[Federal Register Volume 66, Number 130 (Friday, July 6, 2001)]
[Notices]
[Pages 35629-35639]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-16973]


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FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL


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

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

ACTION: Notice of final interagency policy statement.

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

EFFECTIVE DATE: The Policy Statement is effective immediately.

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

[[Page 35630]]


SUPPLEMENTARY INFORMATION:   

I. Background

    On March 10, 1999, the Federal Deposit Insurance Corporation, the 
Federal Reserve Board, the Office of the Comptroller of the Currency, 
the Office of Thrift Supervision, and the Securities and Exchange 
Commission (together, the Agencies) issued a joint letter to financial 
institutions on the allowance for loan and lease losses (the Joint 
Letter). In the Joint Letter, the Agencies agreed to establish a Joint 
Working Group to study ALLL issues and to assist financial institutions 
by providing them with improved guidance on this topic. The Agencies 
agreed that the Joint Working Group would develop and issue parallel 
guidance for two key areas regarding the ALLL:
     Appropriate methodologies and supporting documentation, 
and
     Enhanced disclosures.
    This Policy Statement represents the banking agencies' guidance to 
banks and savings institutions relating to methodologies and supporting 
documentation for the ALLL. The Securities and Exchange Commission 
staff has issued parallel guidance on this topic for public companies 
in Staff Accounting Bulletin No. 102.\1\
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    \1\ In addition, the American Institute of Certified Public 
Accountants (AICPA) is developing guidance on the accounting for 
loan losses and the techniques for measuring probable incurred 
losses in a loan portfolio.
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    This Policy Statement clarifies the banking agencies' expectations 
regarding methodologies and documentation support for the ALLL. For 
financial reporting purposes, including regulatory reporting, the 
provision for loan and lease losses and the ALLL must be determined in 
accordance with generally accepted accounting principles (GAAP). GAAP 
requires that an institution maintain written documentation to support 
the amounts of the ALLL and the provision for loan and lease losses 
reported in the financial statements.
    The Policy Statement does not change existing accounting guidance 
in, or modify the documentation requirements of, GAAP or guidance 
provided in the relevant joint interagency statements issued by the 
Agencies. It is intended to supplement, not replace, the guidance the 
banking agencies provided in their Interagency Policy Statement on the 
Allowance for Loan and Lease Losses, which was issued in December 1993. 
It is also intended to supplement guidance the banking agencies 
provided in their interagency guidelines establishing standards for 
safety and soundness that were issued in 1995 and 1996 pursuant to 
section 39 of the Federal Deposit Insurance Act (FDI Act).\2\ Under the 
guidelines for asset quality, each institution should estimate and 
establish a sufficient ALLL supported by adequate documentation. This 
Policy Statement does not address or change current guidance regarding 
loan charge-offs; therefore, institutions should continue to follow 
existing regulatory guidance that addresses the timing of charge-offs.
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    \2\ Institutions should refer to the guidelines adopted by their 
primary federal regulator as follows: For national banks, Appendix A 
to Part 30; for state member banks, Appendix D to Part 208; for 
state nonmember banks, Appendix A to Part 364; for savings 
associations, Appendix A to Part 570.
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    The guidance in this Policy Statement recognizes that institutions 
should adopt methodologies and documentation practices that are 
appropriate for their size and complexity. For institutions with fewer 
and less complex loan products, the amount of supporting documentation 
for the ALLL may be less exhaustive than for institutions with more 
complex loan products or portfolios.
    Recognizing that a primary mission of the banking agencies is to 
support a safe and sound banking system, examiners will continue to 
evaluate the overall adequacy of the ALLL, including the adequacy of 
supporting documentation, to ensure that it is appropriate. While the 
Policy Statement generally does not provide guidance to examiners in 
conducting safety and soundness examinations, examiners may criticize 
institutions that fail to document and maintain an adequate ALLL in 
accordance with this Policy Statement and other banking agency 
guidance. In such cases, institution management may be cited for 
engaging in unsafe and unsound banking practices and may be subject to 
further supervisory action.

II. The Proposed Policy Statement

    The FFIEC sought public comment on a proposed policy statement on 
ALLL methodologies and documentation practices for banks and savings 
institutions on September 7, 2000 (65 FR 54268). The proposal indicated 
that the purpose of the policy statement was to provide financial 
institutions with enhanced guidance on appropriate ALLL methodologies 
and documentation practices.
    The proposed Policy Statement explained that the board of directors 
of each institution is responsible for ensuring that controls are in 
place to determine the appropriate level of the ALLL. It also 
emphasized the banking agencies' long-standing position that 
institutions should maintain and support the ALLL with documentation 
that is consistent with their stated policies and procedures, GAAP, and 
applicable supervisory guidance.
    The proposal described significant aspects of ALLL methodologies 
and documentation practices. Specifically, the proposal provided 
guidance on maintaining and documenting policies and procedures that 
are appropriately tailored to the size and complexity of the 
institution and its loan portfolio. The proposal stated that an 
institution's ALLL methodology must be a thorough, disciplined, and 
consistently applied process that incorporates management's current 
judgments about the credit quality of the loan portfolio.
    The proposal also discussed the methodology and documentation 
needed to support ALLL estimates prepared in accordance with GAAP, 
which requires loss estimates based upon reviews of individual loans 
and groups of loans. The proposal stated that after determining the 
allowance on individually reviewed loans and groups of loans, 
management should consolidate those loss estimates and summarize the 
amount to be reported in the financial statements for the ALLL. To 
verify that the ALLL methodology is appropriate and conforms to GAAP 
and supervisory guidance, a party who is independent from the ALLL 
estimation process should review the methodology and its application in 
a manner appropriate to the size and complexity of the institution.
    The proposal included illustrations of implementation practices 
that institutions may find useful for enhancing their own ALLL 
practices; an appendix that provided examples of certain key aspects of 
ALLL guidance; a summary of applicable GAAP guidance; and a 
bibliographical list of relevant GAAP guidance, joint interagency 
statements, and other literature on ALLL issues.

III. Discussion of Public Comments

A. General Comments

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

[[Page 35631]]

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

B. Changes to the Proposal in Response to Comments

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

IV. Paperwork Reduction Act

    In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
chapter 35), the banking agencies have reviewed the Policy Statement 
and

[[Page 35632]]

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

V. Policy Statement

    The text of the Policy Statement follows:

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

July 2, 2001.
    Boards of directors of banks and savings institutions are 
responsible for ensuring that their institutions have controls in place 
to consistently determine the allowance for loan and lease losses 
(ALLL) in accordance with the institutions' stated policies and 
procedures, generally accepted accounting principles (GAAP), and ALLL 
supervisory guidance.\1\ To fulfill this responsibility, boards of 
directors instruct management to develop and maintain an appropriate, 
systematic, and consistently applied process to determine the amounts 
of the ALLL and provisions for loan losses. Management should create 
and implement suitable policies and procedures to communicate the ALLL 
process internally to all applicable personnel. Regardless of who 
develops and implements these policies, procedures, and underlying 
controls, the board of directors should assure themselves that the 
policies specifically address the institution's unique goals, systems, 
risk profile, personnel, and other resources before approving them. 
Additionally, by creating an environment that encourages personnel to 
follow these policies and procedures, management improves procedural 
discipline and compliance.
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    \1\ A bibliography is attached that lists applicable ALLL GAAP 
guidance, interagency statements, and other reference materials that 
may assist in understanding and implementing an ALLL in accordance 
with GAAP. See Appendix B for additional information on applying 
GAAP to determine the ALLL.
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    The determination of the amounts of the ALLL and provisions for 
loan and lease losses should be based on management's current judgments 
about the credit quality of the loan portfolio, and should consider all 
known relevant internal and external factors that affect loan 
collectibility as of the reporting date. The amounts reported each 
period for the provision for loan and lease losses and the ALLL should 
be reviewed and approved by the board of directors. To ensure the 
methodology remains appropriate for the institution, the board of 
directors should have the methodology periodically validated and, if 
appropriate, revised. Further, the audit committee\2\ should oversee 
and monitor the internal controls over the ALLL determination 
process.\3\
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    \2\ All institutions are encouraged to establish audit 
committees; however, at small institutions without audit committees, 
the board of directors retains this responsibility.
    \3\ Institutions and their auditors should refer to Statement on 
Auditing Standards No. 61, Communication With Audit Committees (as 
amended by Statement on Auditing Standards No. 90, Audit Committee 
Communications), which requires certain discussions between the 
auditor and the audit committee. These discussions should include 
items, such as accounting policies and estimates, judgments, and 
uncertainties that have a significant impact on the accounting 
information included in the financial statements.
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    The banking agencies'\4\ have long-standing examination policies 
that call for examiners to review an institution's lending and loan 
review functions and recommend improvements, if needed. Additionally, 
in 1995 and 1996, the banking agencies adopted interagency guidelines 
establishing standards for safety and soundness, pursuant to Section 39 
of the Federal Deposit Insurance Act (FDI Act).\5\ The interagency 
asset quality guidelines and the guidance in this paper assist an 
institution in estimating and establishing a sufficient ALLL supported 
by adequate documentation, as required under the FDI Act. Additionally, 
the guidelines require operational and managerial standards that are 
appropriate for an institution's size and the nature and scope of its 
activities.
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    \4\ The banking agencies are the Federal Deposit Insurance 
Corporation, the Federal Reserve Board, the Office of the 
Comptroller of the Currency, and the Office of Thrift Supervision.
    \5\ Institutions should refer to the guidelines adopted by their 
primary federal regulator as follows: For national banks, Appendix A 
to Part 30; for state member banks, Appendix D to Part 208; for 
state nonmember banks, Appendix A to Part 364; for savings 
associations, Appendix A to Part 570.
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    For financial reporting purposes, including regulatory reporting, 
the provision for loan and lease losses and the ALLL must be determined 
in accordance with GAAP. GAAP requires that allowances be well 
documented, with clear explanations of the supporting analyses and 
rationale.\6\ This Policy Statement describes but does not increase the 
documentation requirements already existing within GAAP. Failure to 
maintain, analyze, or support an adequate ALLL in accordance with GAAP 
and supervisory guidance is generally an unsafe and unsound banking 
practice.\7\
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    \6\ The documentation guidance within this Policy Statement is 
predominantly based upon the GAAP guidance from Financial Accounting 
Standards Board (FASB) Statement Numbers 5 and 114 (FAS 5 and FAS 
114, respectively); Emerging Issues Task Force Topic No. D-80 (EITF 
Topic D-80 and attachments), Application of FASB Statements No. 5 
and No. 114 to a Loan Portfolio (which includes the Viewpoints 
Article--an article issued in 1999 by FASB staff providing guidance 
on certain issues regarding the ALLL, particularly on the 
application of FAS 5 and FAS 114 and how these statements 
interrelate), Chapter 7--Credit Losses, the American Institute of 
Certified Public Accountants' (AICPA) Audit and Accounting Guide, 
Banks and Savings Institutions--2000 edition (AICPA Audit Guide); 
and the Securities and Exchange Commission's (SEC) Financial 
Reporting Release No. 28 (FRR 28).
    \7\ Failure to maintain adequate supporting documentation does 
not relieve an institution of its obligation to record an 
appropriate ALLL.
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    This guidance applies equally to all institutions, regardless of 
the size. However, institutions with less complex lending activities 
and products may find it more efficient to combine a number of 
procedures (e.g., information gathering, documentation, and internal 
approval processes) while continuing to ensure the institution has a 
consistent and appropriate methodology. Thus, much of the supporting 
documentation required for an institution with more complex products or 
portfolios may be combined into fewer supporting documents in an 
institution with less complex products or portfolios. For example, 
simplified documentation can include spreadsheets, check lists, and 
other summary documents that many institutions currently use. 
Illustrations A and C provide specific examples of how less complex 
institutions may determine and document portions of their loan loss 
allowance.

Documentation Standards

    Appropriate written supporting documentation for the loan loss 
provision and allowance facilitates review of the ALLL process and 
reported amounts, builds discipline and consistency into the ALLL 
determination process, and improves the process for estimating loan and 
lease losses by helping to ensure that all relevant factors are 
appropriately considered in the ALLL analysis. An institution should 
document the relationship between the findings of its detailed review 
of the loan portfolio and the amount of the ALLL and the provision for 
loan and lease losses reported in each period.\8\
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    \8\ This position is fully described in the SEC's FRR 28, in 
which the SEC indicates that the books and records of public 
companies engaged in lending activities should include documentation 
of the rationale supporting each period's determination that the 
ALLL and provision amounts reported were adequate.
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    At a minimum, institutions should maintain written supporting 
documentation for the following decisions, strategies, and processes:
    (1) Policies and procedures:
    (a) Over the systems and controls that maintain an appropriate ALLL 
and

[[Page 35633]]

    (b) Over the ALLL methodology,
    (2) Loan grading system or process,
    (3) Summary or consolidation of the ALLL balance,
    (4) Validation of the ALLL methodology, and
    (5) Periodic adjustments to the ALLL process.
    The following sections of this Policy Statement provide guidance on 
significant aspects of ALLL methodologies and documentation practices. 
Specifically, the paper provides documentation guidance on:
    (1) Policies and Procedures,
    (2) Methodology,
    (3) ALLL Under FASB Statement of Financial Accounting Standards No. 
114, Accounting by Creditors for Impairment of a Loan (FAS 114),
    (4) ALLL Under FASB Statement of Financial Accounting Standards No. 
5, Accounting for Contingencies (FAS 5),
    (5) Consolidating the Loss Estimates, and
    (6) Validating the ALLL Methodology.

Policies and Procedures

    Financial institutions utilize a wide range of policies, 
procedures, and control systems in their ALLL process. Sound policies 
should be appropriately tailored to the size and complexity of the 
institution and its loan portfolio.
    In order for an institution's ALLL methodology to be effective, the 
institution's written policies and procedures for the systems and 
controls that maintain an appropriate ALLL should address but not be 
limited to:
    (1) The roles and responsibilities of the institution's departments 
and personnel (including the lending function, credit review, financial 
reporting, internal audit, senior management, audit committee, board of 
directors, and others, as applicable) who determine, or review, as 
applicable, the ALLL to be reported in the financial statements;
    (2) The institution's accounting policies for loans and loan 
losses, including the policies for charge-offs and recoveries and for 
estimating the fair value of collateral, where applicable;
    (3) The description of the institution's systematic methodology, 
which should be consistent with the institution's accounting policies 
for determining its ALLL;\9\ and
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    \9\ Further explanation is presented in the Methodology section 
that appears below.
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    (4) The system of internal controls used to ensure that the ALLL 
process is maintained in accordance with GAAP and supervisory guidance.
    An internal control system for the ALLL estimation process should:
    (1) Include measures to provide assurance regarding the reliability 
and integrity of information and compliance with laws, regulations, and 
internal policies and procedures;
    (2) Reasonably assure that the institution's financial statements 
(including regulatory reports) are prepared in accordance with GAAP and 
ALLL supervisory guidance;\10\ and
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    \10\ In addition to the supporting documentation requirements 
for financial institutions, as described in interagency asset 
quality guidelines, public companies are required to comply with the 
books and records provisions of the Securities Exchange Act of 1934 
(Exchange Act). Under Sections 13(b)(2)-(7) of the Exchange Act, 
registrants must make and keep books, records, and accounts, which, 
in reasonable detail, accurately and fairly reflect the transactions 
and dispositions of assets of the registrant. Registrants also must 
maintain internal accounting controls that are sufficient to provide 
reasonable assurances that, among other things, transactions are 
recorded as necessary to permit the preparation of financial 
statements in conformity with GAAP. See also SEC Staff Accounting 
Bulletin No. 99, Materiality.
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    (3) Include a well-defined loan review process containing:
    (a) An effective loan grading system that is consistently applied, 
identifies differing risk characteristics and loan quality problems 
accurately and in a timely manner, and prompts appropriate 
administrative actions;
    (b) Sufficient internal controls to ensure that all relevant loan 
review information is appropriately considered in estimating losses. 
This includes maintaining appropriate reports, details of reviews 
performed, and identification of personnel involved; and
    (c) Clear formal communication and coordination between an 
institution's credit administration function, financial reporting 
group, management, board of directors, and others who are involved in 
the ALLL determination or review process, as applicable (e.g., written 
policies and procedures, management reports, audit programs, and 
committee minutes).

Methodology

    An ALLL methodology is a system that an institution designs and 
implements to reasonably estimate loan and lease losses as of the 
financial statement date. It is critical that ALLL methodologies 
incorporate management's current judgments about the credit quality of 
the loan portfolio through a disciplined and consistently applied 
process.
    An institution's ALLL methodology is influenced by institution-
specific factors, such as an institution's size, organizational 
structure, business environment and strategy, management style, loan 
portfolio characteristics, loan administration procedures, and 
management information systems. However, there are certain common 
elements an institution should incorporate in its ALLL methodology. A 
summary of common elements is provided in Appendix B.\11\
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    \11\ Also, refer to paragraph 7.05 of the AICPA Audit Guide.
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Documentation of ALLL Methodology in Written Policies and Procedures

    An institution's written policies and procedures should describe 
the primary elements of the institution's ALLL methodology, including 
portfolio segmentation and impairment measurement. In order for an 
institution's ALLL methodology to be effective, the institution's 
written policies and procedures should describe the methodology:
    (1) For segmenting the portfolio:
    (a) How the segmentation process is performed (i.e., by loan type, 
industry, risk rates, etc.),
    (b) When a loan grading system is used to segment the portfolio:
    (i) The definitions of each loan grade,
    (ii) A reconciliation of the internal loan grades to supervisory 
loan grades, and
    (iii) The delineation of responsibilities for the loan grading 
system.
    (2) For determining and measuring impairment under FAS 114:
    (a) The methods used to identify loans to be analyzed individually;
    (b) For individually reviewed loans that are impaired, how the 
amount of any impairment is determined and measured, including:
    (i) Procedures describing the impairment measurement techniques 
available and
    (ii) Steps performed to determine which technique is most 
appropriate in a given situation.
    (c) The methods used to determine whether and how loans 
individually evaluated under FAS 114, but not considered to be 
individually impaired, should be grouped with other loans that share 
common characteristics for impairment evaluation under FAS 5.
    (3) For determining and measuring impairment under FAS 5:
    (a) How loans with similar characteristics are grouped to be 
evaluated for loan collectibility (such as loan type, past-due status, 
and risk);
    (b) How loss rates are determined (e.g., historical loss rates 
adjusted for environmental factors or migration analysis) and what 
factors are considered when establishing appropriate time frames over 
which to evaluate loss experience; and

[[Page 35634]]

    (c) Descriptions of qualitative factors (e.g., industry, 
geographical, economic, and political factors) that may affect loss 
rates or other loss measurements.
    The supporting documents for the ALLL may be integrated in an 
institution's credit files, loan review reports or worksheets, board of 
directors' and committee meeting minutes, computer reports, or other 
appropriate documents and files.

ALLL Under FAS 114

    An institution's ALLL methodology related to FAS 114 loans begins 
with the use of its normal loan review procedures to identify whether a 
loan is impaired as defined by the accounting standard. Institutions 
should document:
    (1) The method and process for identifying loans to be evaluated 
under FAS 114 and
    (2) The analysis that resulted in an impairment decision for each 
loan and the determination of the impairment measurement method to be 
used (i.e., present value of expected future cash flows, fair value of 
collateral less costs to sell, or the loan's observable market price).
    Once an institution has determined which of the three available 
measurement methods to use for an impaired loan under FAS 114, it 
should maintain supporting documentation as follows:
    (1) When using the present value of expected future cash flows 
method:
    (a) The amount and timing of cash flows,
    (b) The effective interest rate used to discount the cash flows, 
and
    (c) The basis for the determination of cash flows, including 
consideration of current environmental factors and other information 
reflecting past events and current conditions.
    (2) When using the fair value of collateral method:
    (a) How fair value was determined, including the use of appraisals, 
valuation assumptions, and calculations,
    (b) The supporting rationale for adjustments to appraised values, 
if any,
    (c) The determination of costs to sell, if applicable, and
    (d) Appraisal quality, and the expertise and independence of the 
appraiser.
    (3) When using the observable market price of a loan method:
    (a) The amount, source, and date of the observable market price.
    Illustration A describes a practice used by a small financial 
institution to document its FAS 114 measurement of impairment using a 
comprehensive worksheet.\12\ Q&A #1 and #2 in Appendix A provide 
examples of applying and documenting impairment measurement methods 
under FAS 114.
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    \12\ The referenced ``gray box'' illustrations are presented to 
assist institutions in evaluating how to implement the guidance 
provided in this document. The methods described in the 
illustrations may not be suitable for all institutions and are not 
considered required processes or actions. For additional 
descriptions of key aspects of ALLL guidance, a series of ALLL 
Questions and Answers (Q&As) are included in Appendix A of this 
paper.

    Begin Text Box--Illustration A (Documenting an ALLL Under FAS 
114, Comprehensive worksheet for the impairment measurement 
process): A small institution utilizes a comprehensive worksheet for 
each loan being reviewed individually under FAS 114. Each worksheet 
includes a description of why the loan was selected for individual 
review, the impairment measurement technique used, the measurement 
calculation, a comparison to the current loan balance, and the 
amount of the ALLL for that loan. The rationale for the impairment 
measurement technique used (e.g., present value of expected future 
cash flows, observable market price of the loan, fair value of the 
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collateral) is also described on the worksheet. End Text Box

    Some loans that are evaluated individually for impairment under FAS 
114 may be fully collateralized and therefore require no ALLL. Q&A #3 
in Appendix A presents an example of an institution whose loan 
portfolio includes fully collateralized loans and describes the 
documentation maintained by that institution to support its conclusion 
that no ALLL was needed for those loans.

ALLL Under FAS 5

Segmenting the Portfolio

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

    Begin Text Box--Illustration B (Documenting Segmenting 
Practices, Documenting a refinement in a segmentation method): An 
institution with a significant portfolio of consumer loans performed 
a review of its ALLL methodology. The institution had determined its 
ALLL based upon historical loss rates in the overall consumer 
portfolio. The ALLL methodology was validated by comparing actual 
loss rates (charge-offs) for the past two years to the estimated 
loss rates. During this process, the institution decided to evaluate 
loss rates on an individual product basis (e.g., auto loans, 
unsecured loans, or home equity loans). This analysis disclosed 
significant differences in the loss rates on different products. 
With this additional information, the methodology was amended in the 
current period to segment the portfolio by product, resulting in a 
better estimation of the loan losses associated with the portfolio. 
To support this change in segmentation practice, the credit review 
committee records contain the analysis that was used as a basis for 
the change and the written report describing the need for the change 
End Text Box.

    Institutions use a variety of documents to support the segmentation 
of their portfolios. Some of these documents include:
    (1) Loan trial balances by categories and types of loans,
    (2) Management reports about the mix of loans in the portfolio,
    (3) Delinquency and nonaccrual reports, and
    (4) A summary presentation of the results of an internal or 
external loan grading review.
    Reports generated to assess the profitability of a loan product 
line may be useful in identifying areas in which to further segment the 
portfolio.

Estimating Loss on Groups of Loans

    Based on the segmentation of the loan portfolio, an institution 
should estimate the FAS 5 portion of its ALLL. For those segments that 
require an ALLL,\13\ the

[[Page 35635]]

institution should estimate the loan and lease losses, on at least a 
quarterly basis, based upon its ongoing loan review process and 
analysis of loan performance. The institution should follow a 
systematic and consistently applied approach to select the most 
appropriate loss measurement methods and support its conclusions and 
rationale with written documentation. Regardless of the methods used to 
measure losses, an institution should demonstrate and document that the 
loss measurement methods used to estimate the ALLL for each segment are 
determined in accordance with GAAP as of the financial statement 
date.\14\
---------------------------------------------------------------------------

    \13\ An example of a loan segment that does not generally 
require an ALLL is loans that are fully secured by deposits 
maintained at the lending institution.
    \14\ Refer to paragraph 8(b) of FAS 5. Also, the AICPA is 
currently developing a Statement of Position that will provide more 
specific guidance on accounting for loan losses.
---------------------------------------------------------------------------

    One method of estimating loan losses for groups of loans is through 
the application of loss rates to the groups' aggregate loan balances. 
Such loss rates typically reflect the institution's historical loan 
loss experience for each group of loans, adjusted for relevant 
environmental factors (e.g., industry, geographical, economic, and 
political factors) over a defined period of time. If an institution 
does not have loss experience of its own, it may be appropriate to 
reference the loss experience of other institutions, provided that the 
institution demonstrates that the attributes of the loans in its 
portfolio segment are similar to those of the loans included in the 
portfolio of the institution providing the loss experience.\15\ 
Institutions should maintain supporting documentation for the technique 
used to develop their loss rates, including the period of time over 
which the losses were incurred. If a range of loss is determined, 
institutions should maintain documentation to support the identified 
range and the rationale used for determining which estimate is the best 
estimate within the range of loan losses. An example of how a small 
institution performs a comprehensive historical loss analysis is 
provided as the first item in Illustration C.
---------------------------------------------------------------------------

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

    Before employing a loss estimation model, an institution should 
evaluate and modify, as needed, the model's assumptions to ensure that 
the resulting loss estimate is consistent with GAAP. In order to 
demonstrate consistency with GAAP, institutions that use loss 
estimation models typically document the evaluation, the conclusions 
regarding the appropriateness of estimating loan losses with a model or 
other loss estimation tool, and the support for adjustments to the 
model or its results.

    Begin Text Box--Illustration C (Documenting the Setting of Loss 
Rates, First Illustration, Comprehensive loss analysis in a small 
institution): A small institution determines its loss rates based on 
loss rates over a three-year historical period. The analysis is 
conducted by type of loan and is further segmented by originating 
branch office. The analysis considers charge-offs and recoveries in 
determining the loss rate. The institution also considers the loss 
rates for each loan grade and compares them to historical losses on 
similarly rated loans in arriving at the historical loss factor. The 
institution maintains supporting documentation for its loss factor 
analysis, including historical losses by type of loan, originating 
branch office, and loan grade for the three-year period.
    (Second Illustration, Adjustment of loss rates for changes in 
local economic conditions): An institution develops a factor to 
adjust loss rates for its assessment of the impact of changes in the 
local economy. For example, when analyzing the loss rate on 
commercial real estate loans, the assessment identifies changes in 
recent commercial building occupancy rates. The institution 
generally finds the occupancy statistics to be a good indicator of 
probable losses on these types of loans. The institution maintains 
documentation that summarizes the relationship between current 
occupancy rates and its loss experience. End Text Box

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

    \16\ Refer to paragraph 7.13 in the AICPA Audit Guide.
---------------------------------------------------------------------------

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

Consolidating the Loss Estimates

    To verify that ALLL balances are presented fairly in accordance 
with GAAP and are auditable, management should prepare a document that 
summarizes the amount to be reported in the financial statements for 
the ALLL. The board of directors should review and approve this 
summary.
    Common elements in such summaries include:
    (1) The estimate of the probable loss or range of loss incurred for 
each category evaluated (e.g., individually evaluated impaired loans, 
homogeneous pools, and other groups of loans that are collectively 
evaluated for impairment);
    (2) The aggregate probable loss estimated using the institution's 
methodology;
    (3) A summary of the current ALLL balance;
    (4) The amount, if any, by which the ALLL is to be adjusted;\17\ 
and
---------------------------------------------------------------------------

    \17\ Subsequent to adjustments, there should be no material 
differences between the consolidated loss estimate, as determined by 
the methodology, and the final ALLL balance reported in the 
financial statements.
---------------------------------------------------------------------------

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

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

[[Page 35636]]

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

    Generally, an institution's review and approval process for the 
ALLL relies upon the data provided in these consolidated summaries. 
There may be instances in which individuals or committees that review 
the ALLL methodology and resulting allowance balance identify 
adjustments that need to be made to the loss estimates to provide a 
better estimate of loan losses. These changes may be due to information 
not known at the time of the initial loss estimate (e.g., information 
that surfaces after determining and adjusting, as necessary, historical 
loss rates, or a recent decline in the marketability of property after 
conducting a FAS 114 valuation based upon the fair value of 
collateral). It is important that these adjustments are consistent with 
GAAP and are reviewed and approved by appropriate personnel. 
Additionally, the summary should provide each subsequent reviewer with 
an understanding of the support behind these adjustments. Therefore, 
management should document the nature of any adjustments and the 
underlying rationale for making the changes. This documentation should 
be provided to those making the final determination of the ALLL amount. 
Q&A #6 in Appendix A addresses the documentation of the final amount of 
the ALLL.

Validating the ALLL Methodology

    An institution's ALLL methodology is considered valid when it 
accurately estimates the amount of loss contained in the portfolio. 
Thus, the institution's methodology should include procedures that 
adjust loss estimation methods to reduce differences between estimated 
losses and actual subsequent charge-offs, as necessary.
    To verify that the ALLL methodology is valid and conforms to GAAP 
and supervisory guidance, an institution's directors should establish 
internal control policies, appropriate for the size of the institution 
and the type and complexity of its loan products. These policies should 
include procedures for a review, by a party who is independent of the 
ALLL estimation process, of the ALLL methodology and its application in 
order to confirm its effectiveness.
    In practice, financial institutions employ numerous procedures when 
validating the reasonableness of their ALLL methodology and determining 
whether there may be deficiencies in their overall methodology or loan 
grading process. Examples are:
    (1) A review of trends in loan volume, delinquencies, 
restructurings, and concentrations.
    (2) A review of previous charge-off and recovery history, including 
an evaluation of the timeliness of the entries to record both the 
charge-offs and the recoveries.
    (3) A review by a party that is independent of the ALLL estimation 
process. This often involves the independent party reviewing, on a test 
basis, source documents and underlying assumptions to determine that 
the established methodology develops reasonable loss estimates.
    (4) An evaluation of the appraisal process of the underlying 
collateral. This may be accomplished by periodically comparing the 
appraised value to the actual sales price on selected properties sold.

Supporting Documentation for the Validation Process

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

Appendix A--ALLL Questions and Answers

Introduction

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

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

    Facts: Approximately one-third of Institution A's commercial 
loan portfolio consists of large balance, non-homogeneous loans. Due 
to their large individual balances, these loans meet the criteria 
under Institution A's policies and procedures for individual review 
for impairment under FAS 114. Upon review of the large balance 
loans, Institution A determines that certain of the loans are 
impaired as defined by FAS 114.
    Question: For the commercial loans reviewed under FAS 114 that 
are individually impaired, how should Institution A measure and 
document the impairment on those loans? Can it use an impairment 
measurement method other than the methods allowed by FAS 114?
    Interpretive Response: For those loans that are reviewed 
individually under FAS 114 and considered individually impaired, 
Institution A must use one of the methods for measuring impairment 
that is specified by FAS 114 (that is, the present value of expected 
future cash flows, the loan's observable market price, or the fair 
value of collateral). Accordingly, in the circumstances described 
above, for the loans considered individually impaired under FAS 114, 
it would not be appropriate for Institution A to choose a 
measurement method not prescribed by FAS 114. For example, it would 
not be appropriate to measure loan impairment by applying a loss 
rate to each loan based on the average historical loss percentage 
for all of its commercial loans for the past five years.
    Institution A should maintain, as sufficient, objective 
evidence, written documentation to support its measurement of loan 
impairment under FAS 114. If Institution A uses the present value of 
expected future cash flows to measure impairment of a loan, it 
should document the amount and timing of cash flows, the effective 
interest rate used to discount the cash flows, and the basis for the 
determination of cash flows, including consideration of current 
environmental factor \1\ and other information reflecting past 
events and current conditions. If Institution A uses the fair value 
of collateral to measure impairment, it should document how it 
determined the fair value, including the use of appraisals, 
valuation assumptions and calculations, the supporting rationale for 
adjustments to appraised values, if any, and the determination of 
costs to sell, if applicable, appraisal quality, and the expertise 
and independence of the appraiser. Similarly, Institution A should 
document the amount, source, and date of the observable

[[Page 35637]]

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

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

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

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

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

    Question: What type of documentation should Institution B 
maintain to support its determination of the allowance for loan 
losses of $2 million for the loan to Company X?
    Interpretive Response: Institution B should document that it 
measured impairment of the loan to Company X by using the fair value 
of the loan's collateral, less costs to sell, which it estimated to 
be $8 million. This documentation should include the institution's 
rationale and basis for the $8 million valuation, including the 
revised valuation assumptions it used, the valuation calculation, 
and the determination of costs to sell, if applicable. Because 
Institution B arrived at the valuation of $8 million by modifying an 
earlier appraisal, it should document its rationale and basis for 
the changes it made to the valuation assumptions that resulted in 
the collateral value declining from $12 million eighteen months ago 
to $8 million in the current period.\3\
---------------------------------------------------------------------------

    \3\ In accordance with the FFIEC's Federal Register Notice, 
Implementation Issues Arising from FASB No. 114, ``Accounting by 
Creditors for Impairment of a Loan,'' published February 10, 1995 
(60 FR 7966, February 10, 1995), impaired, collateral-dependent 
loans must be reported at the fair value of collateral, less costs 
to sell, in regulatory reports. This treatment is to be applied to 
all collateral-dependent loans, regardless of type of collateral.
---------------------------------------------------------------------------

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

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

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

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

[[Page 35638]]

summary of the amount and rationale for the adjustment factor, which 
management presents to the audit committee and board for their 
review and approval prior to the issuance of the financial 
statements.

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

    Facts: Institution E has outstanding loans of $2 million to 
Company Y and $1 million to Company Z, both of which are paying as 
agreed upon in the loan documents. The institution's ALLL policy 
specifies that all loans greater than $750,000 must be individually 
reviewed for impairment under FAS 114. Company Y's financial 
statements reflect a strong net worth, good profits, and ongoing 
ability to meet debt service requirements. In contrast, recent 
information indicates Company Z's profitability is declining and its 
cash flow is tight. Accordingly, this loan is rated substandard 
under the institution's loan grading system. Despite its concern, 
management believes Company Z will resolve its problems and 
determines that neither loan is individually impaired as defined by 
FAS 114.
    Institution E segments its loan portfolio to estimate loan 
losses under FAS 5. Two of its loan portfolio segments are Segment 1 
and Segment 2. The loan to Company Y has risk characteristics 
similar to the loans included in Segment 1 and the loan to Company Z 
has risk characteristics similar to the loans included in Segment 
2.\4\
---------------------------------------------------------------------------

    \4\ These groups of loans do not include any loans that have 
been individually reviewed for impairment under FAS 114 and 
determined to be impaired as defined by FAS 114.
---------------------------------------------------------------------------

    In its determination of the ALLL under FAS 5, Institution E 
includes its loans to Company Y and Company Z in the groups of loans 
with similar characteristics (i.e., Segment 1 for Company Y's loan 
and Segment 2 for Company Z's loan). Management's analyses of 
Segment 1 and Segment 2 indicate that it is probable that each 
segment includes some losses, even though the losses cannot be 
identified to one or more specific loans. Management estimates that 
the use of its historical loss rates for these two segments, with 
adjustments for changes in environmental factors provides a 
reasonable estimate of the institution's probable loan losses in 
these segments.
    Question: How does Institution E adequately document an ALLL 
under FAS 5 for these loans that were individually reviewed for 
impairment but are not considered individually impaired?
    Interpretive Response: As part of Institution E's effective ALLL 
methodology, it documents the decision to include its loans to 
Company Y and Company Z in its determination of its ALLL under FAS 
5. It also documents the specific characteristics of the loans that 
were the basis for grouping these loans with other loans in Segment 
1 and Segment 2, respectively. Institution E maintains documentation 
to support its method of estimating loan losses for Segment 1 and 
Segment 2, including the average loss rate used, the analysis of 
historical losses by loan type and by internal risk rating, and 
support for any adjustments to its historical loss rates. The 
institution also maintains copies of the economic and other reports 
that provided source data.

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

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

Appendix B--Application of GAAP

    An ALLL recorded pursuant to GAAP is an institution's best 
estimate of the probable amount of loans and lease-financing 
receivables that it will be unable to collect based on current 
information and events.\1\ A creditor should record an ALLL when the 
criteria for accrual of a loss contingency as set forth in GAAP have 
been met. Estimating the amount of an ALLL involves a high degree of 
management judgment and is inevitably imprecise. Accordingly, an 
institution may determine that the amount of loss falls within a 
range. An institution should record its best estimate within the 
range of loan losses.\2\
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    \1\ This Appendix provides guidance on the ALLL and does not 
address allowances for credit losses for off-balance sheet 
instruments (e.g., loan commitments, guarantees, and standby letters 
of credit). Institutions should record liabilities for these 
exposures in accordance with GAAP. Further guidance on this topic is 
presented in the American Institute of Certified Public Accountants' 
Audit and Accounting Guide, Banks and Savings Institutions, 2000 
edition (AICPA Audit Guide). Additionally, this Appendix does not 
address allowances or accounting for assets or portions of assets 
sold with recourse, which is described in Statement of Financial 
Accounting Standards No. 140, Accounting for Transfers and Servicing 
of Financial Assets and Extinguishments of Liabilities--a 
Replacement of FASB Statement No. 125 (FAS 140).
    \2\ Refer to FASB Interpretation No. 14, Reasonable Estimation 
of the Amount of a Loss, and Emerging Issues Task Force Topic No. D-
80, Application of FASB Statements No. 5 and No. 114 to a Loan 
Portfolio (EITF Topic D-80).
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    Under GAAP, Statement of Financial Accounting Standards No. 5, 
Accounting for Contingencies (FAS 5), provides the basic guidance 
for recognition of a loss contingency, such as the collectibility of 
loans (receivables), when it is probable that a loss has been 
incurred and the amount can be reasonably estimated. Statement of 
Financial Accounting Standards No. 114, Accounting by Creditors for 
Impairment of a Loan (FAS 114) provides more specific guidance about 
the measurement and disclosure of impairment for certain types of 
loans.\3\ Specifically, FAS 114 applies to loans that are identified 
for evaluation on an individual basis. Loans are considered impaired 
when, based on current information and events, it is probable that 
the creditor will be unable to collect all interest and principal 
payments due according to the contractual terms of the loan 
agreement.
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    \3\ EITF Topic D-80 includes additional guidance on the 
requirements of FAS 5 and FAS 114 and how they relate to each other. 
The AICPA is currently developing a Statement of Position (SOP) that 
will provide more specific guidance on accounting for loan losses.
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    For individually impaired loans, FAS 114 provides guidance on 
the acceptable methods to measure impairment. Specifically, FAS 114 
states that when a loan is impaired, a creditor should measure 
impairment based on the present value of expected future principal 
and interest cash flows discounted at the loan's effective interest 
rate, except that as a practical expedient, a creditor may measure 
impairment based on a loan's observable market price or the fair 
value of collateral, if the loan is collateral dependent. When 
developing the estimate of expected future cash flows for a loan, an 
institution should consider all available information reflecting 
past events and current conditions, including the effect of existing 
environmental factors. The following Illustration provides an 
example of an institution estimating a loan's impairment when the 
loan has been partially charged-off.


[[Page 35639]]


    Begin Text Box--Illustration (Interaction of FAS 114 With an 
Adversely Classified Loan, Partial Charge-off, and the Overall 
ALLL): An institution determined that a collateral dependent loan, 
which it identified for evaluation, was impaired. In accordance with 
FAS 114, the institution established an ALLL for the amount that the 
recorded investment in the loan exceeded the fair value of the 
underlying collateral, less costs to sell. Consistent with relevant 
regulatory guidance, the institution classified as ``Loss,'' the 
portion of the recorded investment deemed to be the confirmed loss 
and classified the remaining recorded investment as ``Substandard.'' 
For this loan, the amount classified ``Loss'' was less than the 
impairment amount (as determined under FAS 114). The institution 
charged off the ``Loss'' portion of the loan. After the charge-off, 
the portion of the ALLL related to this ``Substandard'' loan (1) 
reflects an appropriate measure of impairment under FAS 114, and (2) 
is included in the aggregate FAS 114 ALLL for all loans that were 
identified for evaluation and individually considered impaired. The 
aggregate FAS 114 ALLL is included in the institution's overall 
ALLL. End Text Box

    Large groups of smaller-balance homogeneous loans that are 
collectively evaluated for impairment are not included in the scope 
of FAS 114.\4\ Such groups of loans may include, but are not limited 
to, credit card, residential mortgage, and consumer installment 
loans. FAS 5 addresses the accounting for impairment of these loans. 
Also, FAS 5 provides the accounting guidance for impairment of loans 
that are not identified for evaluation on an individual basis and 
loans that are individually evaluated but are not individually 
considered impaired.
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    \4\ In addition, FAS 114 does not apply to loans measured at 
fair value or at the lower of cost or fair value, leases, or debt 
securities.
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    Institutions should ensure that they do not layer their loan 
loss allowances. Layering is the inappropriate practice of recording 
in the ALLL more than one amount for the same probable loan loss. 
Layering can happen when an institution includes a loan in one 
segment, determines its best estimate of loss for that loan either 
individually or on a group basis (after taking into account all 
appropriate environmental factors, conditions, and events), and then 
includes the loan in another group, which receives an additional 
ALLL amount.\5\
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    \5\ According to the Federal Financial Institutions Examination 
Council's Federal Register Notice, Implementation Issues Arising 
from FASB Statement No. 114, Accounting by Creditors for Impairment 
of a Loan, published February 10, 1995, institution-specific issues 
should be reviewed when estimating loan losses under FAS 114. This 
analysis should be conducted as part of the evaluation of each 
individual loan reviewed under FAS 114 to avoid potential ALLL 
layering.
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    While different institutions may use different methods, there 
are certain common elements that should be included in any loan loss 
allowance methodology. Generally, an institution's methodology 
should:\6\
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    \6\ Refer to paragraph 7.05 of the AICPA Audit Guide.
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    (1) Include a detailed analysis of the loan portfolio, performed 
on a regular basis;
    (2) Consider all loans (whether on an individual or group 
basis);
    (3) Identify loans to be evaluated for impairment on an 
individual basis under FAS 114 and segment the remainder of the 
portfolio into groups of loans with similar risk characteristics for 
evaluation and analysis under FAS 5;
    (4) Consider all known relevant internal and external factors 
that may affect loan collectibility;
    (5) Be applied consistently but, when appropriate, be modified 
for new factors affecting collectibility;
    (6) Consider the particular risks inherent in different kinds of 
lending;
    (7) Consider current collateral values (less costs to sell), 
where applicable;
    (8) Require that analyses, estimates, reviews and other ALLL 
methodology functions be performed by competent and well-trained 
personnel;
    (9) Be based on current and reliable data;
    (10) Be well documented, in writing, with clear explanations of 
the supporting analyses and rationale; and
    (11) Include a systematic and logical method to consolidate the 
loss estimates and ensure the ALLL balance is recorded in accordance 
with GAAP.
    A systematic methodology that is properly designed and 
implemented should result in an institution's best estimate of the 
ALLL. Accordingly, institutions should adjust their ALLL balance, 
either upward or downward, in each period for differences between 
the results of the systematic determination process and the 
unadjusted ALLL balance in the general ledger.\7\
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    \7\ Institutions should refer to the guidance on materiality in 
SEC Staff Accounting Bulletin No. 99, Materiality.
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Bibliography

American Institute of Certified Public Accountants' Audit and 
Accounting Guide, Banks and Savings Institutions, 2000 edition
Auditing Standards Board Statement on Auditing Standards No. 61, 
Communication With Audit Committees (AICPA, Professional Standards, 
vol. 1, AU sec. 380)
Emerging Issues Task Force Topic No. D-80, Application of FASB 
Statements No. 5 and No. 114 to a Loan Portfolio (EITF Topic D-80 
and attachments), discussed on May 19-20, 1999
Financial Accounting Standards Board Interpretation No. 14, 
Reasonable Estimation of the Amount of a Loss (An Interpretation of 
FASB Statement No. 5)
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 5, Accounting for Contingencies
Federal Deposit Insurance Act, Section 39, Standards for Safety and 
Soundness (12 U.S.C. 1831p-1)
Federal Financial Institutions Examination Council's Instructions 
for Preparation of Consolidated Reports of Condition and Income
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 114, Accounting by Creditors for Impairment 
of A Loan (An Amendment of FASB Statements No. 5 and 15)
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 118, Accounting by Creditors for Impairment 
of a Loan--Income Recognition and Disclosures (An Amendment of FASB 
Statement No. 114)
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 140, Accounting for Transfers and Servicing 
of Financial Assets and Extinguishments of Liabilities--a 
Replacement of FASB Statement No. 125
Interagency Guidelines Establishing Standards for Safety and 
Soundness, established in 1995 and 1996, as amended on October 15, 
1998
Interagency Policy Statement on the Allowance for Loan and Lease 
Losses (ALLL), December 21, 1993
Joint Interagency Statement (regarding the ALLL), November 24, 1998
Joint Interagency Letter to Financial Institutions (regarding the 
ALLL), March 10, 1999
Joint Interagency Letter to Financial Institutions (regarding the 
ALLL), July 12, 1999
Securities and Exchange Commission Financial Reporting Release No. 
28, Accounting for Loan Losses by Registrants Engaged in Lending 
Activities, December 1, 1986
Securities and Exchange Commission Securities Act Industry Guide 3, 
Statistical Disclosure by Bank Holding Companies
Securities and Exchange Commission Staff Accounting Bulletin No. 99, 
Materiality, August 1999
Securities Exchange Act of 1934, Section 13(b)(2)-(7) (15 U.S.C. 
78m(b)(2)-(7))
United States General Accounting Office Report to Congressional 
Committees, Depository Institutions: Divergent Loan Loss Methods 
Undermine Usefulness of Financial Reports, (GAO/AIMD-95-8), October 
1994

    Dated: July 2, 2001.
Keith J. Todd,
Executive Secretary, Federal Financial Institutions Examination 
Council.
[FR Doc. 01-16973 Filed 7-5-01; 8:45 am]
BILLING CODES 6710-01-P; 6714-01-P; 6720-01-P; 4810-33-P