[Federal Register Volume 65, Number 174 (Thursday, September 7, 2000)]
[Notices]
[Pages 54268-54276]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-22719]


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FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL


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

AGENCY: Federal Financial Institutions Examination Council.

ACTION: Proposed Policy Statement; request for comment.

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SUMMARY: The Federal Financial Institutions Examination Council (FFIEC) 
\1\ is requesting comments on a proposed Policy Statement on Allowance 
for Loan and Lease Losses (ALLL) Methodologies and Documentation for 
Banks and Savings Institutions (Policy Statement). This proposed Policy 
Statement is intended to provide guidance on the design and 
implementation of ALLL methodologies and supporting documentation 
practices.
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    \1\ The FFIEC consists of representatives from the Board of 
Governors of the Federal Reserve System (FRB), the Federal Deposit 
Insurance Corporation (FDIC), the Office of the Comptroller of the 
Currency (OCC), the Office of Thrift Supervision (OTS) (referred to 
as the ``banking agencies''), and the National Credit Union 
Administration. However, this guidance is not directed to credit 
unions.

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DATES: Comments must be received by November 6, 2000.

ADDRESSES: Comments should be directed to Keith J. Todd, Executive 
Secretary, Federal Financial Institutions Examination Council, 2000 K 
Street, N.W., Suite 310, Washington, DC 20006, fax number: (202) 872-
7501. Comments will be available for public inspection during regular 
business hours at the above address. Appointments to inspect comments 
are encouraged and can be arranged by calling the FFIEC at (202) 872-
7500.

FOR FURTHER INFORMATION CONTACT:   
    FDIC: Carol L. Liquori, Examination Specialist, Division of 
Supervision, (202) 898-7289, or Doris L. Marsh, Examination Specialist, 
Division of Supervision, (202) 898-8905, FDIC, 550 17th Street, N.W., 
Washington, DC 20429.
    FRB: Linda V. Griffith, Supervisory Financial Analyst, (202) 452-
3506, or Arthur Lindo, Supervisory Financial Analyst, (202) 452-2695, 
Division of Banking Supervision and Regulation, Board of Governors of 
the Federal Reserve System, 20th Street and Constitution Avenue, N.W., 
Washington, DC 20551.
    OCC: Richard Shack, Senior Accountant, Chief Accountant's Office, 
Core Policy Division, (202) 874-5411, or Louise A. Francis, National 
Bank Examiner, Chief Accountant's Office, Core Policy Division, (202) 
874-1306, Office of the Comptroller of the Currency, 250 E Street, 
S.W., Washington, DC 20219.
    OTS: William Magrini, Policy Analyst, Policy Division, (202) 906-
5744, or Harrison E. Greene, Jr., Securities Accountant, Accounting 
Policy Division, (202) 906-7933, Office of Thrift Supervision, 1700 G 
Street, N.W., Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

I. Background

    On March 10, 1999, the Federal Deposit Insurance Corporation, the 
Federal Reserve Board, the Office of the Comptroller of the Currency, 
the Office of Thrift Supervision, and the Securities and Exchange 
Commission (together, the Agencies) issued a joint letter to financial 
institutions on the allowance for loan and lease losses (the Joint 
Letter). In the Joint Letter, the Agencies agreed to establish a Joint 
Working Group to study ALLL issues and to assist financial institutions 
by providing them with improved guidance on this topic. The Agencies 
agreed that the Joint Working Group would develop and issue parallel 
guidance for two key areas regarding the ALLL:
     Appropriate methodologies and supporting documentation, 
and
     Enhanced disclosures.
    This proposed Policy Statement represents the banking agencies'

[[Page 54269]]

guidance to banks and savings institutions relating to methodologies 
and supporting documentation for the ALLL. The Securities and Exchange 
Commission staff is planning to provide parallel guidance on this topic 
for public companies in a future Staff Accounting Bulletin.\2\
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    \2\ The American Institute of Certified Public Accountants is 
developing more specific guidance on the accounting for loan losses 
and the techniques for measuring probable incurred loss in a loan 
portfolio. This guidance is expected to be released in final form in 
2001.
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    This Policy Statement clarifies the banking agencies' expectations 
regarding methodologies and documentation support for the ALLL from a 
generally accepted accounting principles (GAAP) perspective. For 
financial reporting purposes, including regulatory reporting, the 
provision for loan and lease losses and the ALLL must be determined in 
accordance with GAAP and supervisory guidance. GAAP requires that an 
institution maintain written documentation to support the amounts of 
the ALLL and the provision for loan and lease losses reported in the 
financial statements.
    The proposal is not intended to change existing accounting guidance 
in, or modify the documentation requirements of, GAAP or guidance 
provided in the relevant joint interagency statements issued by the 
Agencies. It is intended to supplement, not replace, the guidance the 
banking agencies provided in their Interagency Policy Statement on the 
Allowance for Loan and Lease Losses, which was issued in December 1993. 
It is also intended to supplement guidance the banking agencies 
provided in their interagency guidelines establishing standards for 
safety and soundness that were issued in 1995 and 1996 pursuant to 
Section 39 of the Federal Deposit Insurance Act (FDI Act).\3\ Under the 
guidelines for asset quality, each institution should estimate and 
establish a sufficient ALLL supported by adequate documentation. The 
proposed Policy Statement does not address or change current guidance 
regarding loan charge-offs; therefore, institutions should continue to 
follow existing regulatory guidance that addresses the timing of 
charge-offs.
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    \3\ Institutions should refer to the guidelines adopted by their 
primary federal regulator as follows: For national banks, Appendix A 
to Part 30; for state member banks, Appendix D to Part 208; for 
state nonmember banks, Appendix A to Part 364; for savings 
associations, Appendix A to Part 570.
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    The guidance in this Policy Statement recognizes that institutions 
should adopt methodologies and documentation practices that are 
appropriate for their size and complexity. For smaller institutions 
with fewer and less complex loan products, the amount of supporting 
documentation for the ALLL may be less exhaustive than for larger 
institutions.
    Recognizing that a primary mission of the banking agencies is to 
support a safe and sound banking system, examiners will continue to 
evaluate the overall adequacy of the ALLL, including the adequacy of 
supporting documentation, to ensure that it is appropriate. While the 
proposed Policy Statement generally does not provide guidance to 
examiners in conducting safety and soundness examinations, examiners 
may criticize institutions that fail to document and maintain an 
adequate ALLL in accordance with this Policy Statement and other 
banking agency guidance. In such cases, institution management may be 
cited for engaging in unsafe and unsound banking practices and may be 
subject to further supervisory action.

II. Principal Elements of the Policy Statement

    The proposed Policy Statement clarifies that the board of directors 
of each institution is responsible for ensuring that controls are in 
place to determine the appropriate level of the ALLL. It also 
emphasizes the banking agencies' long-standing position that 
institutions should maintain and support the ALLL with documentation 
that is consistent with their stated policies and procedures, GAAP, and 
applicable supervisory guidance.
    The proposed Policy Statement provides guidance on significant 
aspects of ALLL methodologies and documentation practices. 
Specifically, the proposal provides guidance on maintaining and 
documenting policies and procedures that are appropriately tailored to 
the size and complexity of the institution and its loan portfolio. The 
proposed Policy Statement notes that it is critical for an 
institution's ALLL methodology to incorporate management's current 
judgments about the credit quality of the loan portfolio. The 
methodology must be a thorough, disciplined, and consistently applied 
process that is reviewed and approved by the institution's board of 
directors.
    The proposal also discusses the methodology and documentation 
needed to support ALLL estimates prepared in accordance with GAAP, 
which requires loss estimates based upon reviews of individual loans 
and groups of loans. After determining the allowance on individually 
reviewed loans and groups of loans, the proposal states that management 
should consolidate these loss estimates and summarize the amount to be 
reported in the financial statements for the ALLL. To verify that the 
ALLL methodology is effective and conforms to GAAP and supervisory 
guidance, a review of the methodology and its application should be 
completed by external or internal auditors or some other party 
unrelated to the ALLL process, as appropriate for the size and 
complexity of the institution.
    The proposal includes illustrations of implementation practices 
that institutions may find useful for enhancing their own ALLL 
practices, an appendix that provides examples of certain key aspects of 
ALLL guidance, a summary of applicable GAAP guidance, and a 
bibliographical list of relevant GAAP guidance, joint interagency 
statements, and other literature on ALLL issues.

III. Comments

    Comment is requested on all aspects of the proposed Policy 
Statement.

IV. Paperwork Reduction Act

    In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
chapter 35), the banking agencies have reviewed the proposed Policy 
Statement and determined that it does not add any collections of 
information pursuant to the Act.

V. Proposed Policy Statement

    The text of the proposed Policy Statement follows:

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

    Boards of directors of banks and savings institutions are 
responsible for ensuring that their institutions have controls in 
place to consistently determine the allowance for loan and lease 
losses (ALLL) in accordance with the institutions' stated policies 
and procedures, generally accepted accounting principles (GAAP), and 
ALLL supervisory guidance.\4\ To fulfill this responsibility, boards 
of directors instruct management to develop and maintain an 
appropriate, systematic, and consistently applied process to 
determine the amounts of the ALLL and provisions for loan losses. 
Management should create and implement suitable policies and 
procedures to communicate the ALLL process internally to all 
applicable personnel. By creating an environment that encourages 
personnel to follow these policies

[[Page 54270]]

and procedures, management improves procedural discipline and 
compliance.
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    \4\ A bibliography is attached that lists applicable ALLL GAAP 
guidance, interagency policy statements, and other reference 
materials that may assist in understanding and implementing an ALLL 
in accordance with GAAP. See Appendix B for additional information 
on applying GAAP to determine the ALLL.
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    The determination of the amounts of the ALLL and provisions for 
loan and lease losses should be based on management's current 
judgments about the credit quality of the loan portfolio, and should 
consider all known relevant internal and external factors that 
affect loan collectibility as of the reporting date. The ALLL 
methodology, the associated policies and procedures, and the amounts 
to be reported each period for the provision for loan and lease 
losses and ALLL should be reviewed and approved by the board of 
directors. To ensure the methodology remains appropriate for the 
institution, the board of directors should have the methodology 
periodically validated and, if appropriate, revised. The board of 
directors' audit committee \5\ should oversee and monitor the 
internal controls over the ALLL determination process.\6\
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    \5\ While all institutions are encouraged to establish audit 
committees, small institutions without audit committees should have 
the board of directors assume this responsibility.
    \6\ Institutions and their auditors should refer to Statement on 
Auditing Standards No. 61, Communication With Audit Committees (as 
amended by Statement on Auditing Standards No. 90, Audit Committee 
Communications), which requires certain discussions between the 
auditor and the audit committee. These discussions should include 
items, such as accounting policies and estimates, judgments, and 
uncertainties, that have a significant impact on the accounting 
information included in the financial statements.
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    The banking agencies' \7\ have long-standing examination 
policies that call for examiners to review an institution's lending 
and loan review functions and recommend improvements, if needed. 
Additionally, in 1995 and 1996, the banking agencies adopted 
interagency guidelines establishing standards for safety and 
soundness, pursuant to Section 39 of the Federal Deposit Insurance 
Act (FDI Act).\8\ The interagency asset quality guidelines and the 
guidance in this paper assist an institution in estimating and 
establishing a sufficient ALLL supported by adequate documentation, 
as required under the FDI Act. Additionally, the guidelines require 
operational and managerial standards that are appropriate for an 
institution's size and the nature and scope of its activities.
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    \7\ The banking agencies are the Federal Deposit Insurance 
Corporation, the Federal Reserve Board, the Office of the 
Comptroller of the Currency, and the Office of Thrift Supervision.
    \8\ Institutions should refer to the guidelines adopted by their 
primary federal regulator as follows: For national banks, Appendix A 
to Part 30; for state member banks, Appendix D to Part 208; for 
state nonmember banks, Appendix A to Part 364; for savings 
associations, Appendix A to Part 570.
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    For financial reporting purposes, including regulatory 
reporting, the provision for loan and lease losses and the ALLL must 
be determined in accordance with GAAP. GAAP requires that allowances 
be well documented, with clear explanations of the supporting 
analyses and rationale. This Policy Statement describes but does not 
increase the documentation requirements already existing within 
GAAP. Failure to maintain, analyze, or support an adequate ALLL in 
accordance with GAAP and supervisory guidance is generally an unsafe 
and unsound banking practice.
    This guidance applies equally to all institutions, regardless of 
the size. Because of their less complex lending activities and 
products, smaller institutions may find it more efficient to combine 
a number of procedures (e.g., information gathering, documentation, 
and internal approval processes) while continuing to ensure the 
institution has a consistent and appropriate methodology. Thus, much 
of the documentation that a larger institution might retain in 
support of the allowance may be combined into fewer supporting 
documents in a smaller institution. For example, simplified 
documentation can include spreadsheets, check lists, and other 
summary documents that many institutions currently use. 
Illustrations A and C provide specific examples of how smaller 
institutions may determine and document portions of their loan loss 
allowance.

Documentation Standards

    Appropriate written supporting documentation facilitates review 
of the ALLL process and reported amounts, builds discipline into the 
ALLL determination process, and improves the process for estimating 
loan and lease losses by helping to ensure that all relevant factors 
are appropriately considered in the ALLL analysis. An institution 
should document the relationship between the findings of its 
detailed review of the loan portfolio and the amount of the ALLL and 
the provision for loan and lease losses reported in each period.\9\
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    \9\ This position is fully described for public companies in the 
Securities and Exchange Commission's (SEC) Financial Reporting 
Release No. 28 (FRR 28), in which the SEC indicates that the books 
and records of public companies engaged in lending activities should 
include documentation of the rationale supporting each period's 
determination that the ALLL and provision amounts reported were 
adequate.
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    At a minimum, institutions should maintain written supporting 
documentation for the following decisions, strategies, and 
processes:
    (1) Policies and procedures:
    (a) Over the systems and controls that maintain an appropriate 
ALLL and
    (b) Over the ALLL methodology,
    (2) Loan grading system or process,
    (3) Summary or ``roll-up'' of the ALLL balance,
    (4) Validation of the ALLL methodology, and
    (5) Justification for periodic adjustments to the ALLL process.
    The following sections of this Policy Statement provide guidance 
on significant aspects of ALLL methodologies and documentation 
practices. Specifically, the paper provides guidance on:
    (1) Policies and Procedures,
    (2) Methodology,
    (3) ALLL Under Financial Accounting Standards Board (FASB) 
Statement of Financial Accounting Standards No. 114, Accounting by 
Creditors for Impairment of a Loan (FAS 114),
    (4) ALLL Under FASB Statement of Financial Accounting Standards 
No. 5, Accounting for Contingencies (FAS 5),
    (5) Consolidating the Loss Estimates, and
    (6) Validating the ALLL Methodology.

Policies and Procedures

    Financial institutions utilize a wide range of policies, 
procedures, and control systems in their ALLL process. Sound 
policies should be appropriately tailored to the size and complexity 
of the institution and its loan portfolio.
    An institution's written policies and procedures for the systems 
and controls that maintain an appropriate ALLL should address but 
not be limited to:
    (1) The roles and responsibilities of the institution's 
departments and personnel (including the lending function, credit 
review, financial reporting, internal audit, senior management, 
audit committee, board of directors, and others, as applicable) who 
determine the ALLL to be reported in the financial statements;
    (2) The institution's accounting policies for loans and loan 
losses, including the policies for charge-offs and recoveries and 
for estimating the fair value of collateral, where applicable;
    (3) The description of the institution's systematic methodology, 
which should be consistent with the institution's accounting 
policies for determining its ALLL; \10\ and
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    \10\ Further explanation is presented in the Methodology section 
that appears below.
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    (4) The system of internal controls used to ensure that the ALLL 
process is maintained in accordance with GAAP and supervisory 
guidance.
    An internal control system for the ALLL estimation process 
should:
    (1) Include measures to ensure the reliability and integrity of 
information and compliance with laws, regulations, and internal 
policies and procedures;
    (2) Ensure that the institution's financial statements 
(including regulatory reports) are prepared in accordance with GAAP 
and ALLL supervisory guidance; \11\ and
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    \11\ 11 In addition to the supporting documentation requirements 
for financial institutions, as described in interagency asset 
quality guidelines, public companies are required to comply with the 
books and records provisions of the Securities Exchange Act of 1934 
(Exchange Act). Under Sections 13(b)(2)-(7) of the Exchange Act, 
registrants must make and keep books, records, and accounts, which, 
in reasonable detail, accurately and fairly reflect the transactions 
and dispositions of assets of the registrant. Registrants also must 
maintain internal accounting controls that are sufficient to provide 
reasonable assurances that, among other things, transactions are 
recorded as necessary to permit the preparation of financial 
statements in conformity with GAAP. See also SEC Staff Accounting 
Bulletin No. 99, Materiality.
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    (3) Include a well-defined loan review process containing:
    (a) An effective loan grading system that is consistently 
applied, identifies differing risk characteristics and loan quality 
problems accurately and in a timely manner, and prompts appropriate 
administrative actions;
    (b) Sufficient internal controls to ensure that all relevant 
loan review information is

[[Page 54271]]

appropriately considered in estimating losses. This includes 
maintaining appropriate reports, details of reviews performed, and 
identification of personnel involved; and
    (c) Clear formal communication and coordination between an 
institution's credit administration function, financial reporting 
group, management, board of directors, and others who are involved 
in the ALLL determination process (e.g., written policies and 
procedures, management reports, audit programs, and committee 
minutes).

Methodology

    An ALLL methodology is a system that an institution designs and 
implements to reasonably estimate loan and lease losses as of the 
financial statement date. It is critical that ALLL methodologies 
incorporate management's current judgments about the credit quality 
of the loan portfolio through a disciplined and consistently applied 
process.
    An institution's ALLL methodology is influenced by institution-
specific factors, such as an institution's size, organizational 
structure, business environment and strategy, management style, loan 
portfolio characteristics, loan administration procedures, and 
management information systems. However, there are certain common 
elements an institution should incorporate in its ALLL methodology. 
A summary of common elements is provided in Appendix B.\12\
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    \12\ Also, refer to paragraph 7.05 of the American Institute of 
Certified Public Accountants' (AICPA) Audit and Accounting Guide, 
Banks and Savings Institutions, 1999 edition (AICPA Audit Guide).
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Documentation of ALLL Methodology in Written Policies and 
Procedures

    An institution's formal policies and procedures should describe 
the primary elements of the institution's ALLL methodology. Such 
elements would include portfolio segmentation, impairment 
measurement, and loss rate determination. Specifically, written 
policies and procedures should describe the methodology:
    (1) For segmenting the portfolio:
    (a) How the segmentation process is performed (i.e., by loan 
type, industry, risk rates, etc.),
    (b) When a loan grading system is used to segment the portfolio:
    (i) The definitions of each loan grade,
    (ii) A reconciliation of the internal loan grades to supervisory 
loan grades, and
    (iii) The delineation of responsibilities for the loan grading 
system.
    (2) For determining and measuring impairment under FAS 114:
    (a) The methods used to identify loans to be analyzed 
individually;
    (b) For individually reviewed loans that are impaired, how the 
amount of any impairment is determined and measured, including:
    (i) Procedures describing the impairment measurement techniques 
available and
    (ii) Steps performed to determine which technique is most 
appropriate in a given situation.
    (c) The methods used to determine whether and how loans 
individually evaluated under FAS 114, but not considered to be 
individually impaired, should be grouped with other loans that share 
common characteristics for impairment evaluation under FAS 5.
    (3) For determining and measuring impairment by applying loss 
rates to loan balances under FAS 5:
    (a) How loans with similar characteristics are grouped to be 
evaluated for loan collectibility (such as loan type, past-due 
status, and risk);
    (b) How historical loss rates are determined and what factors 
are considered when establishing appropriate time frames over which 
to evaluate loss experience; and
    (c) Descriptions of qualitative factors (e.g., changes in 
economic conditions) that may affect loss rates or other loss 
measurements.
    The supporting documents for the ALLL may be integrated in an 
institution's credit files, loan review reports or worksheets, board 
of directors' and committee meeting minutes, computer reports, or 
other appropriate documents and files.

ALLL Under FAS 114

    An institution's ALLL methodology related to FAS 114 loans 
begins with the use of its normal loan review procedures to identify 
whether a loan is impaired as defined by the accounting standard. 
Institutions should document:
    (1) The method and process for identifying loans to be evaluated 
under FAS 114 and
    (2) The analysis that resulted in an impairment decision for 
each loan and the determination of the impairment measurement method 
to be used (i.e., present value of expected future cash flows, fair 
value of collateral less costs to sell, or the loan's observable 
market price).
    Once an institution has determined which of the three available 
measurement methods to use for an impaired loan under FAS 114, it 
should maintain supporting documentation as follows:
    (1) When using the present value of expected future cash flows 
method:
    (a) The amount and timing of cash flows,
    (b) The effective interest rate used to discount the cash flows, 
and
    (c) The basis for the determination of cash flows, including 
consideration of current environmental factors and other information 
reflecting past events and current conditions.
    (2) When using the fair value of collateral method:
    (a) How fair value was determined, including the use of 
appraisals, valuation assumptions, and calculations,
    (b) The supporting rationale for adjustments to appraised 
values, if any,
    (c) The determination of costs to sell, if applicable, and
    (d) Appraisal quality and expertise of the appraiser.
    (3) When using the observable market price of a loan method:
    (a) The amount, source, and date of the observable market price.
    Illustration A describes a practice used by a small financial 
institution to document its FAS 114 measurement of impairment using 
a comprehensive worksheet.\13\ Q&A #1 and #2 in Appendix A provide 
examples of applying and documenting impairment measurement methods 
under FAS 114.
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    \13\ The referenced ``gray box'' illustrations are presented to 
assist institutions in evaluating how to implement the guidance 
provided in this document. The methods described in the 
illustrations may not be suitable for all institutions and are not 
considered required processes or actions. For additional 
descriptions of key aspects of ALLL guidance, a series of ALLL 
Questions and Answers (Q&As) are included in Appendix A of this 
paper.
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    Begin Text Box--Illustration A (Documenting an ALLL Under FAS 
114, Comprehensive worksheet for the impairment measurement 
process): A small institution utilizes a comprehensive worksheet for 
each loan being reviewed individually under FAS 114. Each worksheet 
includes a description of why the loan was selected for individual 
review, the impairment measurement technique used, the measurement 
calculation, a comparison to the current loan balance, and the 
amount of the ALLL for that loan. The rationale for the impairment 
measurement technique used (e.g., present value of expected future 
cash flows, observable market price of the loan, fair value of the 
collateral) is also described on the worksheet. End Text Box
    Some loans that are evaluated individually for impairment under 
FAS 114 may be fully collateralized and therefore require no ALLL. 
Q&A #3 in Appendix A presents an example of an institution whose 
loan portfolio includes fully collateralized loans and describes the 
documentation maintained to support the conclusion that no ALLL was 
needed for those loans.

ALLL Under FAS 5

Segmenting the Portfolio

    For loans evaluated on a group basis under FAS 5, management 
should segment the loan portfolio by identifying risk 
characteristics that are common to groups of loans. Institutions 
decide how to segment their loan portfolios based on many factors, 
which vary with their business strategies as well as their 
information system capabilities. Smaller institutions that are 
involved in less complex activities often segment the portfolio into 
broad loan categories. This method of segmenting the portfolio is 
likely to be appropriate in only the smallest of institutions 
offering a narrow range of loan products. Larger institutions 
typically offer a more diverse and complex mix of loan products. 
Such institutions may start by segmenting the portfolio into major 
loan types but typically have more detailed information available 
that allows them to further segregate the portfolio into product 
line segments based on the risk characteristics of each portfolio 
segment. Regardless of the method used, documentation should be 
maintained to support that the loans in each segment have similar 
attributes or characteristics.
    As economic and other business conditions change, institutions 
often modify their business strategies, which may result in 
adjustments to the way in which they segment their loan portfolio 
for purposes of estimating loan losses. Illustration B presents an 
example in which an institution refined its segmentation method to 
more effectively

[[Page 54272]]

consider risk factors and maintains documentation to support this 
change.
    Begin Text Box--Illustration B (Documenting Segmenting 
Practices, Documenting a refinement in a segmentation method): An 
institution with a significant portfolio of consumer loans performed 
a review of its ALLL methodology. The institution had determined its 
ALLL based upon historical loss rates in the overall consumer 
portfolio. The ALLL methodology was validated by comparing actual 
loss rates (charge-offs) for the past two years to the estimated 
loss rates. During this process, the institution decided to evaluate 
loss rates on an individual product basis (e.g., auto loans, 
unsecured loans, or home equity loans). This analysis disclosed 
significant differences in the loss rates on different products. 
With this additional information, the methodology was amended in the 
current period to segment the portfolio by product, resulting in a 
better estimation of the loan losses associated with the portfolio. 
To support this change in segmentation practice, the credit review 
committee records contain the analysis that was used as a basis for 
the change and the written report describing the need for the 
change. End Text Box
    Institutions use a variety of documents to support the 
segmentation of their portfolios. Some of these documents include:
    (1) Loan trial balances by categories and types of loans,
    (2) Management reports about the mix of loans in the portfolio,
    (3) Delinquency and nonaccrual reports, and
    (4) A summary presentation of the results of an internal or 
external loan grading review.
    Reports generated to assess the profitability of a loan product 
line may be useful in identifying areas in which to further segment 
the portfolio.

Estimating Loss on Groups of Loans

    Based on the segmentation of the portfolio, an institution 
estimates the loan and lease losses to determine the appropriate 
level of the FAS 5 portion of the ALLL.\14\ For those segments that 
require an ALLL, the institution estimates the loan and lease 
losses, on at least a quarterly basis, based upon its ongoing loan 
review process and analysis of loan performance. The institution 
should follow a systematic and consistently applied approach to 
select the most appropriate loss measurement methods and support its 
conclusions and rationale with written documentation. Regardless of 
the method used to determine loss rates, an institution should 
demonstrate and document that the loss rates used to estimate the 
ALLL for each segment are determined in accordance with GAAP as of 
the financial statement date.\15\
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    \14\ An example of a loan segment that does not generally 
require an ALLL includes loans that are fully secured by deposits 
maintained at the lending institution.
    \15\ Refer to paragraph 8(b) of FAS 5. Also, the AICPA is 
currently developing a Statement of Position that will provide more 
specific guidance on accounting for loan losses.
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    One method of estimating loan losses for groups of loans is 
through the application of loss rates to the groups' aggregate loan 
balances. Such loss rates typically reflect historical loan loss 
experience for each group of loans, adjusted for relevant 
environmental factors (e.g., industry, geographical, economic, and 
political factors) over a defined period of time. If an institution 
does not have loss experience of its own, it may be appropriate to 
reference the loss experience of other institutions, provided that 
the institution demonstrates that the attributes of the loans in its 
portfolio segment are similar to those of the loans included in the 
portfolio of the institution providing the loss experience.\16\ 
Institutions should maintain supporting documentation for the 
technique used to develop their loss rates, including the period of 
time over which the losses were incurred. Institutions that 
determine losses based upon a range of loss should maintain 
documentation to support the identified range of loss and the 
rationale used for determining which estimate is the best estimate 
within the range of loan losses. An example of how a small 
institution performs a comprehensive historical loss analysis is 
provided as the first item in Illustration C.
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    \16\ Refer to paragraph 23 of FAS 5.
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    Begin Text Box--Illustration C (Documenting Setting Loss Rates, 
First Illustration, Comprehensive historical loss analysis in a 
small institution): A small institution determines its historical 
loss rates based on annual loss rates over a three-year historical 
period. The analysis is conducted by type of loan and is further 
segmented by originating branch office. The analysis considers 
charge-offs and recoveries in determining the loss rate. The 
institution also considers the loss rates for each loan grade and 
compares them to historical losses on similarly rated loans in 
arriving at the historical loss factor. The institution maintains 
supporting documentation for its loss factor analysis, including 
historical losses by type of loan, originating branch office, and 
loan grade for the three-year period.
    (Second Illustration, Adjustment of historical rates for changes 
in local economic conditions): An institution develops a factor to 
adjust historical loss rates for its assessment of the impact of 
changes in the local economy. For example, when analyzing the loss 
rate on commercial real estate loans, the assessment identifies 
changes in recent commercial building occupancy rates. The 
institution generally finds the occupancy statistics to be a good 
indicator of probable losses on these types of loans. The 
institution maintains documentation that summarizes the relationship 
between current occupancy rates and its loss experience. End Text 
Box 
    Before employing a loss estimation model, an institution should 
evaluate and modify, as needed, the model's assumptions to ensure 
that the resulting loss estimate is consistent with GAAP. 
Institutions that use loss estimation models typically document the 
evaluation, the conclusions regarding the appropriateness of 
estimating loan losses with a model or other loss estimation tool, 
and the support for adjustments to the model or its results.
    To adjust historical loss rates for current conditions, 
institutions should consider environmental factors and then document 
which factors were used in the analysis. Factors that should be 
considered in adjusting historical loss rates include the following: 
\17\
---------------------------------------------------------------------------

    \17\ Refer to paragraph 7.13 in the AICPA Audit Guide.
---------------------------------------------------------------------------

    (1) Levels of and trends in delinquencies and impaired loans;
    (2) Levels of and trends in charge-offs and recoveries;
    (3) Trends in volume and terms of loans;
    (4) Effects of any changes in risk selection and underwriting 
standards, and other changes in lending policies, procedures, and 
practices;
    (5) Experience, ability, and depth of lending management and 
other relevant staff;
    (6) National and local economic trends and conditions, and 
industry conditions; and
    (7) Effects of changes in credit concentrations.
    For any adjustment of historical loss rates, the institution 
should document that the adjustment is necessary to reflect current 
information, events, circumstances, and conditions in the loss 
rates. The second item in Illustration C provides an example of how 
an institution adjusts its commercial real estate historical loss 
rates for changes in local economic conditions. Q&A #4 in Appendix A 
provides an example of maintaining supporting documentation for 
adjustments to portfolio segment loss rates for an environmental 
factor related to an economic downturn in the borrower's primary 
industry. Q&A #5 in Appendix A describes one institution's process 
for determining and documenting an ALLL for loans that are not 
individually impaired but have characteristics indicating there are 
loan losses on a group basis.

Consolidating the Loss Estimates

    To verify that ALLL balances are presented fairly in accordance 
with GAAP and are auditable, management should prepare a document 
that summarizes the amount to be reported in the financial 
statements for the ALLL. The board of directors should review and 
approve this summary.
    Common elements in such summaries include:
    (1) An estimate of the probable loss or range of loss incurred 
for each category evaluated (e.g., individually evaluated impaired 
loans, homogeneous pools, and other groups of loans that are 
collectively evaluated for impairment);
    (2) The aggregate probable loss estimated using the 
institution's methodology;
    (3) A summary of the current ALLL balance;
    (4) The amount, if any, by which the ALLL is to be adjusted; 
\18\ and
---------------------------------------------------------------------------

    \18\ Subsequent to adjustments, there should be no material 
differences between the consolidated loss estimate, as determined by 
the methodology, and the final ALLL balance reported in the 
financial statements.
---------------------------------------------------------------------------

    (5) Depending on the level of detail that supports the ALLL 
analysis, detailed subschedules of loss estimates that reconcile to 
the summary schedule.

[[Page 54273]]

    Illustration D describes how institutions may document their 
estimated ALLL by adding comprehensive explanations to their summary 
schedules.
    Begin Text Box--Illustration D (Consolidating Estimates, 
Descriptive comments added to the consolidated ALLL summary 
schedule): To simplify the supporting documentation process and to 
eliminate redundancy, some institutions include detailed supporting 
information on their summary schedules. For example, in the summary 
schedule that presents FAS 114 allowances, some institutions 
describe their policy for selecting loans for evaluation under FAS 
114. Institutions identify which FAS 114 impairment measurement 
method was used for each individually reviewed impaired loan. Other 
items include brief descriptions of loss factors for particular 
segments of the loan portfolio, the basis for adjustments to loss 
rates, and explanations of changes in ALLL amounts from period to 
period. End Text Box
    Generally, an institution's review and approval process for the 
ALLL relies upon the data provided in these consolidated summaries. 
There may be instances in which individuals or committees that 
review the ALLL methodology and resulting allowance balance identify 
adjustments that need to be made to the loss estimates to provide a 
better estimate of loan losses. These changes may be due to 
information not known at the time of the initial loss estimate 
(e.g., information that surfaces after determining and adjusting, as 
necessary, historical loss rates, or a recent decline in the 
marketability of property after conducting a FAS 114 valuation based 
upon the fair value of collateral). It is important that these 
adjustments are consistent with GAAP and are reviewed and approved 
by appropriate personnel. Additionally, the summary should provide 
each subsequent reviewer with an understanding of the support behind 
these adjustments. Therefore, management should document the nature 
of any adjustments and the underlying rationale for making the 
changes. This documentation should be provided to those making the 
final determination of the ALLL amount. Q&A #6 in Appendix A 
addresses the documentation of the final amount of the ALLL.

Validating the ALLL Methodology

    To verify that the ALLL methodology is effective and conforms to 
GAAP and supervisory guidance, an institution's directors should 
establish internal control procedures, appropriate for the size and 
complexity of the institution. These procedures should include an 
independent review of the methodology and its application.
    In practice, financial institutions employ numerous procedures 
when validating the reasonableness of their ALLL methodology and 
determining whether there may be deficiencies in their overall 
methodology or loan grading process. Examples are:
    (1) A review of trends in loan volume, delinquencies, 
restructurings, and concentrations.
    (2) A review of previous charge-off and recovery history, 
including an evaluation of the timeliness of the entries to record 
both the charge-offs and the recoveries.
    (3) A review by an independent party, such as an independent 
loan review committee, external auditors, or internal audit staff. 
This often involves the independent party reviewing, on a test 
basis, source documents and underlying assumptions to determine that 
the established methodology develops reasonable loss estimates.
    (4) An evaluation of the appraisal process of the underlying 
collateral. This may be accomplished by periodically comparing the 
appraised value to the actual sales price on selected properties 
sold.

Supporting Documentation for the Validation Process

    Management usually supports the validation process with the 
workpapers from the review of the ALLL function. Additional 
documentation often includes the summary findings of the independent 
third party reviewer. The institution's board of directors, or its 
designee, reviews the findings and acknowledges its review in its 
meeting minutes. If the methodology is changed based upon the 
findings of the validation process, documentation that describes and 
supports the changes should be maintained.

Appendix A.--ALLL Questions and Answers

Q&A #1--ALLL Under FAS 114--Measuring and Documenting Impairment

    Facts: Approximately one-third of Institution A's commercial 
loan portfolio consists of large balance, non-homogeneous loans. Due 
to their large individual balances, these loans meet the criteria 
under Institution A's policies and procedures for individual review 
for impairment under FAS 114. Upon review of the large balance 
loans, Institution A determines that certain of the loans are 
impaired as defined by FAS 114.
    Question: For the commercial loans reviewed under FAS 114 that 
are individually impaired, how should Institution A measure and 
document the impairment on those loans? Can it use an impairment 
measurement method other than the methods allowed by FAS 114?
    Interpretive Response: For those loans that are reviewed 
individually under FAS 114 and considered individually impaired, 
Institution A must use one of the methods for measuring impairment 
that is specified by FAS 114 (that is, the present value of expected 
future cash flows, the loan's observable market price, or the fair 
value of collateral). Accordingly, in the circumstances described 
above, for the loans considered individually impaired under FAS 114, 
it would not be appropriate for Institution A to choose a 
measurement method not prescribed by FAS 114. For example, it would 
not be appropriate to measure loan impairment by applying a loss 
rate to each loan based on the average historical loss percentage 
for all of its commercial loans for the past five years.
    Institution A should maintain written documentation to support 
its measurement of loan impairment under FAS 114. If it uses the 
present value of expected future cash flows to measure impairment of 
a loan, it should document the amount and timing of cash flows, the 
effective interest rate used to discount the cash flows, and the 
basis for the determination of cash flows, including consideration 
of current environmental factors and other information reflecting 
past events and current conditions. When using the fair value of 
collateral to measure impairment, Institution A should document how 
it determined the fair value, including the use of appraisals, 
valuation assumptions and calculations, the supporting rationale for 
adjustments to appraised values, if any, and the determination of 
costs to sell, if applicable. Similarly, Institution A should 
document the amount, source, and date of the observable market price 
of a loan, if that method of measuring loan impairment is used.

Q&A #2--ALLL Under FAS 114--Measuring Impairment for a Collateral 
Dependent Loan

    Facts: Institution B has a $10 million loan outstanding to 
Company X that is secured by real estate, which Institution B 
individually evaluates under FAS 114 due to the loan's size. Company 
X is delinquent in its loan payments under the terms of the loan 
agreement. Accordingly, Institution B determines that its loan to 
Company X is impaired, as defined by FAS 114. Because the loan is 
collateral dependent, Institution B measures impairment of the loan 
based on the fair value of the collateral. Institution B determines 
that the most recent valuation of the collateral was performed by an 
appraiser eighteen months ago and, at that time, the estimated value 
of the collateral (fair value less costs to sell) was $12 million.
    Institution B believes that many of the assumptions that were 
used to value the collateral eighteen months ago do not reflect 
current market conditions and, therefore, the appraiser's valuation 
does not approximate current fair value of the collateral. Several 
buildings, which are comparable to the real estate collateral, were 
recently completed in the area, increasing vacancy rates, decreasing 
lease rates, and attracting several tenants away from the borrower. 
Accordingly, credit review personnel at Institution B adjust certain 
of the valuation assumptions to better reflect the current market 
conditions as they relate to the loan's collateral. After adjusting 
the collateral valuation assumptions, the credit review department 
determines that the current estimated fair value of the collateral, 
less costs to sell, is $8 million. Given that the recorded 
investment in the loan is $10 million, Institution B concludes that 
the loan is impaired by $2 million and records an allowance for loan 
losses of $2 million.
    Question: What type of documentation should Institution B 
maintain to support its determination of the allowance for loan 
losses of $2 million for the loan to Company X?
    Interpretive Response: Institution B should document that it 
measured impairment of the loan to Company X by using the fair value 
of the loan's collateral, less costs to sell, which it estimated to 
be $8 million. This documentation should include the institution's 
rationale and basis for the $8 million valuation, including the 
revised valuation assumptions it used, the valuation calculation, 
and the determination of costs to sell, if applicable. Because 
Institution B

[[Page 54274]]

arrived at the valuation of $8 million by modifying an earlier 
appraisal, it should document its rationale and basis for the 
changes it made to the valuation assumptions that resulted in the 
collateral value declining from $12 million eighteen months ago to 
$8 million in the current period.\19\
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    \19\ In accordance with the FFIEC's Federal Register Notice, 
Implementation Issues Arising from FASB No. 114, ``Accounting by 
Creditors for Impairment of a Loan,'' published February 10, 1995 
(60 FR 7966, February 10, 1995), impaired, collateral-dependent 
loans must be reported at the fair value of collateral, less costs 
to sell, in regulatory reports. This treatment is to be applied to 
all collateral-dependent loans, regardless of type of collateral.
---------------------------------------------------------------------------

Q&A #3--ALLL Under FAS 114--Fully Collateralized Loans

    Facts: Institution C has $10 million in loans that are fully 
collateralized by highly rated debt securities with readily 
determinable market values. The loan agreement for each of these 
loans requires the borrower to provide qualifying collateral 
sufficient to maintain a loan-to-value ratio with sufficient margin 
to absorb volatility in the securities' market prices. Institution 
C's collateral department has physical control of the debt 
securities through safekeeping arrangements. In addition, 
Institution C perfected its security interest in the collateral when 
the funds were originally distributed. On a quarterly basis, 
Institution C's credit administration function determines the market 
value of the collateral for each loan using two independent market 
quotes and compares the collateral value to the loan carrying value. 
If there are any collateral deficiencies, Institution C notifies the 
borrower and requests that the borrower immediately remedy the 
deficiency. Due in part to its efficient operation, Institution C 
has historically not incurred any material losses on these loans. 
Institution C believes these loans are fully-collateralized and 
therefore does not maintain any ALLL balance for these loans.
    Question: What documentation does Institution C maintain to 
adequately support its determination that no allowance is needed for 
this group of loans?
    Interpretive Response: Institution C's management summary of the 
ALLL includes documentation indicating that, in accordance with the 
institution's ALLL policy, the collateral protection on these loans 
has been verified by the institution, no probable loss has been 
incurred, and no ALLL is necessary. Documentation in Institution C's 
loan files includes the two independent market quotes obtained each 
quarter for each loan's collateral amount, the documents evidencing 
the perfection of the security interest in the collateral, and other 
relevant supporting documents. Additionally, Institution C's ALLL 
policy includes a discussion of how to determine when a loan is 
considered ``fully collateralized'' and does not require an ALLL. 
The policy requires the following factors, at a minimum, to be 
considered and the institution's findings concerning these factors 
to be fully documented:
    (1) Volatility of the market value of the collateral
    (2) Recency and reliability of the appraisal or other valuation
    (3) Recency of the bank or other third party inspection of the 
collateral
    (4) Historical losses on similar loans
    (5) Confidence in the bank's lien or security position including 
appropriate:
    (a) Type of security perfection (e.g., physical possession of 
collateral or secured filing)
    (b) Filing of security perfection (i.e., correct documents and 
with the appropriate officials), and
    (c) Relationship to other liens.

Q&A #4--ALLL Under FAS 5--Adjusting Loss Rates

    Facts: Institution D's lending area includes a metropolitan area 
that is financially dependent upon the profitability of a number of 
manufacturing businesses. These businesses use highly specialized 
equipment and significant quantities of rare metals in the 
manufacturing process. Due to increased low-cost foreign 
competition, several of the parts suppliers servicing these 
manufacturing firms declared bankruptcy. The foreign suppliers have 
subsequently increased prices and the manufacturing firms have 
suffered from increased equipment maintenance costs and smaller 
profit margins. Additionally, the cost of the rare metals used in 
the manufacturing process increased and has now stabilized at double 
last year's price. Due to these events, the manufacturing businesses 
are experiencing financial difficulties and have recently announced 
downsizing plans.
    Although Institution D has yet to confirm an increase in its 
loss experience as a result of these events, management knows that 
the institution lends to a significant number of businesses and 
individuals whose repayment ability depends upon the long-term 
viability of the manufacturing businesses. Institution D's 
management has identified particular segments of its commercial and 
consumer customer bases that include borrowers highly dependent upon 
sales or salary from the manufacturing businesses. Institution D's 
management performs an analysis of the affected portfolio segments 
to adjust its historical loss rates used to determine the ALLL.
    Question: How should Institution D document its support for the 
loss rate adjustments that result from considering these 
manufacturing firms' financial downturns?
    Interpretive Response: Institution D should document its 
identification of the particular segments of its commercial and 
consumer loan portfolio for which it is probable that the 
manufacturing business' financial downturn has resulted in loan 
losses. In addition, Institution D should document its analysis that 
resulted in the adjustments to the loss rates for the affected 
portfolio segments. As part of its documentation, Institution D 
maintains copies of the documents supporting the analysis, including 
relevant newspaper articles, economic reports, and economic data.
    Because Institution D has had similar situations in the past, 
its supporting documentation also includes an analysis of how the 
current situation compares to the institution's previous loss 
experiences in similar circumstances. A summary of the amount and 
rationale for the adjustment factor is presented to the audit 
committee and board for their review and approval prior to the 
issuance of the financial statements.

Q&A #5--ALLL Under FAS 5--Estimating Losses on Loans Individually 
Reviewed for Impairment but Not Considered Individually Impaired

    Facts: Institution E has outstanding loans of $2 million to 
Company Y and $1 million to Company Z, both of which are paying as 
agreed upon in the loan documents. The institution's ALLL policy 
specifies that all loans greater than $750,000 must be individually 
reviewed for impairment under FAS 114. Company Y's financial 
statements reflect a strong net worth, good profits, and ongoing 
ability to meet debt service requirements. In contrast, recent 
information indicates Company Z's profitability is declining and its 
cash flow is tight. Accordingly, this loan is rated substandard 
under the institution's loan grading system. Despite its concern, 
management believes Company Z will resolve its problems and 
determines that neither loan is individually impaired as defined by 
FAS 114.
    Institution E segments its loan portfolio to estimate loan 
losses under FAS 5. Two of its loan portfolio segments are Segment 1 
and Segment 2. The loan to Company Y has risk characteristics 
similar to the loans included in Segment 1 and the loan to Company Z 
has risk characteristics similar to the loans included in Segment 
2.\20\
---------------------------------------------------------------------------

    \20\ These groups of loans do not include any loans that have 
been individually reviewed for impairment under FAS 114 and 
determined to be impaired as defined by FAS 114.
---------------------------------------------------------------------------

    Question: How does Institution E adequately support and document 
an ALLL under FAS 5 for these loans that were individually reviewed 
for impairment but are not considered individually impaired?
    Interpretive Response: In its determination of the ALLL under 
FAS 5, Institution E includes its loans to Company Y and Company Z 
in the groups of loans with similar characteristics (i.e., Segment 1 
for Company Y's loan and Segment 2 for Company Z's loan). 
Management's analyses of Segment 1 and Segment 2 indicates that it 
is probable that each segment includes some losses, even though the 
losses cannot be identified to one or more specific loans. 
Management estimates that the use of its historical loss rates for 
these two segments, with adjustments for changes in environmental 
factors, such as current local economic conditions, provides a 
reasonable estimate of the institution's probable loan losses in 
these segments.
    Institution E documents its decision to include its loans to 
Company Y and Company Z in its determination of its ALLL under FAS 
5. It also documents the specific characteristics of the loans that 
were the basis for grouping these loans with other loans in Segment 
1 and Segment 2, respectively. Institution E maintains documentation 
to support its method of estimating loan losses for Segment 1 and

[[Page 54275]]

Segment 2, including the average loss rate used, the analysis of 
historical losses by loan type and by internal risk rating, and 
support for any adjustments to its historical loss rates. The 
institution also maintains copies of the economic and other reports 
that provided source data.

Q&A #6--Consolidating the Loss Estimates--Documenting the Reported ALLL

    Facts: Institution F determines its ALLL using an established 
systematic process. The accounting department prepares supporting 
schedules that include the amount of each of the components of the 
ALLL, as well as the total ALLL amount, for review by senior 
management and the Credit Committee. Members of senior management 
and the Credit Committee meet to discuss the ALLL. During these 
discussions, they identify changes to be made to certain of the ALLL 
estimates. As a result of the adjustments made by management, the 
total amount of the ALLL changes. The supporting schedules are not 
updated to reflect the adjustments made by senior management and the 
Credit Committee. When performing their audit of the financial 
statements, the independent accountants are provided with the 
original ALLL supporting schedules that were reviewed by management 
and the Credit Committee, as well as a verbal explanation of the 
changes made by management and the Credit Committee when they met to 
discuss the loan loss allowance.
    Question: Are Institution F's documentation practices related to 
the balance of its loan loss allowance appropriate?
    Interpretive Response: No. An institution must maintain 
supporting documentation for the loan loss allowance amount reported 
in its financial statements. An institution should document not only 
the determination of the ALLL using its methodology, but also any 
subsequent adjustments to the amount of the ALLL and the rationale 
for those adjustments, such as adjustments made by management or 
board committees as in the circumstances described above.

Appendix B--Application of GAAP

    An ALLL recorded pursuant to GAAP is an institution's best 
estimate of the probable amount of loans and lease-financing 
receivables that it will be unable to collect based on current 
information and events.\21\ A creditor should record an ALLL when 
the criteria for accrual of a loss contingency as set forth in GAAP 
have been met. Estimating the amount of an ALLL involves a high 
degree of management judgment and is inevitably imprecise. 
Accordingly, an institution may determine that the amount of loss 
falls within a range. An institution should record its best estimate 
within the range of loan losses.\22\
---------------------------------------------------------------------------

    \21\ This Appendix provides guidance on the ALLL and does not 
address allowances for credit losses for off-balance sheet 
instruments (e.g., loan commitments, guarantees, and standby letters 
of credit). Institutions should record liabilities for these 
exposures in accordance with GAAP. Further guidance on this topic is 
presented in the American Institute of Certified Public Accountants' 
Audit and Accounting Guide, Banks and Savings Institutions (AICPA 
Audit Guide). Additionally, this Appendix does not address 
allowances or accounting for assets or portions of assets sold with 
recourse, which is described in Statement of Financial Accounting 
Standards No. 125, Accounting for Transfers and Servicing of 
Financial Assets and Extinguishments of Liabilities (FAS 125).
    \22\ Refer to FASB Interpretation No. 14, Reasonable Estimation 
of the Amount of a Loss, and Emerging Issues Task Force Topick No. 
D-80, Application of FASB Statements No. 5 and No. 114 to a Loan 
Portfolio (EITF Topic D-80).
---------------------------------------------------------------------------

    Under GAAP, Statement of Financial Accounting Standards No. 5, 
Accounting for Contingencies (FAS 5), provides the basic guidance 
for recognition of a loss contingency, such as the collectibility of 
loans (receivables), when it is probable that a loss has been 
incurred and the amount can be reasonably estimated. Statement of 
Financial Accounting Standards No. 114, Accounting by Creditors for 
Impairment of a Loan (FAS 114) provides more specific guidance about 
the measurement and disclosure of impairment for certain types of 
loans.\23\ Specifically, FAS 114 applies to loans that are 
identified for evaluation on an individual basis. Loans are 
considered impaired when, based on current information and events, 
it is probable that the creditor will be unable to collect all 
interest and principal payments due according to the contractual 
terms of the loan agreement.
---------------------------------------------------------------------------

    \23\ EITF Topic D-80 includes additional guidance on the 
requirements of FAS 5 and FAS 114 and how they relate to each other. 
The AICPA is currently developing a Statement of Position (SOP) that 
will provide more specific guidance on accounting for loan losses.
---------------------------------------------------------------------------

    For individually impaired loans, FAS 114 provides guidance on 
the acceptable methods to measure impairment. Specifically, FAS 114 
states that when a loan is impaired, a creditor should measure 
impairment based on the present value of expected future principal 
and interest cash flows discounted at the loan's effective interest 
rate, except that as a practical expedient, a creditor may measure 
impairment based on a loan's observable market price or the fair 
value of collateral, if the loan is collateral dependent. When 
developing the estimate of expected future cash flows for a loan, an 
institution should consider all available information reflecting 
past events and current conditions, including the effect of existing 
environmental factors. The following Illustration provides an 
example of an institution estimating a loan's impairment when the 
loan has been partially charged-off.
    Begin Text Box--Illustration (Interaction of FAS 114 With an 
Adversely Classified Loan, Partial Charge-Off, and the Overall 
ALLL): An institution determined that a collateral dependent loan, 
which it identified for evaluation, was impaired. In accordance with 
FAS 114, the institution established an ALLL for the amount that the 
recorded investment in the loan exceeded the fair value of the 
underlying collateral, less costs to sell. Consistent with relevant 
regulatory guidance, the institution classified a portion of the 
recorded investment as ``Loss'' and the remaining recorded 
investment as ``Substandard.'' For this loan, the amount classified 
``Loss,'' which was deemed to be the confirmed loss, was less than 
the impairment amount (as determined under FAS 114). The institution 
charged off the ``Loss'' portion of the loan. After the charge-off, 
the portion of the ALLL related to this ``Substandard'' loan (1) 
reflects an appropriate measure of impairment under FAS 114, and (2) 
is included in the aggregate FAS 114 ALLL for all loans that were 
identified for evaluation and individually considered impaired. The 
aggregate FAS 114 ALLL is included in the institution's overall 
ALLL. End Text Box
    Large groups of smaller-balance homogeneous loans that are 
collectively evaluated for impairment are not included in the scope 
of FAS 114.\24\ Such groups of loans may include, but are not 
limited to, credit card, residential mortgage, and consumer 
installment loans. FAS 5 addresses the accounting for impairment of 
these loans. Also, FAS 5 provides the accounting guidance for 
impairment of loans that are not identified for evaluation on an 
individual basis and loans that are individually evaluated but are 
not individually considered impaired.
---------------------------------------------------------------------------

    \24\ In addition, FAS 114 does not apply to loans measured at 
fair value or at the lower of cost or fair value, leases, or debt 
securities.
---------------------------------------------------------------------------

    Institutions should ensure that they do not layer their loan 
loss allowances. Layering is the inappropriate practice of recording 
in the ALLL more than one amount for the same probable loan loss. 
Layering can happen when an institution includes a loan in one 
segment, determines its best estimate of loss for that loan either 
individually or on a group basis (after taking into account all 
appropriate environmental factors, conditions, and events), and then 
includes the loan in another group, which receives an additional 
ALLL amount.\25\
---------------------------------------------------------------------------

    \25\ According to the Federal Financial Institutions Examination 
Council's Federal Register Notice, Implementation Issues Arising 
from FASB Statement No. 114, Accounting by Creditors for Impairment 
of a Loan, published February 10, 1995, institution-specific issues 
should be reviewed when estimating loan losses under FAS 114. This 
analysis should be conducted as part of the evaluation of each 
individual loan reviewed under FAS 114 to avoid potential ALLL 
layering.
---------------------------------------------------------------------------

    There are certain common elements an institution should 
incorporate in its loan loss allowance methodology. Generally, an 
institution's methodology should: \26\
---------------------------------------------------------------------------

    \26\ Refer to paragraph 7.05 of the AICPA Audit Guide.
---------------------------------------------------------------------------

    (1) Include a detailed analysis of the loan portfolio, performed 
on a regular basis;
    (2) Consider all loans (whether on an individual or group 
basis);
    (3) Identify loans to be evaluated for impairment on an 
individual basis under FAS 114 and segment the remainder of the 
portfolio into groups of loans with similar risk characteristics for 
evaluation and analysis under FAS 5;
    (4) Consider all known relevant internal and external factors 
that may affect loan collectibility;
    (5) Be applied consistently but, when appropriate, be modified 
for new factors affecting collectibility;
    (6) Consider the particular risks inherent in different kinds of 
lending;

[[Page 54276]]

    (7) Consider collateral values (less costs to sell), where 
applicable;
    (8) Require that analyses, estimates, reviews and other ALLL 
methodology functions be performed by competent and well-trained 
personnel;
    (9) Be based on current and reliable data;
    (10) Be well documented with clear explanations of the 
supporting analyses and rationale; and
    (11) Include a systematic and logical method to consolidate the 
loss estimates and ensure the ALLL balance is recorded in accordance 
with GAAP.
    A systematic methodology that is properly designed and 
implemented should result in an institution's best estimate of the 
ALLL. Accordingly, institutions should adjust their ALLL balance, 
either upward or downward, in each period for material differences 
between the results of the systematic determination process and the 
unadjusted ALLL balance in the general ledger.\27\
---------------------------------------------------------------------------

    \27\ Institutions should refer to the guidance on materiality in 
SEC Staff Accounting Bulletin No. 99, Materiality.
---------------------------------------------------------------------------

Bibliography

GAAP and Auditing Guidance

American Institute of Certified Public Accountants' Audit and 
Accounting Guide, Banks and Savings Institutions, 1999 edition
Auditing Standards Board Statement on Auditing Standards No. 61, 
Communication With Audit Committees (AICPA, Professional Standards, 
vol. 1, AU sec. 380)
Emerging Issues Task Force Topic No. D-80, Application of FASB 
Statements No. 5 and No. 114 to a Loan Portfolio (EITF Topic D-80 
and attachments), discussed on May 19-20, 1999
Financial Accounting Standards Board Interpretation No. 14, 
Reasonable Estimation of the Amount of a Loss (An Interpretation of 
FASB Statement No. 5)
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 5, Accounting for Contingencies
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 114, Accounting by Creditors for Impairment 
of A Loan (An Amendment of FASB Statements No. 5 and 15)
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 118, Accounting by Creditors for Impairment 
of a Loan--Income Recognition and Disclosures (An Amendment of FASB 
Statement No. 114)
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 125, Accounting for Transfers and Servicing 
of Financial Assets and Extinguishments of Liabilities

Regulatory Guidance

Federal Deposit Insurance Act, Section 39, Standards for Safety and 
Soundness (12 U.S.C. 1831p-1)
Federal Financial Institutions Examination Council's Instructions 
for Preparation of Consolidated Reports of Condition and Income
Interagency Guidelines Establishing Standards for Safety and 
Soundness, established in 1995 and 1996, as amended on October 15, 
1998
Interagency Policy Statement on the Allowance for Loan and Lease 
Losses (ALLL), December 21, 1993
Joint Interagency Statement (regarding the ALLL), November 24, 1998
Joint Interagency Letter to Financial Institutions (regarding the 
ALLL), March 10, 1999
Joint Interagency Letter to Financial Institutions (regarding the 
ALLL), July 12, 1999
Securities and Exchange Commission Financial Reporting Release No. 
28, Accounting for Loan Losses by Registrants Engaged in Lending 
Activities, December 1, 1986
Securities and Exchange Commission Securities Act Industry Guide 3, 
Statistical Disclosure by Bank Holding Companies
Securities and Exchange Commission Staff Accounting Bulletin No. 99, 
Materiality, August 1999
Securities Exchange Act of 1934, Section 13(b)(2)-(7) (15 U.S.C. 
78m(b)(2)-(7))
United States General Accounting Office Report to Congressional 
Committees, Depository Institutions: Divergent Loan Loss Methods 
Undermine Usefulness of Financial Reports, (GAO/AIMD-95-8), October 
1994

    Dated: August 30, 2000.
Joanne M. Giese,
Assistant Executive Secretary, Federal Financial Institutions 
Examination Council.

[FR Doc. 00-22719 Filed 9-6-00; 8:45 am]
BILLING CODE 6210-01-P (25%), 6714-01-P (25%) 6720-01-P (25%), 4810-33-
P (25%)