[Federal Register Volume 59, Number 94 (Tuesday, May 17, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11956]

[[Page Unknown]]

[Federal Register: May 17, 1994]




Implementation Issues Arising From FASB Statement No. 114, 
``Accounting by Creditors for Impairment of a Loan''

AGENCY: Federal Financial Institutions Examination Council.

ACTION: Request for comment.


SUMMARY: The Federal Financial Institutions Examination Council 
(FFIEC)\1\ is seeking public comment on certain issues arising from the 
adoption by the Financial Accounting Standards Board of Statement No. 
114 (FAS 114), ``Accounting by creditors for Impairment of a Loan.'' 
These issues include the character of the FAS 114 allowance (i.e., 
whether it should be a general allowance that is includible in Tier 2 
capital, or a specific allowance that is not includible in Tier 2 
capital) and whether regulatory nonaccrual rules should be maintained 
for purposes of reporting on the Consolidated Reports of Condition and 
Income (Call Report) filed by banks and the Thrift Financial Report 
(TFR) filed by savings associations. After reviewing the public 
comments and making final decisions on these issues, appropriate 
changes will be made to the instructions for the Call Report and TFR 
and other regulatory guidance to incorporate changes arising from the 
adoption of FAS 114.

    \1\The FFIEC consists of representatives from the Board of 
Governors of the Federal Reserve System (FRB), the Federal Deposit 
Insurance Corporation (FDIC), the Office of the Comptroller of the 
Currency (OCC), the Office of Thrift Supervision (OTS) (referred to 
as the ``agencies''), and the National Credit Union Administration. 
However, this request for comment is not directed to credit unions. 
Section 1006(c) of the Federal Financial Institutions Examination 
Council Act requires the FFIEC to develop uniform reporting 
standards for federally-supervised financial institutions.

DATES: Comments must be received by July 1, 1994.

ADDRESSES: Comments should be directed to Joe M. Cleaver, Executive 
Secretary, Federal Financial Institutions Examination Council, 2100 
Pennsylvania, Avenue, NW, suite 200, Washington DC 20037. (Fax number 
202-634-6556.) Comments will be available for public inspection during 
regular business hours at the above address. Appointments to inspect 
the comments are encouraged (202) 634-6526.

At the FRB: Gerald A. Edwards, Jr., Assistant Director (202) 452-2741 
or Charles H. Holm, Project Manager (202) 452-3502. For questions 
pertaining to regulatory capital issues, Rhoger H. Pugh, Assistant 
Director (202) 728-5883, or Kevin M. Bertsch, Senior Financial Analyst 
(202) 452-5265.
    At the FDIC: Robert F. Storch, Chief, Accounting Section, Division 
of Supervision (202) 898-8906, or Doris L. Marsh, Examination 
Specialist, Accounting Section, Division of Supervision (202) 898-8905.
    At the OCC: Eugene W. Green, Deputy Chief Accountant, (202) 874-
4933, or Frank Carbone, National Bank Examiner (202) 874-5170.
    At the OTS: Robert Fishman, Acting Deputy Assistant Director for 
Supervision Policy (202) 906-5672, or Timothy Stier, Deputy Chief 
Accountant (202) 906-5699.


I. Summary of FAS 114

    FAS 114 was adopted in May, 1993 by the Financial Accounting 
Standards Board (FASB) and is effective for fiscal years beginning 
after December 15, 1994. The statement applies to all creditors and to 
all loans that are identified for evaluation of collectibility, except: 
(1) large groups of smaller-balance homogeneous loans that are 
collectively evaluated for impairment (such as credit card, residential 
mortgage, and consumer installment loans); (2) loans that are measured 
at fair value or at the lower of cost or fair value (such as loans held 
for sale); (3) leases; and (4) debt securities.
    Under this standard, a loan is impaired when it is probable that a 
creditor will be unable to collect all amounts due (including interest 
and principal) according to the contractual terms of a loan agreement. 
When a loan is impaired, a creditor must measure the extent of that 
impairment by determining the present value of expected future cash 
flows discounted at the loan's effective interest rate, or as practical 
expedients, either the loan's observable market price or the fair value 
of the collateral of a loan if it is collateral dependent. Although a 
creditor is generally allowed to use any of these three measurement 
methods to determine the amount of impairment, a creditor must measure 
impairment based on the fair value of collateral when the creditor 
determines that foreclosure is probable. If the value of the impaired 
loan (using the methods described in FAS 114) is less than the recorded 
balance of the loan, a creditor must recognize the impairment by 
creating a valuation allowance (referred to in the standard as an 
``allowance for credit losses'') for the difference and recognizing a 
corresponding bad debt expense.
    The FASB has recently proposed to amend FAS 114 to eliminate 
certain income recognition requirements specified in the standard to 
permit institutions flexibility in deciding how income on impaired 
loans should be reported. In addition, certain disclosures regarding 
income recognition on impaired loans would be required under the 
proposed amendment to FAS 114.

II. Regulatory Reporting Guidance Related to FAS 114

    The FFIEC and the agencies are requiring institutions to adopt FAS 
114 as of its effective date for purposes of reporting on the Call 
Report and TFR. Furthermore, the agencies will permit early adoption. 
Additional regulatory guidance regarding impaired, collateral dependent 
loans and the adequacy of the allowance for loan and lease losses 
(ALLL) is provided below, which the agencies plan to incorporate into 
regulatory reporting and examination guidance, as appropriate.
    The FFIEC and the agencies intend to adhere to the FAS 114 
measurement standards discussed above for regulatory reporting purposes 
in most cases. However, consistent with the ``Interagency Policy 
Statement on the Review and Classification of Commercial Real Estate 
Loans, ``issued on November 7, 1991, the FFIEC and the agencies will 
expect institutions to measure impaired, collateral-dependent loans for 
purposes of regulatory reports at the fair value of the collateral.\2\

    \2\This supervisory treatment would be applied to all 
collateral-dependent loans, regardless of the type of collateral.

    FAS 114 does not address the overall adequacy of the ALLL. However, 
in addition to requiring an allowance for credit losses for impaired 
loans, FAS 114 requires each institution to continue to maintain an 
allowance that complies with Statement of Financial Accounting 
Standards No. 5 (FAS 5), ``Accounting for Contingencies.'' Thus, 
consistent with existing regulatory policy, the ALLL should be adequate 
to cover all estimated credit losses arising from the loan and lease 
portfolio, including losses on loans that do not meet FAS 114's 
impairment criterion.
    The agencies do not plan to automatically require additional 
allowances for credit losses for impaired loans over and above what is 
required on these loans under FAS 114. However, an additional allowance 
on impaired loans may be necessary based on consideration of 
institution-specific factors, such as historical loss experience 
compared with estimates of such losses, concerns about the reliability 
of cash flow estimates, or the quality of an institution's loan review 
function and controls over its process for estimating its FAS 114 

III. Issues for Comment

    The adoption of FAS 114 may require changes in certain existing 
regulatory reporting and capital requirements and in other supervisory 
policies. The FFIEC is seeking comment on the specific reporting issues 
described below.

1. The Character of the FAS 114 Allowance

    Should that portion of an institution's allowance established 
pursuant to FAS 114 be reported and considered as a specific allowance 
and, thus, not be eligible for inclusion in Tier 2 capital under the 
agencies' current capital rules? Alternatively, should the FAS 114 
allowance be regarded as a general allowance which would be eligible 
for inclusion in Tier 2 capital subject to existing limits?
    The agencies' risk-based capital rules are based upon, and 
consistent with, the Basle Accord.\3\ Under this international 
framework and the agencies' rules, ``general allowances'' for loan and 
lease losses that have been created against unidentified losses and 
that are not ascribed to particular assets or groups of assets may be 
included in Tier 2 capital subject to certain limitations.\4\ The 
Accord also states that ``where, however, provisions or reserves have 
been created against identified losses or in respect of an identified 
deterioration in value of any asset or group or subsets of assets, they 
are not freely available to meet unidentified losses which may 
subsequently arise elsewhere in the portfolio and do not possess an 
essential characteristic of capital. Such provisions or reserves should 
not, therefore, be included in the capital base.'' Thus, if the 
allowances established for a certain asset or group of assets in 
accordance with FAS 114 are determined to be ``created against 
identified losses or in respect of an identified deterioration in value 
of any asset or group or subsets of assets,'' then they would be 
reportable as ``specific allowances'' for purposes of the Call Report 
and TFR and would not be eligible for inclusion in Tier 2 capital under 
the Basle Accord or the current capital rules of the agencies.

    \3\The Basle Accord is a risk-based capital framework that was 
proposed by the Basle Committee on Banking Supervision (Basle 
Supervisors Committee) and endorsed by the Central Bank Governors of 
the Group of Ten (G-10) countries in July, 1988.
    \4\Under the agencies' capital rules, general allowances 
includible in Tier 2 are limited to 1.25 percent of risk weighted 
assets and an institution's Tier 2 capital cannot exceed its Tier 1 

    Currently, the entire balance of the ALLL for banks and the general 
valuation allowances for loans and leases (GVAs) for savings 
associations are reported as general allowances and are includable in 
Tier 2 capital, subject only to the limitations referenced above. A 
rationale for this position on the ALLL has been that regulatory 
charge-off policies require banks to promptly write off identified 
deteriorations in the value of loans and thereby ``cleanse'' these 
allowances. In the case of savings associations, specific valuation 
allowances are reported separately from GVAs. Although the Securities 
and Exchange Commission's (SEC) Industry Guide 3 requires the 
allocation of the ALLL and GVAs to specific groups of loans in Form 10-
K annual reports in part to assist analysts in assessing the overall 
adequacy of allowances, the agencies have determined that such 
allocations are solely for disclosure purposes and are not ``created 
against identified losses.'' In addition, the agencies have determined 
that these disclosure requirements do not affect the availability of 
these allowances to meet identified losses arising elsewhere in an 
institution's portfolio.
    The adoption of FAS 114 does not affect the necessity for banks to 
cleanse their allowances through the prompt recognition of identified 
losses. Furthermore, FAS 114 could be viewed as simply setting forth an 
estimation technique similar to that prescribed by SEC Industry Guide 
3. Thus, while the FAS 114 allowance would be separately disclosed, it 
need not be viewed as ``created against identified losses or in respect 
of an identified deterioration in value of any asset or group or 
subsets of assets.'' Accordingly, allowances established pursuant to 
FAS 114 could be viewed as general allowances.
    On the other hand, FAS 114 requires that valuation allowances be 
established for the amount by which the value of impaired loans as 
determined by the analytical methods described in the standard (i.e., 
present or fair value) is less than the recorded balance of these 
loans. This analysis may be viewed as more loan specific than previous 
analytical methods used to estimate the ALLL and GVAs. Thus, FAS 114 
could be viewed as requiring the establishment of specific allowances 
to account for impairment in particular assets or groups of assets.
    In order to be considered general allowances under the Basle 
Accord, allowances must be freely available to absorb losses arising 
anywhere in a loan portfolio. A determination of whether FAS 114 
allowances are freely available to absorb losses should take into 
account the requirement that, under the standard, the depletion of such 
allowances through the charge-off of loans other than those for which 
they were established requires the replenishment of these allowances. 
On the other hand, this determination should also recognize that the 
portion of an institution's allowance attributable to FAS 114 is not 
precluded from being available to meet identified losses on any asset 
in its portfolio.
    While a decision on the character of the FAS 114 allowance has 
relatively limited reporting implications, it has more important 
implications for determining institutions' regulatory capital ratios. 
If FAS 114 allowances are viewed as specific in nature and, thus, 
inconsistent with the Basle Accord and the agencies' capital rules, the 
FAS 114 allowance would be deducted from assets and none of it could be 
included in regulatory capital.\5\ Certain institutions may have lower 
regulatory capital ratios if the FAS 114 allowance is considered a 
specific allowance rather than a general allowance.

    \5\Consistent with FAS 114 disclosure requirements, the agencies 
plan to require supplemental reporting of the amount of FAS 114 
allowances in regulatory reports.

2. Maintenance of Nonaccrual Reporting Requirements

    Should regulatory nonaccrual standards be maintained for loans 
subject to FAS 114?
    Under the longstanding reporting standards of the banking agencies 
(OCC, FRB, and FDIC), banks are required to discontinue the accrual of 
income on a loan when:
    (a) The institution places the loan on a cash basis because of 
deterioration in the financial condition of the borrower.
    (b) The collection in full of contractual principle or interest is 
not expected, or
    (c) Principal or interest has been in default for 90 days or more 
unless the loan is both well secured and in the process of collection.
    This third nonaccrual criterion does not apply to 1-to-4 family 
residential mortgages or consumer loans of banks. However, these 
organizations are expected to establish appropriate policies for these 
types of loans in order to prevent the overstatement of income. These 
nonaccrual requirements prevent the accrual of income in advance of 
payment on seriously delinquent loans. Savings associations follow 
similar nonaccrual practices.\6\

    \6\Under existing generally accepted accounting principles 
(GAAP) and regulatory reporting instructions, and institution should 
consider the amount of any accrued but uncollected interest included 
in its reported assets when estimating its ALLL or GVA.

    FAS 114 was viewed by many as superseding current regulatory 
nonaccrual standards since it established a method to recognize income 
based on an impaired loan's present value. However, FASB has recently 
issued, for public comment, a proposal to eliminate the detailed 
guidance in the statement on the recognition of income on impaired 
loans. This proposal allows a creditor to use existing methods for 
recognizing interest income on impaired loans. Thus, if this proposed 
change is adopted, an institution's continued use of the regulatory 
nonaccrual requirements for income recognition purposes would not be 
inconsistent with FAS 114.
    If FASB's proposed changes are adopted and the agencies retain 
their nonaccrual rules for impaired loans, interest income recognized 
from such loans would generally be limited to the amount of cash 
interest received. However, to the extent that this limitation reduces 
the amount of interest income that institutions would be able to 
recognize on impaired loans, institutions would generally have a 
corresponding reduction in the provision for credit losses necessary to 
bring the values of impaired loans to their present values as defined 
by FAS 114. Thus, the agencies do not believe that the retention of the 
regulatory nonaccrual standards would in many cases materially affect 
the total amount of income reported by institutions.\7\

    \7\On the other hand, in other cases, the total amount of income 
reported under a FAS 114 approach without nonaccrual requirements 
could materially differ from the total that would be reported if the 
agencies' nonaccrual requirements apply in conjunction with FAS 114. 
For example, such a difference could arise when loans are 90 days or 
more past due but are not deemed to be impaired by the institution.

    The agencies have identified several reasons for maintaining their 
existing nonaccrual requirements. First, retention of the nonaccrual 
rules for impaired loans will maintain a framework so that institutions 
report interest income on a consistent basis. GAAP generally has been 
silent on whether the accrual of interest is appropriate on impaired 
loans. As a result, the agencies' regulatory rules have been adopted by 
institutions for purposes of both their regulatory reports and 
financial statements and thus became GAAP in practice. Second, 
nonaccrual policies would prohibit interest income from being 
recognized on impaired loans for uncollected contractual interest. 
Third, not all seriously delinquent loans would be subject to FAS 114 
and the agencies would need to maintain some standard to ensure that 
interest income is not overstated on these loans.\8\ Fourth, since 
nonaccrual requirements are consistent with the current reporting 
structure, institutions would not have to significantly change their 
reporting systems and statistical consistency would be maintained for 
all uses of these data by regulators, bankers, analysts, and others. 
Fifth, FASB staff may undertake a project to determine the proper 
recognition of income on impaired loans. Since such a project could 
change the income recognition rules under GAAP within a few years, 
retaining current nonaccrual standards could eliminate the possibility 
that institutions might have to significantly change their internal 
systems twice in a short period of time and could thus potentially 
reduce reporting burden. Finally, if the current reporting requirements 
for nonaccrual of interest income are retained, the agencies may not 
have to make significant changes to existing reporting and disclosure 
requirements for past due and impaired loans.

    \8\If the agencies retain their nonaccrual requirements for 
loans subject to FAS 114, it would be less likely that total income 
from certain past due loans could be overstated by the recognition 
of uncollected contractual interest solely based on an expectation 
of collection (as permitted under FAS 114).

    On the other hand, while retaining regulatory nonaccrual 
requirements would not be inconsistent with GAAP, it could be viewed as 
adding another element to accounting for impaired loans, and, thus, 
could increase the complexity of implementing FAS 114. Furthermore, as 
noted above, if the regulatory nonaccrual rules for impaired loans are 
eliminated, the total amount of income reported under FAS 114 for many 
impaired loans may be the same as if the regulatory nonacrual rules are 

3. Other Issues

    In addition to the issues discussed above, the agencies seek 
written comments on the following issues.
    1. Comment is sought on (a) how much the adoption of FAS 114 is 
expected to change overall allowance levels, and (b) what portion of 
total overall allowances are expected to be related to impaired loans 
evaluated pursuant to FAS 114.
    2. Comment is sought on implementation issues arising from FAS 114 
to the extent they relate to U.S. branches and agencies of foreign 
banks. These entities are required to file quarterly the Report of 
Assets and Liabilities of U.S. Branches and Agencies of Foreign Banks 
(002 Report), which in many respects is similar to the bank Call 
Report. The 002 Report requires U.S. branches and agencies of foreign 
banks to report the amount of nonaccrual loans (see issue 2 
``Maintenance of Nonaccrual Reporting Requirements'').
    3. Comment is sought on how FAS 114 might affect an institution's 
internal loan review process and its internal loan classification 
system for loans subject to FAS 114. In this regard, the FFIEC notes 
that according to the December 21, 1993, Interagency Policy Statement 
on the Allowance for Loan and Lease Losses, each institution should 
ensure that it has a formal credit grading system that can be 
reconciled with the classification framework used by the agencies.

    Dated: May 12, 1994.

Keith J. Todd,
Assistant Executive Secretary, Federal Financial Institutions 
Examination Council.
[FR Doc. 94-11956 Filed 5-16-94; 8:45 am]