but does not
increase, the documentation requirements already existing within GAAP.
The footnote states that the documentation guidance in the Policy
Statement is predominantly based upon certain specifically identified
pronouncements that have been issued by the Financial Accounting
Standards Board, the Emerging Issues Task Force, the American Institute
of Certified Public Accountants, and the SEC. Such pronouncements
represent established accounting principles or are widely recognized as
being generally accepted.
A few commenters were concerned that the discussion in the proposed
policy statement regarding the estimation of loan losses for groups of
loans based upon historical loss data meant that institutions were
prohibited from using loss estimation methods other than those based
upon historical loss data. The application of historical loss rates to
segmented portions of the loan portfolio, adjusted for environmental
factors, is one way to estimate ALLLs for pools of loans. However,
other methods are acceptable if they estimate losses in accordance with
GAAP. The Policy Statement has been revised to refer to other types of
loss estimation techniques.
A few commenters questioned the banking agencies' intent in
including examples of documentation in the Q&A portion of the proposed
policy statement. They interpreted the examples to be a list of
requirements or a ``safe harbor'' of supporting documentation. The
banking agencies included these examples to assist institutions in
generating ideas on how to implement the guidance and did not intend to
create a list of required documents. So that the purpose of the
examples is better understood, the banking agencies have clarified the
language in the examples and have added an introductory paragraph to
the Q&A section in Appendix A.
Lastly, some commenters suggested the guidance in the proposed
policy statement placed undue burden upon financial institutions'
boards of directors. The banking agencies did not intend to expand
directors' responsibilities beyond those that currently exist. At
present, directors are responsible for approving ALLL policies and
attesting to the validity of the regulatory reports, which includes the
ALLL. While the board of directors has ultimate responsibility for
these functions, daily administration of policies and recordkeeping may
be delegated to operating management. The banking agencies have
clarified the guidance to state that the scope of board of directors'
responsibilities is not changed or expanded with the issuance of this
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 Policy Statement
and

[[Page 35632]]

determined that it does not add any collections of information pursuant
to the Act.

V. Policy Statement

The text of the Policy Statement follows:

Policy Statement on Allowance for Loan and Lease Losses
Methodologies and Documentation for Banks and Savings Institutions

July 2, 2001.
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.\1\ 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. Regardless of who
develops and implements these policies, procedures, and underlying
controls, the board of directors should assure themselves that the
policies specifically address the institution's unique goals, systems,
risk profile, personnel, and other resources before approving them.
Additionally, by creating an environment that encourages personnel to
follow these policies and procedures, management improves procedural
discipline and compliance.
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\1\ A bibliography is attached that lists applicable ALLL GAAP
guidance, interagency 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 amounts reported each
period for the provision for loan and lease losses and the 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. Further, the audit committee\2\ should oversee
and monitor the internal controls over the ALLL determination
process.\3\
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\2\ All institutions are encouraged to establish audit
committees; however, at small institutions without audit committees,
the board of directors retains this responsibility.
\3\ 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'\4\ 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).\5\ 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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\4\ 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.
\5\ 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.\6\ 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.\7\
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\6\ The documentation guidance within this Policy Statement is
predominantly based upon the GAAP guidance from Financial Accounting
Standards Board (FASB) Statement Numbers 5 and 114 (FAS 5 and FAS
114, respectively); Emerging Issues Task Force Topic No. D-80 (EITF
Topic D-80 and attachments), Application of FASB Statements No. 5
and No. 114 to a Loan Portfolio (which includes the Viewpoints
Article--an article issued in 1999 by FASB staff providing guidance
on certain issues regarding the ALLL, particularly on the
application of FAS 5 and FAS 114 and how these statements
interrelate), Chapter 7--Credit Losses, the American Institute of
Certified Public Accountants' (AICPA) Audit and Accounting Guide,
Banks and Savings Institutions--2000 edition (AICPA Audit Guide);
and the Securities and Exchange Commission's (SEC) Financial
Reporting Release No. 28 (FRR 28).
\7\ Failure to maintain adequate supporting documentation does
not relieve an institution of its obligation to record an
appropriate ALLL.
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This guidance applies equally to all institutions, regardless of
the size. However, institutions with less complex lending activities
and products 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 supporting
documentation required for an institution with more complex products or
portfolios may be combined into fewer supporting documents in an
institution with less complex products or portfolios. 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 less complex
institutions may determine and document portions of their loan loss
allowance.

Documentation Standards

Appropriate written supporting documentation for the loan loss
provision and allowance facilitates review of the ALLL process and
reported amounts, builds discipline and consistency 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.\8\
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\8\ This position is fully described in the SEC's 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

[[Page 35633]]

(b) Over the ALLL methodology,
(2) Loan grading system or process,
(3) Summary or consolidation of the ALLL balance,
(4) Validation of the ALLL methodology, and
(5) 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 documentation guidance on:
(1) Policies and Procedures,
(2) Methodology,
(3) ALLL Under 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.
In order for an institution's ALLL methodology to be effective, the
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, or review, as
applicable, 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;\9\ and
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\9\ 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 provide assurance regarding the reliability
and integrity of information and compliance with laws, regulations, and
internal policies and procedures;
(2) Reasonably assure that the institution's financial statements
(including regulatory reports) are prepared in accordance with GAAP and
ALLL supervisory guidance;\10\ and
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\10\ 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 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 or review process, as applicable (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.\11\
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\11\ Also, refer to paragraph 7.05 of the AICPA Audit Guide.
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Documentation of ALLL Methodology in Written Policies and Procedures

An institution's written policies and procedures should describe
the primary elements of the institution's ALLL methodology, including
portfolio segmentation and impairment measurement. In order for an
institution's ALLL methodology to be effective, the institution's
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 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 loss rates are determined (e.g., historical loss rates
adjusted for environmental factors or migration analysis) and what
factors are considered when establishing appropriate time frames over
which to evaluate loss experience; and

[[Page 35634]]

(c) Descriptions of qualitative factors (e.g., industry,
geographical, economic, and political factors) 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 the expertise and independence 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.\12\ Q&A #1 and #2 in Appendix A provide
examples of applying and documenting impairment measurement methods
under FAS 114.
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\12\ 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.

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
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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 by that institution to support its 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 typically 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 small
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 segmentation method used, an institution should
maintain documentation to support its conclusion 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
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 loan portfolio, an institution
should estimate the FAS 5 portion of its ALLL. For those segments that
require an ALLL,\13\ the

[[Page 35635]]

institution should estimate 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 methods used to
measure losses, an institution should demonstrate and document that the
loss measurement methods used to estimate the ALLL for each segment are
determined in accordance with GAAP as of the financial statement
date.\14\
---------------------------------------------------------------------------

\13\ An example of a loan segment that does not generally
require an ALLL is loans that are fully secured by deposits
maintained at the lending institution.
\14\ 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.
---------------------------------------------------------------------------

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 the institution's 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.\15\
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. If a range of loss is determined,
institutions should maintain documentation to support the identified
range 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.
---------------------------------------------------------------------------

\15\ Refer to paragraph 23 of FAS 5.
---------------------------------------------------------------------------

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. In order to
demonstrate consistency 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.

Begin Text Box--Illustration C (Documenting the Setting of Loss
Rates, First Illustration, Comprehensive loss analysis in a small
institution): A small institution determines its loss rates based on
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 loss rates for changes in
local economic conditions): An institution develops a factor to
adjust 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

In developing loss measurements, institutions should consider the
impact of current environmental factors and then document which factors
were used in the analysis and how those factors affected the loss
measurements. Factors that should be considered in developing loss
measurements include the following:\16\
---------------------------------------------------------------------------

\16\ 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;
(7) Industry conditions; and
(8) Effects of changes in credit concentrations.
For any adjustment of loss measurements for environmental factors,
the institution should maintain sufficient, objective evidence to
support the amount of the adjustment and to explain why the adjustment
is necessary to reflect current information, events, circumstances, and
conditions in the loss measurements.
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) The 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;\17\
and
---------------------------------------------------------------------------

\17\ 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.
---------------------------------------------------------------------------

(5) Depending on the level of detail that supports the ALLL
analysis, detailed subschedules of loss estimates that reconcile to the
summary schedule.
Illustration D describes how an institution documents its estimated
ALLL by adding comprehensive explanations to its summary schedule.

Begin Text Box--Illustration D (Summarizing Loss Estimates,
Descriptive comments added to the consolidated ALLL summary
schedule): To simplify the supporting documentation process and to
eliminate redundancy, an institution adds detailed supporting
information to its summary schedule. For example, this institution's
board of directors receives, within the body of the ALLL summary

[[Page 35636]]

schedule, a brief description of the institution's policy for
selecting loans for evaluation under FAS 114. Additionally, the
institution identifies which FAS 114 impairment measurement method
was used for each individually reviewed impaired loan. Other items
on the schedule include a brief description of the loss factors for
each segment of the loan portfolio, the basis for adjustments to
loss rates, and explanations of changes in ALLL amounts from period
to period, including cross-references to more detailed supporting
documents. 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

An institution's ALLL methodology is considered valid when it
accurately estimates the amount of loss contained in the portfolio.
Thus, the institution's methodology should include procedures that
adjust loss estimation methods to reduce differences between estimated
losses and actual subsequent charge-offs, as necessary.
To verify that the ALLL methodology is valid and conforms to GAAP
and supervisory guidance, an institution's directors should establish
internal control policies, appropriate for the size of the institution
and the type and complexity of its loan products. These policies should
include procedures for a review, by a party who is independent of the
ALLL estimation process, of the ALLL methodology and its application in
order to confirm its effectiveness.
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 a party that is independent of the ALLL estimation
process. 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 ALLL review function. Additional documentation
often includes the summary findings of the independent 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

Introduction

The Questions and Answers (Q&As) presented in this appendix
serve several purposes, including (1) To illustrate the banking
agencies' views, as set forth in this Policy Statement, about the
types of decisions, determinations, and processes an institution
should document with respect to its ALLL methodology and amounts;
and (2) to illustrate the types of ALLL documentation and processes
an institution might prepare, retain, or use in a particular set of
circumstances. The level and types of documentation described in the
Q&As should be considered neither the minimum acceptable level of
documentation nor an all-inclusive list. Institutions are expected
to apply the guidance in this Policy Statement to their individual
facts, circumstances, and situations. If an institution's fact
pattern differs from the fact patterns incorporated in the following
Q&As, the institution may decide to prepare and maintain different
types of documentation than did the institutions depicted in these
Q&As.

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, as sufficient, objective
evidence, written documentation to support its measurement of loan
impairment under FAS 114. If Institution A 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 factor \1\ and other information reflecting past
events and current conditions. If Institution A uses the fair value
of collateral to measure impairment, it 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, appraisal quality, and the expertise
and independence of the appraiser. Similarly, Institution A should
document the amount, source, and date of the observable

[[Page 35637]]

market price of a loan, if that method of measuring loan impairment
is used.
---------------------------------------------------------------------------

\1\ Question #16 in Exhibit D-80A of EITF Topic D-80 and
attachments indicates that environmental factors include existing
industry, geographical, economic, and political factors.
---------------------------------------------------------------------------

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 certain 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.\2\ 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.
---------------------------------------------------------------------------

\2\ When reviewing collateral dependent loans, Institution B may
often find it more appropriate to obtain an updated appraisal to
estimate the effect of current market conditions on the appraised
value instead of internally estimating an adjustment.
---------------------------------------------------------------------------

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 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.\3\
---------------------------------------------------------------------------

\3\ 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.
---------------------------------------------------------------------------

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.
Institution C's policy requires the following factors 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 institution's or third party's inspection of
the collateral
(4) Historical losses on similar loans;
(5) Confidence in the institution'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; and
(6) Other factors as appropriate for the loan type.

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
it 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. In this particular case,
Institution D has experienced similar business and lending
conditions in the past that it can compare to current conditions.
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, economic data, and
notes from discussions with individual borrowers.
Because in this case Institution D has had similar situations in
the past, its supporting documentation also includes an analysis of
how the current conditions compare to its previous loss experiences
in similar circumstances. As part of its effective ALLL methodology,
Institution D creates a

[[Page 35638]]

summary of the amount and rationale for the adjustment factor, which
management presents 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.\4\
---------------------------------------------------------------------------

\4\ 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.
---------------------------------------------------------------------------

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 indicate 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 provides a
reasonable estimate of the institution's probable loan losses in
these segments.
Question: How does Institution E adequately document an ALLL
under FAS 5 for these loans that were individually reviewed for
impairment but are not considered individually impaired?
Interpretive Response: As part of Institution E's effective ALLL
methodology, it documents the 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
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. At the end of each period, the accounting
department prepares a summary schedule that includes the amount of
each of the components of the ALLL, as well as the total ALLL
amount, for review by senior management, the Credit Committee, and,
ultimately, the board of directors. Members of senior management and
the Credit Committee meet to discuss the ALLL. During these
discussions, they identify changes that are required by GAAP to be
made to certain of the ALLL estimates. As a result of the
adjustments made by senior management, the total amount of the ALLL
changes. However, senior management (or its designee) does not
update the ALLL summary schedule to reflect the adjustments or
reasons for the adjustments. When performing their audit of the
financial statements, the independent accountants are provided with
the original ALLL summary schedule that was reviewed by senior
management and the Credit Committee, as well as a verbal explanation
of the changes made by senior 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 in compliance with existing
documentation guidance in this area?
Interpretive Response: No. An institution must maintain
supporting documentation for the loan loss allowance amount reported
in its financial statements. As illustrated above, there may be
instances in which ALLL reviewers identify adjustments that need to
be made to the loan loss estimates. The nature of the adjustments,
how they were measured or determined, and the underlying rationale
for making the changes to the ALLL balance should be documented.
Appropriate documentation of the adjustments should be provided to
the board of directors (or its designee) for review of the final
ALLL amount to be reported in the financial statements. For
institutions subject to external audit, this documentation should
also be made available to the independent accountants. If changes
frequently occur during management or credit committee reviews of
the ALLL, management may find it appropriate to analyze the reasons
for the frequent changes and to reassess the methodology the
institution uses.

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.\1\ 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.\2\
---------------------------------------------------------------------------

\1\ 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, 2000
edition (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. 140, Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities--a
Replacement of FASB Statement No. 125 (FAS 140).
\2\ Refer to FASB Interpretation No. 14, Reasonable Estimation
of the Amount of a Loss, and 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).
---------------------------------------------------------------------------

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.\3\ 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.
---------------------------------------------------------------------------

\3\ 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.
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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.

[[Page 35639]]

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 as ``Loss,'' the
portion of the recorded investment deemed to be the confirmed loss
and classified the remaining recorded investment as ``Substandard.''
For this loan, the amount classified ``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.\4\ 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.
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\4\ 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.
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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.\5\
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\5\ 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.
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While different institutions may use different methods, there
are certain common elements that should be included in any loan loss
allowance methodology. Generally, an institution's methodology
should:\6\
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\6\ Refer to paragraph 7.05 of the AICPA Audit Guide.
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(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;
(7) Consider current 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, in writing, 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 differences between
the results of the systematic determination process and the
unadjusted ALLL balance in the general ledger.\7\
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\7\ Institutions should refer to the guidance on materiality in
SEC Staff Accounting Bulletin No. 99, Materiality.
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Bibliography

American Institute of Certified Public Accountants' Audit and
Accounting Guide, Banks and Savings Institutions, 2000 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
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
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. 140, Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities--a
Replacement of FASB Statement No. 125
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: July 2, 2001.
Keith J. Todd,
Executive Secretary, Federal Financial Institutions Examination
Council.
[FR Doc. 01-16973 Filed 7-5-01; 8:45 am]
BILLING CODES 6710-01-P; 6714-01-P; 6720-01-P; 4810-33-P