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The allowance for loan losses: understanding and applying FASB 5.

When should depository institutions recognize loan losses ?

Depressed economic times and stepped-up regulatory scrutiny of depository institution (DI) loan portfolios have drawn new attention to an old concept: the allowance for loan and lease losses (ALLL). Nevertheless, not everyone interprets the authoritative literature in the same way or, more important, shares the same objective. Questions of ALLL adequacy at DIs and the timing of loan loss provisions often cause controversy, as might be expected given the diversity of interested parties-- management, auditors, regulators, depositors, shareholders and politicians.

It might be possible to resolve these conflicts if interested parties better understand existing generally accepted accounting principles and agree on a common objective. Rules, methodologies (the principles and procedures of inquiry) and a common language for discussion can be based on that foundation. Without it, desired allowances and provisions will continue to be at odds, while discussions among interested parties will continue to be difficult and frustrating.

REASONABLE ALLL

The current state of affairs can be best illustrated by two troublesome statements some DIs are hearing from examiners:

* "We've been analyzing losses on your consumer loan portfolio. They seem to be fairly stable at 100 basis points a year, but we expect that rate to increase because of what we predict for the local economy. Also, your portfolio has an average life of three years, so we think your reserve should consider these facts and be adequate to handle all future losses through liquidation of the existing portfolio."

* "We've reviewed all your specific allocations of the ALLL to specific problem loans, to the pools of classified loans and to remaining uncriticized loans. Your ALLL covers all those needs, but it's still not enough. We want you to book a supplemental amount but can't tell you how much it should be."

But it's not fair to just single out examiners. Securities and Exchange Commission reviewers and some managers and auditors also might agree with these statements. Others will disagree, based on tradition or experience, but be unable to articulate technical challenges. How should management and the DIs' auditors analyze such statements and requests for additional provisions? Are they reasonable? Consistent with GAAP?

To begin, the ALLL must be

* Based on an appropriate concept or principle.

* Documented by management in such a manner as to be reviewable by examiners, auditors and others.

Differences of opinion may arise, but only then is there a basis for a rational discussion of differences in desired dollar amounts. The Financial Accounting Standard Board's emerging issues task force confirmed in Issue no. 85-44, Differences between Loan Loss Allowances for GAAP and RAP, that differences may exist between regulatory accounting principles (RAP) and GAAP allowances, but warned auditors to be skeptical of such differences. In practice, few differences appear to exist between the total ALLL for RAP and GAAP, although differences often appear among components justifying the total allowance. Quite often, these differences reflect varying concepts or objectives for the ALLL.

This article explains the current GAAP basis Of the ALLL, points out today's conflicting ideas and offers a systematic methodology for evaluating the ALLL.

THE GAAP CONCEPT

FASB Statement no. 5, Accounting for Contingencies, established the GAAP concept behind the ALLL. Statement no. 5 applies not only to loan losses but also to environmental and insurance losses. It requires tosses to be recognized in the financial statements in the period they occur, not before or after the loss event. Statement no. 5 defines a loss contingency as "an existing condition, situation, or set of circumstances involving uncertainty as to possible ... loss ... to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm . . . the loss or impairment of an asset or the incurrence of a liability."

The FASB's focus was on losses that must be estimated. A loss of a known amount attributable to a known asset is simply a loss, not a loss contingency, which involves an estimate of the probable loss incurred that is not known with certainty-- an estimate that must be made to recognize the loss in the loss period.

The information gap. Unfortunately, the costs of all events resulting in loan losses cannot be known the instant the losses occur. An information gap almost always exists. Exhibit 1, below, illustrates the information gap for a single loan. Between the time of the loss event (such as a Job loss), and the event confirming the loss (personal bankruptcy), the lender's knowledge of the specific loss goes from zero to nearly 100%. The information gap for this type of borrower is closed substantially when the borrower stops making payments. Past-due records, for example, tend to be highly reliable loss indicators for some loan types. For other types of borrowers, the financial information flow to the lender is slow and payment periods are longer, extending the information gap.

This information gap is the reason for the ALLL. That is, the ALLL can be thought of as a quantification of losses that probably occurred within the information gap. Some borrowers may be able to continue debt service for a time after a loss event; others, having no resources to fall back on, are quickly devastated. Other borrowers hang on longer but eventually succumb.

This diversity of loss experience was illustrated by three different pools of borrowers, each affected by the same event-- the overnight fall in oil prices during the mid-1980s.

One pool had borrowed against its oil and gas reserves. The impact of price changes on their cash flows and debt service ability was rapid and generally estimable within a few weeks. Two other borrower pools consisted of oil drilling rig owners, ranging from large, multirig, international companies to single-rig owners-operators. When oil prices fell, the number of working rigs fell and their value plummeted. Cash flows turned negative. Thinly capitalized borrowers without backlogs hit the skids hard and fast so that within a few months the amount of losses became apparent.

Other, better capitalized, borrowers with backlogs held on much longer, but eventually defaulted; the loss eventually sustained from these borrowers was far more difficult to estimate, and in some cases the amount took years to determine. Still other borrowers serviced and repaid their loans.

Statement no. 5 recognizes the existence of an information gap by providing the following guidance on loss accrual: "An estimated loss from a loss contingency... shall be accrued by a charge to income if both of the following conditions are met: a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss. b. The amount of the loss can be reasonably estimated."

Exhibit 2, page 98, illustrates these ideas and depicts the ALLL. As of the reporting date, the depository institutions have little or no information about recent loss events. The longer ago the losses occurred, the more likely specific borrowers and precise loss amounts are known. The objective of providing an ALLL is to quantify incurred, but not precisely known, losses.

A critical but often overlooked concept is that Statement no. 5 does not require or permit an accrual for losses that have not happened as of the reporting date. Nor is the objective to estimate the loan portfolio's fair market value. Inherent in fair market value is anticipation of possible and future losses, and consideration of such would not be appropriate in accounting for a loan portfolio under historical cost accounting, unless the portfolio is held for sale.

Thus, hypothetical statements, such as "We expect that rate (of loss) to increase" and "The ALLL should be adequate to handle all future losses through liquidation," are troublesome if they are intended to cause DIs to make provisions for loss contingencies that will occur in the future. Even when the rate of future losses is reasonably predictable, Statement no. 5 requires those losses to be recognized in the future periods in which they occur.

POLICY STATEMENTS ISSUED BY OTHERS

In the past few years, other interested parties issued documents addressing both the adequacy of the ALL L and the requirement for a documented, systematic methodology for evaluating asset impairment. Although parts of this guidance seem at odds with the GAAP concept, some consistent themes emerge: Losses should be provided for, and a documented, comprehensive methodology should be used on a consistent basis.

The American Institute of CPAs addresses the ALLL in both the banks and savings and loan associations audit and accounting guides and in greater depth in Au* diting the Allowance for Credit Losses of Banks, an auditing procedures study. One key to its continued usefulness to auditors, examiners and management is it incorporates a building-blocks approach to evaluating the ALLL's adequacy. Typical building blocks include components for

* Specific loans having identified potential losses.

* Estimated losses on pools of criticized loans.

* Pools of homogeneous, high-volume loans such as consumer installment loans, residential mortgages and credit card loans.

* Off-balance-sheet credit risks.

* Other loans not included in the above

blocks.

The SEC issued Financial Reporting Release no. 28, Accounting for Loan Losses by Registrants Engaged in Lending Activities, in 1986 and has since taken several enforcement actions to reinforce the need for procedural discipline in determining loan loss amounts.

The Office of the Comptroller of the Currency (OCC) issued revised Banking Circular 201 in early 1992. It recommends building an ALLL evaluation system based on historical loss experience adjusted by several subjective factors, including

* Trends in portfolio volume, maturity and composition.

* Off-balance-sheet credit risk.

* Volumes and trends in delinquencies

and nonaccruals.

* Lending policies and procedures, including those for charge-off, collection and recovery.

* National and local economic conditions.

* The experience, ability and depth of

lending officers. The OCC also accepted the building-blocks approach when supported by a well-documented methodology responsive to these subjective factors.

On May 7, 1991, the Federal Deposit Insurance Corporation issued a memorandum to its regional directors incorporating many of the same basic concepts. The memo says, "The range of amounts over which an institution's general allowance would be considered adequate is typically determined by adding the various components of the allowance, including specific allocations or loss estimations for certain identified loans (i.e., those individually reviewed), specific allocations for pools of loans (not individually reviewed), and the supplemental portion for inherent loan portfolio losses."

SYSTEMATIC METHODOLOGIES ARE AVAILABLE ARE AVAILABLE

Systematic methodologies consistent with Statement no. 5 and SEC guidance and acceptable to examiners have been developed by many depository institutions. Typically, they track losses, specific allocations, loan risk classifications and loan pool activity for purposes of calculating historical loss ratios by pool and classification. For a better estimate of losses incurred, more sophisticated models were developed to calculate inherent but unrecognized migration of loans from one risk classification to another. While regulators require no specific method, banks that have developed these models and adjust historical average loss rates for the subjective factors discussed above tend to fare better upon examination.

These models and methodologies address the process of determining the ALLL but are not always derived from an appreciation of the concept underlying Statement no. 5. Indeed, many are developed without any clear concept or accounting objective other than to "book enough to satisfy the regulators" or to "book one year's worth of average charge-offs."

Further, these models, including the necessary subjective adjustments to historical average loss rates, often fait to appropriately incorporate

* Differences in the length or nature of the information gap for different types of loans (exhibit 1).

* Differences in borrower characteristics between loan pools.

* The location of the DI on the loss curve with respect to significant loss-causing shocks.

Exhibit 3, page 98, illustrates the importance of the DI's location on the loss curve, In periods of increasing losses, the historical average loss rate typically is an insufficient estimate of losses incurred in the current period. The historical loss rate needs to be subjectively adjusted upward. After actual losses peak, the average rate will exceed actual losses. Graphically, the ALLL's objective is to measure the area under the actual, not average, loss curve relating to loss events occurring through the date of the financial statements.

Typically, this involves multiplying the subjectively adjusted historical loss rate by the appropriate information gap period. The result is multiplied by the outstanding balance of the applicable segment of the loan portfolio corresponding to the type of loans for which the average loss rate was calculated. To compensate for variations over time in any given segment's total balance, the loss rate usually is calculated as a percentage of the average balance of loans in that segment.

Thus, if the subjectively adjusted historical loss rate is 5% per period and the current outstanding balance is $1,000, the model would indicate losses of $50 have been incurred. This loss estimate assumes the length of the information gap is one period; if the information gap lasted three periods, the ALLL would triple.

HOW PROBABLE IS "PROBABLE"?

The Government Accounting Office recently was very critical of current practice in DI accounting for loan losses. One criticism in its report, Failed Banks: Accounting and Auditing Reforms Urgently Needed (April 1991), and again in Depository Institutions: Flexible Accounting Rules Lead to Inflated Financial Reports (June 1992), concerns the term "probable" when used to measure loan impairment. Statement no. 5 does not require accrual for a loss contingency unless it is "probable that an asset had been impaired." (For more on the June 1992 report, see the sidebar on page 99.)

For banks, the GAO believes "probable" has "come to mean 'virtually certain' rather than 'more likely than not.'" It recommended "losses for problem loans (loans that are not performing based on their contractual terms) should be taken if considered to be more likely than not, rather than probable."

In practice, "virtually certain" has not been clearly adopted as the working definition of "probable," but "more likely than not" is not universally accepted, either. The FASB discussed this issue as part of its loan impairment project and tentatively decided to stick with "probable" rather than redefining the threshold as "more likely than not." Paragraph 84 of Statement no. 5 says the conditions for loss accrual "are not intended to be so rigid that they require virtual certainty before a loss is accrued."

Therefore, the word "probable" currently seems to encompass the range of probabilities between "more likely than not" and "virtual certainty." Additional guidance is not proposed in the FASB's exposure draft of a statement stemming from its loan impairment project, so the existing ambiguity will linger. (For more on the FASB ED, see the sidebar at right.)

REAL WORLD APPLICATION

The concept of loan impairment is complex, particularly when it is applied and technical concepts meet the real world. While all interested parties agree an adequate ALLL is needed, often no agreement exists on a proper amount because often no consensus has been reached in practice on the objective (the accounting concept). Systematic methodologies for evaluating the ALLL are absolutely necessary, but they need a conceptual foundation. The FASB's loan impairment project is likely to retain Statement no. 5's underlying concept and may help clarify some of these issues; in the meantime, a better understanding of Statement no. 5 may help establish an ALLL acceptable to most parties.

EXECUTIVE SUMMARY

* MANY INTERESTED PARTIES are concerned about the adequacy of depository institutions' (DIs') allowance for loan and lease losses (ALLL) and the timing of these provisions.

* SOME RECOMMENDATIONS for increased ALLL and some evaluation methodologies are not consistent with the provisions of FASB Statement no. 5.

* STATEMENT NO. 5 REQUIRES a loan loss to be recognized in the period in which the loss occurs, not in the period before the loss event and, desirably, not in a period after the loss event.

* AN INFORMATION GAP almost always exists, causing lenders, on any given date, to not know precisely which of their loans is impaired or the exact amount of the impairment. The ALLL can be thought of as the quantification of losses that occurred within the information gap.

* MANY DIs HAVE developed systematic methodologies to estimate the needed allowance. Losses, specific allocations, loan risk classifications and loan pool activity are tracked to permit calculation of historical loss ratios.

* THE GOVERNMENT Accounting Office is concerned that institutions are recognizing problem loans only when they are "virtually certain" rather than "more likely than not." The GAO believes the latter criterion should be used.

GAO ISSUES REPORT ON NONPERFORMING LOANS

In June, the General Accounting Office issued a report, Depository Institutions: Flexible Accounting Rules Lead to Inflated Financial Reports, to congressional committees. The report gives the results of the GAO's review of accounting rules relating to the recognition and measurement of losses for nonperforming loans. Congress had requested the GAO review those accounting rules following the GAO's 1991 report Failed Banks: Accounting and Auditing Reforms Urgently Needed, which concluded flexible accounting rules had allowed banks to understate financial statement losses before failure.

The 1992 report concludes accounting rules applicable to nonperforming loans are flexible and ambiguous and are being misused in practice-causing a delay in recognition of loan losses in the financial statements. The report criticizes two specific accounting practices:

* The use of undiscounted cash flows when measuring the loss reserve (for example, not including the time value of money).

* Ignoring the marketplace as a measure of value of problem loans and substituting optimistic values based on estimated improved future market conditions.

The report recognizes the Financial Accounting Standards Board project on accounting by creditors for impairment of a loan but says it "does not address all the problems we identified, and the proposed rules would not result in appropriate loss estimates." Further, the FASB project will not be effective until fiscal years beginning after December 15, 1993.

The report recommends federal banks and thrift regulators establish accounting standards for accounting for nonperforming loans. (For the American Institute of CPAs' response, see JofA, Highlights, Aug. 92, page 4.)

--Arleen K. Rodda, director, American Institute of CPAs standards division.

Ms. Rodda is an employee of the AICPA and her views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.

MEASURING THE ALLOWANCE FOR LOAN LOSSES

There are two major facets to reporting loan impairment: timing, or "when," and measurement, or "how much." Financial Accounting Standards Board Statement no. 5, Accounting for Contingencies, addresses the question of when. On June 30, 1992, the FASB issued an Exposure Draft, Accounting by Creditors for Impairment of a Loan, specifying how an allowance for credit loss relating to a certain loan should be measured--the question of how much.

Recognition of impairment. A loan is considered impaired when it is probable the creditor will be unable to collect the contractual principal and interest. The term "probable" is defined in Statement no. 5, as discussed in the accompanying article.

Appropriate discount rate. When a loan is impaired, the valuation allowance to be established is the difference between the recorded investment of the impaired loan and the present value of the 1oan's expected future cash flows, discounted at the 1oan's effective interest rate (the 1oan's contractual interest rate adjusted for any deferred loan fees or costs, premiums or discounts). The FASB concluded loan impairment measurement should reflect only the deterioration of credit. By using the effective interest rate, the creditor is isolating credit deterioration and holding other values constant.

Income recognition. From one period to the next, the present value of expected future cash flows varies due to the passage of time and changes in the amount or timing of those cash flows. The portion associated with the passage of time is treated as interest income; the portion associated with changes in the amount or timing of cash flows is treated as bad debt expense.

Other issues. The ED also addresses troubled debt restructurings and certain disclosure requirements.

--Arleen K. Rodda, CPA, director, American Institute of CPAs accounting standards division.

Ms. Rodda is an employee of the AICPA and her views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.

DORSEY L. BASKIN, JR., CPA, is a partner of Arthur andersen & Co. in Washington, D.C., where he is national technical director for depository institutions. He is a member of the American Institute of CPAs savings institutions committee.
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Title Annotation:includes related articles on loan losses and nonperforming loans
Author:Rodda, Arleen K.
Publication:Journal of Accountancy
Date:Oct 1, 1992
Words:3448
Previous Article:Tackling a common appraisal problem.
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