[Federal Register Volume 66, Number 134 (Thursday, July 12, 2001)]
[Rules and Regulations]
[Pages 36457-36465]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-17425]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 211

[Release No. SAB 102]


Staff Accounting Bulletin No. 102

AGENCY: Securities and Exchange Commission.

ACTION: Publication of staff accounting bulletin.

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SUMMARY: This staff accounting bulletin expresses certain of the 
staff's views on the development, documentation, and application of a 
systematic methodology as required by Financial Reporting Release No. 
28 for determining allowances for loan and lease losses in accordance 
with generally accepted accounting principles. In particular, the 
guidance focuses on the documentation the staff normally would expect 
registrants to prepare and maintain in support of their allowances for 
loan losses. The guidance in this staff accounting bulletin is being 
issued in light of the March 10, 1999 Joint Interagency Letter to 
Financial Institutions in which the staff agreed to provide, in 
parallel with guidance provided by the federal banking agencies, 
guidance on loan loss allowance methodologies and supporting 
documentation. On July 6, 2001, the federal banking agencies issued 
their guidance through the Federal Financial Institutions

[[Page 36458]]

Examination Council (FFIEC) as interagency guidance, ``Policy Statement 
on Allowance for Loan and Lease Losses Methodologies and Documentation 
for Banks and Savings Institutions.''

DATES: Effective July 6, 2001.

FOR FURTHER INFORMATION CONTACT: Jenifer Minke-Girard, Office of the 
Chief Accountant (202-942-4400), or Donald A.Walker, Jr., Division of 
Corporation Finance (202-942-1799), Securities and Exchange Commission, 
450 Fifth Street, NW., Washington, DC 20549; electronic addresses: 
[email protected]; [email protected].

SUPPLEMENTARY INFORMATION:

Background

    In December 1986, the Commission issued Financial Reporting Release 
No. 28, which added subsection (b), Procedural Discipline in 
Determining the Allowance and Provision for Loan Losses to be Reported, 
of Section 401.09, Accounting for Loan Losses by Registrants Engaged in 
Lending Activities, to the Codification of Financial Reporting Policies 
(hereafter referred to as FRR No. 28). In FRR No. 28, the Commission 
noted that certain registrants had appeared to lack adequate 
documentation of procedures for performing detailed reviews of loan 
portfolios and for determining amounts of allowances and provisions for 
loan losses. The Commission indicated that the staff normally would 
expect to find ``that the books and records of registrants engaged in 
lending activities include documentation of: (a) Systematic methodology 
to be employed each period in determining the amount of loan losses to 
be reported, and (b) rationale supporting each period's determination 
that the amounts reported were adequate.''
    Since the issuance of FRR No. 28, the Commission's staff has 
continued to observe, in some cases, insufficient documentation of 
allowances for loan losses. In the ordinary course of its reviews of 
filings, the staff asked a number of registrants why significant 
favorable or unfavorable trends in the quality of the loan portfolio, 
as evidenced by statistical data presented in Management's Discussion 
and Analysis and/or in the notes to the financial statements, did not 
correspond with decreases or increases in the allowance for loan losses 
reported in the financial statements. Explanations offered by some 
registrants have indicated a lack of reasoned analysis or discipline in 
the establishment of the loss allowance. Some registrants assured the 
staff that they had assessed significant loans individually for 
impairment, but could not produce documentation demonstrating how the 
loans were evaluated or how any loan impairment was measured. In other 
cases, registrants' internal documentation indicating that a particular 
loan was impaired could not be reconciled with management's ultimate 
decision not to provide for any loss on that loan. Several registrants 
that recorded loan loss allowances for pools of loans did not maintain 
documentation indicating how the amounts of the loan loss allowances 
were determined or how the amounts related to the composition of the 
loan pool at any particular balance sheet date.
    The staff's observations were similar to those of the General 
Accounting Office (GAO). In its October 1994 Report to Congressional 
Committees, Depository Institutions: Divergent Loan Loss Methods 
Undermine Usefulness of Financial Reports (GAO Report), the GAO 
reported its findings resulting from its review of the loan loss 
reserving practices of 12 depository institutions. One of the GAO's 
principal findings was that most of the reviewed institutions' loan 
loss allowances included large supplemental reserves that generally 
were not linked to an analysis of loss exposure or supported by 
evidence.\1\ The GAO noted: ``Such use of unjustified supplemental 
reserves can conceal critical changes in the quality of an 
institution's loan portfolio and undermine the credibility of financial 
reports.'' \2\
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    \1\ Page 5 of GAO Report.
    \2\ Ibid.
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    In recognition of these concerns, the Federal Deposit Insurance 
Corporation, the Federal Reserve Board, the Office of the Comptroller 
of the Currency, the Office of Thrift Supervision, and the Commission 
(together, the Agencies) issued a joint letter to financial 
institutions on the allowance for loan and lease losses (ALLL) on March 
10, 1999 (the Joint Letter). In the Joint Letter, the Agencies 
announced the establishment of a Joint Working Group to study ALLL 
issues and to assist financial institutions by providing them with 
improved guidance on this topic.\3\
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    \3\ The Accounting Standards Executive Committee (AcSEC) of the 
American Institute of Certified Public Accountants (AICPA) is in the 
process of developing guidance on the accounting for loan losses and 
the techniques for measuring probable incurred losses in a loan 
portfolio.
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    On September 7, 2000, the federal banking agencies, working through 
the FFIEC, sought public comment on a proposed policy statement on ALLL 
methodologies and documentation practices for banks and savings 
institutions. After considering the 31 comment letters received on the 
proposed guidance, the FFIEC issued its final interagency guidance, 
``Policy Statement on Allowance for Loan and Lease Losses Methodologies 
and Documentation for Banks and Savings Institutions,'' on July 6, 
2001. This Staff Accounting Bulletin represents the SEC staff's views 
relating to methodologies and supporting documentation for the ALLL 
that should be observed by all public companies in complying with the 
federal securities laws and the Commission's interpretations. It is 
also generally consistent with the guidance published by the FFIEC on 
July 6, 2001.
    Loan loss estimates developed without a disciplined methodology or 
adequate documentation (of both a disciplined methodology and the 
resulting amounts of loan loss provisions and allowances) can undermine 
the credibility of an institution's financial statements. A critical 
function of the independent accountant's examination of the financial 
statements is to evaluate the reasonableness of accounting estimates 
made by management, including its estimates of loan impairments and the 
associated allowance for loan losses.\4\ To perform that duty, an 
auditor must obtain an understanding of how management developed the 
estimate, and must apply that understanding to the review and testing 
of the estimation process or its results.\5\ The auditor must obtain 
sufficient competent evidential matter supporting the financial 
statements, and must give adequate attention to the propriety and 
accuracy of the data underlying material assumptions and estimates. 
Chapter 7 of the AICPA Audit and Accounting Guide, Banks and Savings 
Institutions (Audit Guide), states that ``[a]n institution's method of 
estimating credit losses * * * should * * * be well documented, with 
clear explanations of the supporting analyses and rationale.'' \6\ 
Additionally, the Audit Guide states that ``the institution's 
conclusions about the appropriate amount [of the loan loss allowance] 
should be well documented.'' \7\ Chapter 7 \8\ provides details of 
audit procedures to be performed, including procedures that relate to 
documentary evidence supporting the loan loss allowance. The staff 
believes that the documentation

[[Page 36459]]

described in this Staff Accounting Bulletin regarding a registrant's 
loan loss allowance methodologies, policies, procedures, and decisions 
is likely to be necessary for most registrants with material loan 
portfolios in order to provide sufficient competent evidential matter 
that auditors must consider in accordance with GAAS.\9\
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    \4\ See Auditing Accounting Estimates, AU Section 342.04.
    \5\ See AU Section 342.10.
    \6\ See paragraph 7.05, item j, in the Audit Guide.
    \7\ See paragraph 7.14 in the Audit Guide.
    \8\ See, in particular, the section on Auditing in paragraphs 
7.34 to 7.74.
    \9\ In responding to requests for comment on the interagency 
guidance published by the FFIEC, AcSEC stated:
    ``Although AcSEC agrees that documentation is needed to support 
loss recognition, AcSEC believes the Policy Statement should make 
clear that financial institutions may not avoid recognizing losses 
by deliberately failing to comply with the Policy Statement's 
documentation requirements.'' The Commission's staff agrees with the 
statement made by AcSEC and reiterates that the statements made 
herein represent interpretations and examples of documentation that 
are likely to be necessary for sufficient competent evidential 
matter in the course of an audit in accordance with GAAS. Failure to 
adequately document the loan loss allowance is not in accordance 
with GAAP (see paragraphs 7.05 and 7.14 in the Audit Guide) and can 
also demonstrate a lack of adequate internal accounting controls.
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    The statements in staff accounting bulletins are not rules or 
interpretations of the Commission, nor are they published as bearing 
the Commission's official approval. They represent interpretations and 
practices followed by the Division of Corporation Finance and the 
Office of the Chief Accountant in administering the disclosure 
requirements of the Federal securities laws.

    Dated: July 6, 2001.
Margaret H. McFarland,
Deputy Secretary.

PART 211--[AMENDED]

    Accordingly, Part 211 of Title 17 of the Code of Federal 
Regulations is amended by adding Staff Accounting Bulletin No. 102 to 
the table found in Subpart B.

Staff Accounting Bulletin No. 102

    Note: The text of Staff Accounting Bulletin No. 102 will not 
appear in the Code of Federal Regulations.

    The staff hereby revises the title of Topic 6 of the Staff 
Accounting Bulletin Series to be ``Interpretations of Accounting 
Series Releases and Financial Reporting Releases'' and adds Section 
L entitled ``Financial Reporting Release No. 28--Accounting for Loan 
Losses by Registrants Engaged in Lending Activities'' to Topic 6.

Topic 6: Interpretations of Accounting Series Releases and Financial 
Reporting Releases

* * * * *

L. Financial Reporting Release No. 28--Accounting for Loan Losses 
by Registrants Engaged in Lending Activities

1. Accounting for Loan Losses--General

    Generally accepted accounting principles (GAAP) for recognition 
of loan losses is provided by Statement of Financial Accounting 
Standards No. 5, Accounting for Contingencies (SFAS No. 5) and No. 
114, Accounting by Creditors for Impairment of a Loan (SFAS No. 
114).\10\ An estimated loss from a loss contingency, such as the 
collectibility of receivables, should be accrued when, based on 
information available prior to the issuance of the financial 
statements, it is probable that an asset has been impaired or a 
liability has been incurred at the date of the financial statements 
and the amount of the loss can be reasonably estimated.\11\ SFAS No. 
114 provides more specific guidance on measurement of loan 
impairment and related disclosures but does not change the 
fundamental recognition criteria for loan losses provided by SFAS 
No. 5. Additional guidance on the recognition, measurement, and 
disclosure of loan losses is provided by Emerging Issues Task Force 
(EITF) Topic No. D-80, Application of FASB Statements No. 5 and No. 
114 to a Loan Portfolio (EITF Topic D-80), FASB Interpretation No. 
14, Reasonable Estimation of the Amount of a Loss (FIN 14), and the 
American Institute of Certified Public Accountants (AICPA) Audit and 
Accounting Guide, Banks and Savings Institutions.
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    \10\ As amended by Statement of Financial Accounting Standards 
No. 118, Accounting by Creditors for Impairment of a Loan--Income 
Recognition and Disclosures.
    \11\ Paragraph 8 of SFAS No. 5.
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    Further guidance for SEC registrants is provided by Financial 
Reporting Release No. 28, which added subsection (b), Procedural 
Discipline in Determining the Allowance and Provision for Loan 
Losses to be Reported, of Section 401.09, Accounting for Loan Losses 
by Registrants Engaged in Lending Activities, to the Codification of 
Financial Reporting Policies (hereafter referred to as FRR No. 28). 
Additionally, 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.
    This staff interpretation applies to all registrants that are 
creditors in loan transactions that, individually or in the 
aggregate, have a material effect on the registrant's financial 
statements.\12\
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    \12\ For purposes of this interpretation, a loan is defined 
(consistent with paragraph 4 of SFAS No. 114) as a contractual right 
to receive money on demand or on fixed or determinable dates that is 
recognized as an asset in the creditor's statement of financial 
position. For purposes of this interpretation, loans do not include 
trade accounts receivable or notes receivable with terms less than 
one year or debt securities subject to the provisions of FASB 
Statement of Financial Accounting Standards No. 115, Accounting for 
Certain Investments in Debt and Equity Securities.
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2. Developing and Documenting a Systematic Methodology

    2.A. Developing a Systematic Methodology. Facts: Registrant A, 
or one of its consolidated subsidiaries, engages in lending 
activities and is developing or performing a review of its loan loss 
allowance methodology.
    Question 1: What are some of the factors or elements that the 
staff normally would expect Registrant A to consider when developing 
(or subsequently performing an assessment of) its methodology for 
determining its loan loss allowance under GAAP?
    Interpretive Response: The staff normally would expect a 
registrant that engages in lending activities to develop and 
document a systematic methodology\13\ to determine its provision for 
loan losses and allowance for loan losses as of each financial 
reporting date. It is critical that loan loss allowance 
methodologies incorporate management's current judgments about the 
credit quality of the loan portfolio through a disciplined and 
consistently applied process. A registrant's loan loss allowance 
methodology is influenced by entity-specific factors, such as an 
entity's size, organizational structure, business environment and 
strategy, management style, loan portfolio characteristics, loan 
administration procedures, and management information systems. 
However, as indicated in the AICPA Audit and Accounting Guide, Banks 
and Savings Institutions (Audit Guide), ``[w]hile different 
institutions may use different methods, there are certain common 
elements that should be included in any [loan loss allowance] 
methodology for it to be effective.''\14\ A registrant's loan loss 
allowance methodology generally should:\15\
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    \13\ FRR No. 28 states that ``* * * the Commission's staff 
normally would expect to find that the books and records of 
registrants engaged in lending activities include documentation of 
[the]: (a) systematic methodology to be employed each period in 
determining the amount of the loan losses to be reported, and (b) 
rationale supporting each period's determination that the amounts 
reported were adequate.''
    \14\ See paragraph 7.05 of the Audit Guide.
    \15\ Ibid.
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     Include a detailed analysis of the loan portfolio, 
performed on a regular basis;
     Consider all loans (whether on an individual or group 
basis);
     Identify loans to be evaluated for impairment on an 
individual basis under SFAS No. 114 and segment the remainder of the 
portfolio into groups of loans with similar risk characteristics for 
evaluation and analysis under SFAS No. 5;
     Consider all known relevant internal and external 
factors that may affect loan collectibility;
     Be applied consistently but, when appropriate, be 
modified for new factors affecting collectibility;

[[Page 36460]]

     Consider the particular risks inherent in different 
kinds of lending;
     Consider current collateral values (less costs to 
sell), where applicable;
     Require that analyses, estimates, reviews and other 
loan loss allowance methodology functions be performed by competent 
and well-trained personnel;
     Be based on current and reliable data;
     Be well documented, in writing, with clear explanations 
of the supporting analyses and rationale (see Question 2 below for 
staff views on documenting a loan loss allowance methodology); and
     Include a systematic and logical method to consolidate 
the loss estimates and ensure the loan loss allowance balance is 
recorded in accordance with GAAP.
    For many entities engaged in lending activities, the allowance 
and provision for loan losses are significant elements of the 
financial statements. Therefore, the staff believes it is 
appropriate for an entity's management to review, on a periodic 
basis, its methodology for determining its allowance for loan 
losses.\16\ Additionally, for registrants that have audit 
committees, the staff believes that oversight of the financial 
reporting and auditing of the loan loss allowance by the audit 
committee can strengthen the registrant's control system and process 
for determining its allowance for loan losses.\17\
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    \16\ For federally insured depositry institutions, the December 
21, 1993 ``Interagency Policy Statement on the Allowance for Loan 
and Lease Losses (ALLL)'' (the 1993 Interagency Policy Statement) 
indicates that boards of directors and management have certain 
responsibilities for the ALLL process and amounts reported. For 
example, as indicated on page 4 of that statement, ``the board of 
directors and management are expected to: Ensure that the 
institution has an effective loan review system and control * * * 
[;] Ensure the prompt charge-off of loans, or portions of loans, 
that available information confirms to be uncollectible[; and] 
Ensure that the institution's process for determining an adequate 
level for the ALLL is based on a comprehensive, adequately 
documented, and consistently applied analysis of the institution's 
loan and lease portfolio.* * *''
    \17\ Statement on Auditing Standards No. 61, Communication With 
Audit Committees (as amended by Statement on Auditing Standards No. 
90, Audit Committee Communications) (SAS No.61) states, in part:
    ``In connection with each SEC engagement * * * the auditor 
should discuss with the audit committee the auditor's judgments 
about the quality, not just the acceptability, of the entity's 
accounting principles as applied in its financial reporting * * * 
The discussion should * * * include items that have a significant 
impact on the representational faithfulness, verifiability, and 
neutrality of the accounting information included in the financial 
statements. [Footnote omitted.] Examples of items that may have such 
an impact are the following:
     Selection of new or changes to accounting policies
     Estimates, judgments, and uncertainties
     Unusual transactions
     Accounting policies relating to significant financial 
statement items, including the timing or transactions and the period 
in which they are recorded. * * *''
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    A systematic methodology that is properly designed and 
implemented should result in a registrant's best estimate of its 
allowance for loan losses.\18\ Accordingly, the staff normally would 
expect registrants to adjust their loan loss allowance balance, 
either upward or downward, in each period for differences between 
the results of the systematic determination process and the 
unadjusted loan loss allowance balance in the general ledger.\19\
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    \18\ Registrants should also refer to FIN 14, which provides 
accounting and disclosure guidance for situations in which a range 
of loss can be reasonably estimated but no single amount within the 
range appears to be a better estimate than any other amount within 
the range.
    \19\ Registrants should refer to the guidance on materiality in 
SEC Staff Accounting Bulletin No. 99, Materiality (SAB No. 99).
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2.B. Documenting a Systematic Methodology

    Question 2: Assume the same facts as in Question 1. What would 
the staff normally expect Registrant A to include in its 
documentation of its loan loss allowance methodology?
    Interpretive Response: In FRR No. 28, the Commission provided 
guidance for documentation of loan loss provisions and allowances 
for registrants engaged in lending activities. The staff believes 
that appropriate written supporting documentation for the loan loss 
provision and allowance facilitates review of the loan loss 
allowance process and reported amounts, builds discipline and 
consistency into the loan loss allowance determination process, and 
improves the process for estimating loan losses by helping to ensure 
that all relevant factors are appropriately considered in the 
allowance analysis. The staff, therefore, normally would expect a 
registrant to document the relationship between the findings of its 
detailed review of the loan portfolio and the amount of the loan 
loss allowance and the provision for loan losses reported in each 
period.\20\
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    \20\ FRR No. 28 states: ``The specific rationale upon which the 
[loan loss allowance and provision] amount actually reported is 
based--i.e., the bridge between the findings of the detailed review 
[of the loan portfolio] and the amount actually reported in each 
period--would be documented to help ensure the adequacy of the 
reported amount, to improve auditability, and to serve as a 
benchmark for exercise of prudent judgment in future periods.''
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    The staff normally would expect to find that registrants 
maintain written supporting documentation for the following 
decisions, strategies, and processes: \21\
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    \21\ Paragraph 7.39 in the Audit Guide outlines specific aspects 
of effective internal control related to the allowance for loan 
losses. These specific aspects include the control environment 
(``management communication of the need for proper reporting of the 
allowance''); management reports that summarize loan activity and 
the institution's procedures and controls (``accumulation of 
relevant, sufficient, and reliable data on which to base 
management's estimate of the allowance''); ``independent loan 
review;'' review of information and assumptions (``adequate review 
and approval of the allowance estimates by the individuals specified 
in management's written policy''); assessment of the process 
(``comparison of prior estimates related to the allowance with 
subsequent results to assess the reliability of the process used to 
develop the allowance''); and ``consideration by management of 
whether the allowance is conistent with the operational plans of the 
institution.''
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     Policies and procedures:
     Over the systems and controls that maintain an 
appropriate loan loss allowance, and
     Over the loan loss allowance methodology;
     Loan grading system or process;
     Summary or consolidation of the loan loss allowance 
balance;
     Validation of the loan loss allowance methodology; and
     Periodic adjustments to the loan loss allowance 
process.
    Question 3: The Interpretive Response to Question 2 indicates 
that the staff normally would expect to find that registrants 
maintain written supporting documentation for their loan loss 
allowance policies and procedures. In the staff's view, what aspects 
of a registrant's loan loss allowance internal accounting control 
systems and processes would appropriately be addressed in its 
written policies and procedures?
    Interpretive Response: The staff is aware that registrants 
utilize a wide range of policies, procedures, and control systems in 
their loan loss allowance processes, and these policies, procedures, 
and systems are tailored to the size and complexity of the 
registrant and its loan portfolio. However, the staff believes that, 
in order for a registrant's loan loss allowance methodology to be 
effective, the registrant's written policies and procedures for the 
systems and controls that maintain an appropriate loan loss 
allowance would likely address the following:
     The roles and responsibilities of the registrant'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 loan loss allowance to be 
reported in the financial statements; \22\
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    \22\ Paragraph 7.39 of the Audit Guide discusses ``management 
communication of the need for proper reporting of the allowance.'' 
As indicated in that paragraph, the ``control environment strongly 
influences the effectiveness of the system of controls and * * * 
reflects the overall attitude, awareness, and action of the board of 
directors and management concerning the importance of control.''
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     The registrant'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; \23\
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    \23\ Paragraph 7.33 of the Audit Guide refers to the 
documenation, for disclosure purposes, that an entity should include 
in the notes to the financial statements describing the accounting 
policies the entity used to estimate its allowance and related 
provision for loan losses.
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     The description of the registrant's systematic 
methodology, which should be consistent with the registrant's 
accounting policies for determining its loan loss allowance (see 
Question 4 below for further discussion); \24\ and
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    \24\ Ibid. As indicated in Paragraph 7.33, ``[s]uch a 
description should identify the factors that influenced management's 
judgment (for example, historical losses and existing economic 
conditions) and may also include discussion of risk elements 
relevant to particular categories of financial instruments.''

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[[Page 36461]]

     The system of internal controls used to ensure that the 
loan loss allowance process is maintained in accordance with 
GAAP.\25\
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    \25\ See also paragraph 7.39 in the Audit Guide which provides 
information about specific aspects of effective internal control 
related to the allowance for loan losses.
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    The staff normally would expect an internal control system \26\ 
for the loan loss allowance estimation process to:
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    \26\ Ibid. Public companies are required to comply with the 
books and records provisions of the 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.
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     Include measures to provide assurance regarding the 
reliability \27\ and integrity of information and compliance with 
laws, regulations, and internal policies and procedures; \28\
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    \27\ FASB Statement of Concepts No. 2, Qualitative 
Characteristics of Accounting Information, provides guidance on 
``reliability'' as a primary quality of accounting information.
    \28\ Section 13(b)(2)-(7) of the Exchange Act.
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     Reasonably assure that the registrant's financial 
statements are prepared in accordance with GAAP; and
     Include a well-defined loan review process.\29\
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    \29\ As indicated in paragraph 7.05, item a, in the Audit Guide, 
a loan loss allowance methodology should ``include a detailed and 
regular analysis of the loan portfolio * * *'' Paragraphs 7.06 to 
7.13 provide additional information on how creditors traditionally 
identify and review loans on an individual basis and review or 
analyze loans on a group or pool basis.
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    A well-defined loan review process \30\ typically contains:
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    \30\ Ibid. Additionally, paragraph 7.39 in the Audit Guide 
provides guidance on the loan review process. As stated in that 
paragraph, ``[m]anagement reports summarizing loan activity, 
renewals, and delinquencies are vital to the timely identification 
of problem loans.'' The paragraph further states: ``Loan reviews 
should be conducted by institution personnel who are independent of 
the underwriting, supervision, and collections functions. The 
specific lines of reporting depend on the complexity of the 
institution's organizational structure, but the loan reviewers 
should report to a high level of management that is independent from 
the lending process in the institution.''
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     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; \31\
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    \31\ Ibid.
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     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; \32\ and
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    \32\ Ibid.
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     Clear formal communication and coordination between a 
registrant's credit administration function, financial reporting 
group, management, board of directors, and others who are involved 
in the loan loss allowance determination or review process, as 
applicable (e.g., written policies and procedures, management 
reports, audit programs, and committee minutes).\33\
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    \33\ Ibid.
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    Question 4: The Interpretive Response to Question 3 indicates 
that the staff normally would expect a registrant's written loan 
loss allowance policies and procedures to include a description of 
the registrant's systematic allowance methodology, which should be 
consistent with its accounting policies for determining its loan 
loss allowance. What elements of a registrant's loan loss allowance 
methodology would the staff normally expect to be described in the 
registrant's written policies and procedures?
    Interpretive Response: The staff normally would expect a 
registrant's written policies and procedures to describe the primary 
elements of its loan loss allowance methodology, including portfolio 
segmentation and impairment measurement. The staff normally would 
expect that, in order for a registrant's loan loss allowance 
methodology to be effective, the registrant's written policies and 
procedures would describe the methodology:
     For segmenting the portfolio:
     How the segmentation process is performed (i.e., by loan 
type, industry, risk rates, etc.); \34\
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    \34\ Paragraph 7.07 in the Audit Guide states that ``creditors 
have traditionally identified loans that are to be evaluated for 
collectibility by dividing the loan portfolio into different 
segments. Each segment should contain loans with similar 
characteristics, such as risk classification, past-due status, and 
type of loan.'' Paragraph 7.08 provides additional guidance on 
classifying individual loans and paragraph 7.13 indicates 
considerations for groups or pools of loans.
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     When a loan grading system is used to segment the 
portfolio:
     The definitions of each loan grade;
     A reconciliation of the internal loan grades to 
supervisory loan grades, if applicable; and
     The delineation of responsibilities for the loan 
grading system.
     For determining and measuring impairment under SFAS No. 
114: \35\
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    \35\ See SFAS No. 114, paragraphs 8 through 10 on recognition of 
impairment and paragraphs 11 through 16 on measurement of 
impairment. See also the guidance in EITF Topic D-80.
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     The methods used to identify loans to be analyzed 
individually;
     For individually reviewed loans that are impaired, how the 
amount of any impairment is determined and measured, including:
     Procedures describing the impairment measurement 
techniques available; and
     Steps performed to determine which technique is most 
appropriate in a given situation.
     The methods used to determine whether and how loans 
individually evaluated under SFAS No. 114, but not considered to be 
individually impaired, should be grouped with other loans that share 
common characteristics for impairment evaluation under SFAS No. 
5.\36\
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    \36\ See EITF Topic D-80, Exhibit D-80A, Question #10.
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     For determining and measuring impairment under SFAS No. 
5: \37\
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    \37\ See SFAS No. 5, paragraphs 8(a) and 8(b) on accrual of loss 
contingencies and paragraphs 22 and 23 on collectibility of 
receivables. See also the guidance in EITF Topic D-80.
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     How loans with similar characteristics are grouped to be 
evaluated for loan collectibility (such as loan type, past-due 
status, and risk);
     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
     Descriptions of qualitative factors (e.g., industry, 
geographical, economic, and political factors) that may affect loss 
rates or other loss measurements.

3. Applying a Systematic Methodology--Measuring and Documenting Loan 
Losses Under SFAS No. 114

3.A. Measuring and Documenting Loan Losses under SFAS No. 114--
General

    Facts: Approximately one-third of Registrant B's commercial loan 
portfolio consists of large balance, non-homogeneous loans. Due to 
their large individual balances, these loans meet the criteria under 
Registrant B's policies and procedures for individual review for 
impairment under SFAS No. 114. Upon review of the large balance 
loans, Registrant B determines that certain of the loans are 
impaired as defined by SFAS No. 114.\38\
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    \38\ Paragraph 8 of SFAS No. 114 provides that a loan is 
impaired when, based on current information and events, it is 
probable that all amounts due will not be collected pursuant to the 
terms of the loan agreement.
---------------------------------------------------------------------------

    Question 5: For the commercial loans reviewed under SFAS No. 114 
that are individually impaired, how would the staff normally expect 
Registrant B to measure and document the impairment on those loans? 
Can it use an impairment measurement method other than the methods 
allowed by SFAS No. 114?
    Interpretive Response: For those loans that are reviewed 
individually under SFAS No. 114 and considered individually 
impaired, Registrant B must use one of the methods for measuring 
impairment that is specified by SFAS No. 114 (that is, the present 
value of expected future cash flows, the loan's observable market 
price, or the fair value of collateral).\39\ Accordingly, in the 
circumstances described above, for the loans considered individually 
impaired under SFAS No. 114, it would not be appropriate for 
Registrant B to choose a measurement method not prescribed by SFAS 
No. 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.
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    \39\ See paragraph 13 of SFAS No. 114.
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    The staff normally would expect Registrant B to maintain as 
sufficient, objective evidence \40\ written documentation to support

[[Page 36462]]

its measurement of loan impairment under SFAS No. 114.\41\ If 
Registrant B 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 \42\ and 
other information reflecting past events and current conditions. If 
Registrant B uses the fair value of collateral to measure 
impairment, the staff normally would expect to find that Registrant 
B had documented 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.\43\ 
Similarly, the staff normally would expect to find that Registrant B 
had documented the amount, source, and date of the observable market 
price of a loan, if that method of measuring loan impairment is 
used.
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    \40\ Under GAAS, auditors should obtain ``sufficient competent 
evidential matter'' to support its audit opinion. See AU Section 
326, Evidential Matter. The staff normally would expect registrants 
to maintain such evidential matter for its allowances for loan 
losses for use by the auditors in conducting their annual audit.
    \41\ Paragraph 7.45 in the Audit Guide outlines sources of 
information, available from management, that the independent 
accountant should consider in identifying loans that contain high 
credit risk or other significant exposures and concentrations. These 
sources of information would also likely include documentation of 
loan impairment under SFAS No. 114 or SFAS No. 5. Additionally, as 
indicated in paragraphs 7.56 to 7.68 of the Audit Guide, the 
independent accountant, in conducting an audit, may perform a 
detailed loan file review for selected loans. A registrant's loan 
files may contain documentation about borrowers' financial resources 
and cash flows (see paragraph 7.63) or about the collateral securing 
the loans, if applicable (see paragraphs 7.65 and 7.66).
    \42\ Question #16 in Exhibit D-80A of EITF Topic D-80 indicates 
that environmental factors include existing industry, geographical, 
economic, and political factors.
    \43\ See paragraphs 7.65 and 7.66 in the Audit Guide for 
additional information about documentation of loan collateral.
---------------------------------------------------------------------------

3.B. Measuring and Documenting Loan Losses under SFAS No. 114 for a 
Collateral Dependent Loan

    Facts: Registrant C has a $10 million loan outstanding to 
Company X that is secured by real estate, which Registrant C 
individually evaluates under SFAS No. 114 due to the loan's size. 
Company X is delinquent in its loan payments under the terms of the 
loan agreement. Accordingly, Registrant C determines that its loan 
to Company X is impaired, as defined by SFAS No. 114. Because the 
loan is collateral dependent, Registrant C measures impairment of 
the loan based on the fair value of the collateral. Registrant C 
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.
    Registrant C 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 Registrant C adjust certain 
of the valuation assumptions to better reflect the current market 
conditions as they relate to the loan's collateral.\44\ 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.\45\ Given that the 
recorded investment in the loan is $10 million, Registrant C 
concludes that the loan is impaired by $2 million and records an 
allowance for loan losses of $2 million.
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    \44\ When reviewing collateral dependent loans, Registrant C 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.
    \45\ An auditor who uses the work of a specialist, such as an 
appraiser, in performing an audit in accordance with generally 
accepted auditing standards (GAAS) should refer to the guidance in 
AU Section 336, Using the Work of a Specialist.
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    Question 6: What documentation would the staff normally expect 
Registrant C to maintain to support its determination of the 
allowance for loan losses of $2 million for the loan to Company X?
    Interpretive Response: The staff normally would expect 
Registrant C to 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.\46\ This 
documentation \47\ should include the registrant'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 Registrant C 
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.
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    \46\ See paragraphs 7.65 to 7.66 in the Audit Guide for further 
information about documentation of loan collateral and associated 
audit procedures that may be performed by the independent 
accountant.
    \47\ As stated in paragraph 7.14 of the Audit Guide, ``[t]he 
institution's conclusions about the appropriate amount [of loan 
impairment and the allowance for loan losses] should be well 
documented.''
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3.C. Measuring and Documenting Loan Losses under SFAS No. 114--
Fully Collateralized Loans

    Question 7: In the staff's view, what is an example of an 
acceptable documentation practice for a registrant to adequately 
support its determination that no allowance for loan losses should 
be recorded for a group of loans because the loans are fully 
collateralized?
    Interpretive Response: Consider the following fact pattern: 
Registrant D 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. Registrant D's collateral department 
has physical control of the debt securities through safekeeping 
arrangements. In addition, Registrant D perfected its security 
interest in the collateral when the funds were originally 
distributed. On a quarterly basis, Registrant D'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, Registrant D notifies the borrower 
and requests that the borrower immediately remedy the deficiency. 
Due in part to its efficient operation, Registrant D has 
historically not incurred any material losses on these loans. 
Registrant D believes these loans are fully-collateralized and 
therefore does not maintain any loan loss allowance balance for 
these loans.
    Registrant D's management summary of the loan loss allowance 
includes documentation indicating that, in accordance with its loan 
loss allowance policy, the collateral protection on these loans has 
been verified by the registrant, no probable loss has been incurred, 
and no loan loss allowance is necessary. Documentation in Registrant 
D'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, 
Registrant D's loan loss allowance policy includes a discussion of 
how to determine when a loan is considered ``fully collateralized'' 
and does not require a loan loss allowance. Registrant D's policy 
requires the following factors to be considered and its findings 
concerning these factors to be fully documented:
     Volatility of the market value of the collateral;
     Recency and reliability of the appraisal or other 
valuation;
     Recency of the registrant's or third party's inspection 
of the collateral;
     Historical losses on similar loans;
     Confidence in the registrant's lien or security 
position including appropriate:
     Type of security perfection (e.g., physical possession of 
collateral or secured filing);
     Filing of security perfection (i.e., correct documents and 
with the appropriate officials); and
     Relationship to other liens; and
     Other factors as appropriate for the loan type.
    In the staff's view, Registrant D's documentation supporting its 
determination that certain of its loans are fully collateralized, 
and no loan loss allowance should be recorded for those loans, is 
acceptable under FRR No. 28.

[[Page 36463]]

4. Applying a Systematic Methodology--Measuring and Documenting Loan 
Losses under SFAS No. 5

4.A. Measuring and Documenting Loan Losses under SFAS No. 5--
General

    Question 8: In the staff's view, what are some general 
considerations for a registrant in applying its systematic 
methodology to measure and document loan losses under SFAS No. 5?
    Interpretive Response: For loans evaluated on a group basis 
under SFAS No. 5, the staff believes that a registrant should 
segment the loan portfolio by identifying risk characteristics that 
are common to groups of loans.\48\ Registrants 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. Regardless of the segmentation method used, the staff 
normally would expect a registrant to maintain documentation to 
support its conclusion that the loans in each segment have similar 
attributes or characteristics. As economic and other business 
conditions change, registrants 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. 
The staff normally would expect registrants to maintain 
documentation to support these segmentation adjustments.\49\
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    \48\ Paragraph 7.07 of the Audit Guide indicates that ``[e]ach 
segment [of the loan portfolio] should contain loans with similar 
characteristics, such as risk classification, past-due status, and 
type of loan.''
    \49\ Segmentation of the loan portfolio is a standard element in 
a loan loss allowance methodology. As indicated in paragraph 7.05 of 
the Audit Guide, the loan loss allowance methodology ``should be 
well documented, with clear explanations of the supporting analyses 
and rationale.''
---------------------------------------------------------------------------

    Based on the segmentation of the loan portfolio, a registrant 
should estimate the SFAS No. 5 portion of its loan loss allowance. 
For those segments that require an allowance for loan losses,\50\ 
the registrant should estimate the loan losses, on at least a 
quarterly basis, based upon its ongoing loan review process and 
analysis of loan performance.\51\ The registrant 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.\52\
---------------------------------------------------------------------------

    \50\ An example of a loan segment that does not generally 
require an allowance for loan losses is a group of loans that are 
fully secured by deposits maintained at the lending institution.
    \51\ FRR No. 28 refers to a ``systematic methodology to be 
employed each period'' in determining provisions and allowances for 
loan losses. As indicated in FRR No. 28, the staff normally would 
expect that the systematic methodology would be documented ``to help 
ensure that all matters affecting loan collectibility will 
consistently be identified in the detailed [loan] review process. * 
* *''
    \52\ Ibid. Also, as indicated in paragraph 7.05 of the Audit 
Guide, the loan loss allowance methodology ``should be well 
documented, with clear explanations of the supporting analyses and 
rationale.'' Further, as indicated in paragraph 7.14 of the Audit 
Guide, ``[t]he institution's conclusions about the appropriate 
amount [of the allowance] should be well documented.''
---------------------------------------------------------------------------

    Facts: After identifying certain loans for evaluation under SFAS 
No. 114, Registrant E segments its remaining loan portfolio into 
five pools of loans. For three of the pools, it measures loan 
impairment under SFAS No. 5 by applying historical loss rates, 
adjusted for relevant environmental factors, to the pools' aggregate 
loan balances. For the remaining two pools of loans, Registrant E 
uses a loss estimation model that is consistent with GAAP to measure 
loan impairment under SFAS No. 5.
    Question 9: What documentation would the staff normally expect 
Registrant E to prepare to support its loan loss allowance for its 
pools of loans under SFAS No. 5?
    Interpretive Response: Regardless of the method used to 
determine loan loss measurements under SFAS No. 5, Registrant E 
should demonstrate and document that the loss measurement methods 
used to estimate the loan loss allowance for each segment of its 
loan portfolio are determined in accordance with GAAP as of the 
financial statement date.\53\
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    \53\ Refer to paragraph 8(b) of SFAS No. 5. Also, as indicated 
in Exhibit D-80A of EITF Topic D-80, ``[t]he approach for 
determination of the allowance should be well documented and applied 
consistently from period to period.'' (See the overview section of 
Exhibit D-80A and Question #18.)
---------------------------------------------------------------------------

    As indicated for Registrant E, 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 registrant'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 a registrant does not have loss 
experience of its own, it may be appropriate to reference the loss 
experience of other companies in the same business, provided that 
the registrant demonstrates that the attributes of the loans in its 
portfolio segment are similar to those of the loans included in the 
portfolio of the registrant providing the loss experience.\54\ 
Registrants 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, registrants 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.\55\
---------------------------------------------------------------------------

    \54\ Refer to paragraph 23 of SFAS No. 5.
    \55\ Registrants should also refer to FIN 14, which provides 
guidance for situations in which a range of loss can be reasonably 
estimated but no single amount within the range appears to be a 
better estimate than any other amount within the range. Also, 
paragraph 7.14 of the Audit Guide notes the use of ``a method that 
results in a range of estimates for the allowance,'' except for 
impairment measurement under SFAS No. 114, which is based on ``a 
single best estimate and not a range of estimates.'' Paragraph 7.14 
also states that ``[t]he institution's conclusions about the 
appropriate amount should be well documented.''
---------------------------------------------------------------------------

    The staff normally would expect that, before employing a loss 
estimation model, a registrant would 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, registrants that use loss estimation models should typically 
document the evaluation, the conclusions regarding the 
appropriateness of estimating loan losses with a model or other loss 
estimation tool, and the objective support for adjustments to the 
model or its results.\56\
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    \56\ The systematic methodology (including, if applicable, loss 
estimation models) used to determine loan loss provisions and 
allowances should be documented in accordance with FRR No. 28, 
paragraph 7.05 of the Audit Guide, and EITF Topic D-80.
---------------------------------------------------------------------------

    In developing loss measurements, registrants 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: \57\
---------------------------------------------------------------------------

    \57\ Refer to paragraph 7.13 in the Audit Guide.
---------------------------------------------------------------------------

     Levels of and trends in delinquencies and impaired 
loans;
     Levels of and trends in charge-offs and recoveries;
     Trends in volume and terms of loans;
     Effects of any changes in risk selection and 
underwriting standards, and other changes in lending policies, 
procedures, and practices;
     Experience, ability, and depth of lending management 
and other relevant staff;
     National and local economic trends and conditions;
     Industry conditions; and
      Effects of changes in credit concentrations.
    For any adjustment of loss measurements for environmental 
factors, a registrant should maintain sufficient, objective evidence 
\58\ (a) to support the amount of the adjustment and (b) to explain 
why the adjustment is necessary to reflect current information, 
events, circumstances, and conditions in the loss measurements.
---------------------------------------------------------------------------

    \58\ AU Section 326 describes the ``sufficient competent 
evidential matter'' that auditors must consider in accordance with 
GAAS.
---------------------------------------------------------------------------

4.B. Measuring and Documenting Loan Losses under SFAS No. 5--
Adjusting Loss Rates

    Facts: Registrant F'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

[[Page 36464]]

difficulties and have recently announced downsizing plans.
    Although Registrant F 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. Registrant F'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. Registrant F's management performs an 
analysis of the affected portfolio segments to adjust its historical 
loss rates used to determine the loan loss allowance. In this 
particular case, Registrant F has experienced similar business and 
lending conditions in the past that it can compare to current 
conditions.
    Question 10: How would the staff normally expect Registrant F to 
document its support for the loss rate adjustments that result from 
considering these manufacturing firms' financial downturns? \59\
---------------------------------------------------------------------------

    \59\ This question and response would also apply to other 
registrant fact patterns in which the registrant adjusts loss rates 
for environmental factors.
---------------------------------------------------------------------------

    Interpretive Response: The staff normally would expect 
Registrant F to 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, the staff normally would 
expect Registrant F to document its analysis that resulted in the 
adjustments to the loss rates for the affected portfolio 
segments.\60\ The staff normally would expect that, as part of its 
documentation, Registrant F would maintain copies of the documents 
supporting the analysis, which may include relevant economic 
reports, economic data, and information from individual borrowers.
---------------------------------------------------------------------------

    \60\ Paragraph 7.33 of the Audit Guide refers to the 
documentation, for disclosure purposes, that an entity should 
include in the notes to the financial statements describing the 
accounting policies and methodology the entity used to estimate its 
allowance and related provision for loan losses. As indicated in 
paragraph 7.33, ``[s]uch a description should identify the factors 
that influenced management's judgment (for example, historical 
losses and existing economic conditions) and may also include 
discussion of risk elements relevant to particular categories of 
financial instruments.''
---------------------------------------------------------------------------

    Because in this case Registrant F has experienced similar 
business and lending conditions in the past, it should consider 
including in its supporting documentation an analysis of how the 
current conditions compare to its previous loss experiences in 
similar circumstances. The staff normally would expect that, as part 
of Registrant F's effective loan loss allowance methodology, it 
would create a summary of the amount and rationale for the 
adjustment factor for review by management prior to the issuance of 
the financial statements.\61\
---------------------------------------------------------------------------

    \61\ Paragraph 7.39 in the Audit Guide indicates that effective 
internal control related to the allowance for loan losses should 
include ``accumulation of relevant, sufficient, and reliable data on 
which to base management's estimate of the allowance.''
---------------------------------------------------------------------------

4.C. Measuring and Documenting Loan Losses under SFAS No. 5--
Estimating Losses on Loans Individually Reviewed for Impairment but 
Not Considered Individually Impaired

    Facts: Registrant G 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 registrant's loan loss 
allowance policy specifies that all loans greater than $750,000 must 
be individually reviewed for impairment under SFAS No. 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 registrant'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 
SFAS No. 114.
    Registrant G segments its loan portfolio to estimate loan losses 
under SFAS No. 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.\62\
    In its determination of its loan loss allowance under SFAS No. 
5, Registrant G 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).\63\ 
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 registrant's probable 
loan losses in these segments.
---------------------------------------------------------------------------

    \62\ These groups of loans do not include any loans that have 
been individually reviewed for impairment under SFAS No. 114 and 
determined to be impaired as defined by SFAS No.114.
    \63\ Question #10 in Exhibit D-80A of EITF Topic D-80 states 
that if a creditor concludes that an individual loan specifically 
identified for evaluation is not impaired under SFAS No. 114, that 
loan may be included in the assessment of the allowance for loan 
losses under SFAS No. 5, but only if specific characteristics of the 
loan indicate that it is probable that there would be an incurred 
loss in a group of loans with those characteristics.
---------------------------------------------------------------------------

    Question 11: How would the staff normally expect Registrant G to 
adequately document a loan loss allowance under SFAS No. 5 for these 
loans that were individually reviewed for impairment but are not 
considered individually impaired?
    Interpretive Response: The staff normally would expect that, as 
part of Registrant G's effective loan loss allowance methodology, it 
would document its decision to include its loans to Company Y and 
Company Z in its determination of its loan loss allowance under SFAS 
No. 5.\64\ The staff also normally would expect that Registrant G 
would document the specific characteristics of the loans that were 
the basis for grouping these loans with other loans in Segment 1 and 
Segment 2, respectively.\65\ Additionally, the staff normally would 
expect Registrant G to maintain documentation to support its method 
of estimating loan losses for Segment 1 and Segment 2, which 
typically would include 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.\66\ The 
registrant would typically maintain copies of the economic and other 
reports that provided source data.
---------------------------------------------------------------------------

    \64\ Paragraph 7.05 in the Audit Guide indicates that an 
entity's method of estimating credit losses should ``include a 
detailed and regular analysis of the loan portfolio,'' ``consider 
all loans (whether on an individual or poll-of-loans basis),'' ``be 
based on current and reliable data,'' and ``be well documented, with 
clear explanations of the supporting analysis and rationale.'' 
Question #10 in Exhibit D-80A of EITF Topic D-80 provides guidance 
as to the analysis to be performed when determining whether a loan 
that is not individually impaired under SFAS No. 114 should be 
included in the assessment of the loan loss allowance under SFAS No. 
5.
    \65\ Ibid.
    \66\ Ibid.
---------------------------------------------------------------------------

    When measuring and documenting loan losses, Registrant G should 
take steps to prevent layering loan loss allowances. Layering is the 
inappropriate practice of recording in the allowance more than one 
amount for the same probable loan loss. Layering can happen when a 
registrant 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 loan loss allowance 
amount.

5. Documenting the Results of a Systematic Methodology

5.A. Documenting the Results of a Systematic Methodology--General

    Facts: Registrant H has completed its estimation of its loan 
loss allowance for the current reporting period, in accordance with 
GAAP, using its established systematic methodology.
    Question 12: What summary documentation would the staff normally 
expect Registrant H to prepare to support the amount of its loan 
loss allowance to be reported in its financial statements?
    Interpretive Response: The staff normally would expect that, to 
verify that loan loss allowance balances are presented fairly in 
accordance with GAAP and are auditable, management would prepare a 
document that summarizes the amount to be reported in the financial 
statements for the loan loss allowance.\67\ Common elements that the 
staff

[[Page 36465]]

normally would expect to find documented in loan loss allowance 
summaries include:\68\
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    \67\ FFR No. 28 states: ``The specific rationale upon which the 
[loan loss allowance and provision] amount actually reported is 
based--i.e., the bridge between the findings of the detailed review 
[of the loan portfolio] and the amount actually reported in each 
period--would be documented to help ensure the adequacy of the 
reported amount, to improve auditability, and to serve as a 
benchmark for exercise of prudent judgment in future periods.''
    \68\ See also paragraph 7.14 of the Audit Guide.
---------------------------------------------------------------------------

     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);
     The aggregate probable loss estimated using the 
registrant's methodology;
     A summary of the current loan loss allowance balance;
     The amount, if any, by which the loan loss allowance 
balance is to be adjusted;\69\ and
---------------------------------------------------------------------------

    \69\ Subsequent to adjustments, the staff normally would expect 
that there would be no material differences between the consolidated 
loss estimate, as determined by the methodology, and the final loan 
loss allowance balance reported in the financial statements. 
Registrants should refer to SAB No. 99 and Statement on Auditing 
Standards No. 89, Audit Adjustments, and its amendments to AU 
Section 310.
---------------------------------------------------------------------------

     Depending on the level of detail that supports the loan 
loss allowance analysis, detailed subschedules of loss estimates 
that reconcile to the summary schedule.
    Generally, a registrant's review and approval process for the 
loan loss allowance relies upon the data provided in these 
consolidated summaries. There may be instances in which individuals 
or committees that review the loan loss allowance 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 SFAS No. 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.\70\ Additionally, it would typically be appropriate for 
the summary to provide each subsequent reviewer with an 
understanding of the support behind these adjustments. Therefore, 
the staff normally would expect management to document the nature of 
any adjustments and the underlying rationale for making the 
changes.\71\ The staff also normally would expect this documentation 
to be provided to those among management making the final 
determination of the loan loss allowance amount.\72\
---------------------------------------------------------------------------

    \70\ Paragraph 7.39 in the Audit Guide indicates that effective 
internal control related to the allowance for loan losses should 
include ``adequate review and approval of the allowance estimates by 
the individuals specified in management's written policy.''
    \71\ See the guidance in paragraph 7.14 of the Audit Guide 
(``The institution's conclusions about the appropriate amount should 
be well documented.'') and in FRR No. 28 (``The specific rationale 
upon which the amount actually reported in each individual period is 
based* * * would be documented* * *'').
    \72\ Ibid.
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5.B. Documenting the Results of a Systematic Methodology--Allowance 
Adjustments

    Facts: Registrant I determines its loan loss allowance using an 
established systematic process. At the end of each reporting period, 
the accounting department prepares a summary schedule that includes 
the amount of each of the components of the loan loss allowance, as 
well as the total loan loss allowance amount, for review by senior 
management, including the Credit Committee. Members of senior 
management meet to discuss the loan loss allowance. During these 
discussions, they identify changes that are required by GAAP to be 
made to certain of the loan loss allowance estimates. As a result of 
the adjustments made by senior management, the total amount of the 
loan loss allowance changes. However, senior management (or its 
designee) does not update the loan loss allowance 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 loan loss allowance 
summary schedule reviewed by senior management, as well as a verbal 
explanation of the changes made by senior management when they met 
to discuss the loan loss allowance.
    Question 13: In the staff's view, are Registrant I's 
documentation practices related to the balance of its loan loss 
allowance in compliance with existing documentation guidance in this 
area?
    Interpretive Response: No. A registrant should maintain 
supporting documentation for the loan loss allowance amount reported 
in its financial statements.\73\ As illustrated above, there may be 
instances in which loan loss allowance reviewers identify 
adjustments that need to be made to the loan loss estimates. The 
staff normally would expect the nature of the adjustments, how they 
were measured or determined, and the underlying rationale for making 
the changes to the loan loss allowance balance to be documented.\74\ 
The staff also normally would expect appropriate documentation of 
the adjustments to be provided to management for review of the final 
loan loss allowance amount to be reported in the financial 
statements. This documentation should also be made available to the 
independent accountants. If changes frequently occur during 
management or credit committee reviews of the loan loss allowance, 
management may find it appropriate to analyze the reasons for the 
frequent changes and to reassess the methodology the registrant 
uses.\75\
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    \73\ Ibid.
    \74\ Ibid.
    \75\ As outlined in paragraph 7.39 of the Audit Guide, effective 
internal controls related to the allowance for loan losses should 
include adequate review and approval of allowance estimates, 
including review of sources of relevant information, review of 
development of assumptions, review of reasonableness of assumptions 
and resulting estimates, and consideration of changes in previously 
established methods to arrive at the allowance.
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6. Validating a Systematic Methodology

    Question 14: What is the staff's guidance to a registrant on 
validating, and documenting the validation of, its systematic 
methodology used to estimate loan loss allowances?
    Interpretive Response: The staff believes that a registrant's 
loan loss allowance methodology is considered valid when it 
accurately estimates the amount of loss contained in the portfolio. 
Thus, the staff normally would expect the registrant's methodology 
to include procedures that adjust loan loss estimation methods to 
reduce differences between estimated losses and actual subsequent 
charge-offs, as necessary. To verify that the loan loss allowance 
methodology is valid and conforms to GAAP, the staff believes it is 
appropriate for management to establish internal control 
policies,\76\ appropriate for the size of the registrant and the 
type and complexity of its loan products. These policies may include 
procedures for a review, by a party who is independent of the 
allowance for loan losses estimation process, of the allowance for 
loan losses methodology and its application in order to confirm its 
effectiveness.
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    \76\ Ibid.
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    In practice, registrants employ numerous procedures when 
validating the reasonableness of their loan loss allowance 
methodology and determining whether there may be deficiencies in 
their overall methodology or loan grading process. Examples are:
     A review of trends in loan volume, delinquencies, 
restructurings, and concentrations.
     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.
     A review by a party that is independent of the loan 
loss allowance 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.
     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.
    It is the staff's understanding that, in practice, management 
usually supports the validation process with the workpapers from the 
loan loss allowance review function. Additional documentation often 
includes the summary findings of the independent reviewer. The staff 
normally would expect that, if the methodology is changed based upon 
the findings of the validation process, documentation that describes 
and supports the changes would be maintained.\77\

    \77\ See paragraph 7.39 of the Audit Guide.
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[FR Doc. 01-17425 Filed 7-11-01; 8:45 am]
BILLING CODE 8010-01-P