[Federal Register Volume 66, Number 208 (Friday, October 26, 2001)]
[Notices]
[Pages 54290-54301]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-26935]


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NATIONAL CREDIT UNION ADMINISTRATION


Allowance for Loan and Lease Losses Methodologies and 
Documentation for Federally-Insured Credit Unions

AGENCY: National Credit Union Administration.

ACTION: Notice of Proposed Interpretive Ruling and Policy Statement 
(IRPS) 01-3, with request for comments.

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SUMMARY: The National Credit Union Administration (NCUA) is proposing 
to adopt an Interpretive Ruling and Policy Statement on Allowance for 
Loan and Lease Losses (ALLL) Methodologies and Documentation for 
Federally-Insured Credit Unions (the proposed IRPS). The federal 
banking agencies recently issued a final policy statement intended to 
clarify the banking agencies' expectations regarding methodologies and 
documentation support for the ALLL. The Securities and Exchange 
Commission (SEC) issued parallel guidance in a Staff Bulletin. 
Likewise, it is necessary for the NCUA to issue analogous guidelines 
for federally-insured credit unions in order clarify the NCUA's 
expectations regarding methodologies and documentation support for the 
ALLL. This proposed IRPS is intended to provide the necessary parallel 
guidance for federally-insured credit unions.
    The proposed IRPS provides guidance on the design and 
implementation of ALLL methodologies and supporting documentation 
practices. The guidance recognizes that credit unions should adopt 
methodologies and documentation practices that are appropriate for 
their size and complexity.

DATES: NCUA welcomes comments on the proposed IRPS. Comments must be 
received on or before January 24, 2002.

ADDRESSES: Send comments to Becky Baker, Secretary to the NCUA Board, 
National Credit Union Administration, 1775 Duke Street, Alexandria, 
Virginia 22314-3428. You may also fax comments to (703) 837-2823, or e-
mail comments to [email protected]. Please send comments by one 
method only.

FOR FURTHER INFORMATION CONTACT: Karen Kelbly, Program Officer, Office 
of Examination and Insurance, at the above address or telephone (703) 
518-6389.

SUPPLEMENTARY INFORMATION:

I. Keypoints

     Credit union management is responsible for establishing an 
appropriate ALLL and documenting their methodology.
     Credit union methodologies should conform to generally 
accepted accounting principles (GAAP).
     Credit unions with lending portfolios comprised of 
homogeneous pools of consumer loans (such as credit card and automobile 
loans) and mortgage loans will find methodology and documentation 
requirements discussed herein to be less burdensome than those for 
credit unions with lending portfolios comprised of larger-balance, non-
homogeneous loans. Simply put, credit unions must review all loans (by 
groups as appropriate) for relevant internal and external factors, loss 
history, collateral values, and methods to ensure they are applied 
consistently when estimating probable existing losses but, when 
appropriate, modify loss estimates for new factors affecting 
collectibility.
     The FAS 5 discussions throughout this document will be 
most relevant to the majority of credit unions.
     Independent review of management's methodology and 
documentation practices by the supervisory committee, internal or 
external auditors is emphasized.
     Illustrations are provided that may be useful to a credit 
union in enhancing their own ALLL estimation methodology and 
documentation practices.

II. 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 (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.
    As a result, the banking agencies issued a final Policy Statement 
providing 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

[[Page 54291]]

Accounting Bulletin No. 102.\1\ This proposed IRPS is intended to 
provide parallel guidance for federally-insured credit unions.
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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 proposed IRPS clarifies the NCUA's 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 a credit union maintain written documentation to support the 
amounts of the ALLL and the provision for loan and lease losses 
reported in the financial statements.
    The proposal does not change existing accounting guidance in, or 
modify the documentation requirements of, GAAP. It is intended to 
supplement, not replace, current guidance. The proposed IRPS does not 
address or change current guidance regarding loan charge-offs; 
therefore, credit unions should continue to follow existing regulatory 
guidance that addresses the timing of charge-offs.
    The guidance in this proposed IRPS recognizes that credit unions 
should adopt methodologies and documentation practices that are 
appropriate for their size and complexity. For credit unions with fewer 
and less complex loan products, the amount of supporting documentation 
for the ALLL may be less exhaustive than for credit unions with more 
complex loan products or portfolios.
    Recognizing that a primary mission of the NCUA is to support a safe 
and sound credit union system, examiners will continue to evaluate the 
overall adequacy of the ALLL, including the adequacy of supporting 
documentation, to ensure that it is appropriate. While the proposed 
IRPS generally does not provide guidance to examiners in conducting 
safety and soundness examinations, examiners may take exception to 
credit union practices that fail to document and maintain an adequate 
ALLL in accordance with this IRPS, and other NCUA guidance. In such 
cases, credit union management may be cited for engaging in unsafe and 
unsound practices and may be subject to further supervisory action.

III. The Proposed IRPS

    Four of the FFIEC agencies including 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) sought public comment on a proposed 
policy statement on ALLL Methodologies and Documentation 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. This IRPS proposes parallel 
guidance for federally-insured credit unions. The following is a 
summary of the proposal:
    The proposed IRPS explains that the board of directors of each 
credit union is responsible for ensuring that controls are in place to 
determine the appropriate level of the ALLL. It also emphasizes the 
NCUA's long-standing position that credit unions should maintain and 
support the ALLL with documentation that is consistent with their 
stated policies and procedures, GAAP, and applicable supervisory 
guidance.
    The proposed IRPS describes significant aspects of ALLL 
methodologies and documentation practices. Specifically, the proposal 
provides guidance on maintaining and documenting policies and 
procedures that are appropriately tailored to the size and complexity 
of the credit union and its loan portfolio. The proposed IRPS states 
that a credit union'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 discusses the methodology and documentation 
needed to support ALLL estimates prepared in accordance with GAAP, 
which requires loss estimates based upon reviews of individual loans 
and groups of loans. The proposal states 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 effective and conforms to GAAP and 
supervisory guidance, the supervisory committee, the internal or 
external auditors or some other designated 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 
credit union.
    The proposal includes illustrations of implementation practices 
that credit unions may find useful for enhancing their own ALLL 
practices; a summary of applicable GAAP guidance; an appendix that 
provides examples of certain key aspects of ALLL guidance; and a 
bibliographical list of relevant GAAP guidance, joint interagency 
statements, and other literature on ALLL issues.

IV. Regulatory Procedures

Regulatory Flexibility Act

    The Regulatory Flexibility Act requires that NCUA prepare an 
analysis describing any significant economic impact agency rulemaking 
may have on a substantial number of small credit unions. 5 U.S.C. 601 
et seq. For purposes of this analysis, NCUA considers credit unions 
under $1 million in assets as small credit unions.
    Credit unions over $10 million in assets must follow GAAP in the 
call reports they file with the NCUA Board. All other credit unions 
must comply with GAAP in relation to the ALLL in order to meet 
regulatory requirements of full and fair disclosure. This proposed IRPS 
describes simplified ALLL requirements for the less complex loan 
activities that small credit unions engage in. For example, small 
credit unions may satisfy their ALLL responsibilities with consolidated 
documentation, the use of standardized checklists and worksheets, and 
simplified loan categorizations and segmentation. Accordingly, the NCUA 
has determined and certifies that this proposed IRPS will not have a 
significant economic impact on a substantial number of small credit 
unions beyond what is already required of them.

Paperwork Reduction Act

    NCUA has determined that this proposed IRPS does not increase 
paperwork requirements under the Paperwork Reduction Act of 1995 (44 
U.S.C. chapter 35) and regulations of the Office of Management and 
Budget.

Executive Order 13132

    Executive Order 13132 encourages independent regulatory agencies to 
consider the impact of their regulatory actions on state and local 
interests. In adherence to fundamental federalism principles, NCUA, an 
independent regulatory agency as defined in 44 U.S.C. 3502(5), 
voluntarily complies with the executive order.
    This proposed IRPS applies to all credit unions, but does not have 
substantial direct effect on the states, on the relationship between 
the national

[[Page 54292]]

government and the states, or on the distribution of power and 
responsibilities among the various levels of government. NCUA has 
determined that this proposed IRPS does not constitute a policy that 
has federalism implications for purposes of the executive order.

    By the National Credit Union Administration Board, on October 
18, 2001.
Becky Baker,
Secretary of the Board.

    Authority: 12 U.S.C. 1782a; 12 CFR 702.402.

Proposed Interpretive Ruling and Policy Statement No. 01-3

Allowance for Loan and Lease Losses Methodologies and Documentation for 
Federally-Insured Credit Unions (IRPS 01-3)

    Boards of directors of federally-insured credit unions are 
responsible for ensuring that their credit unions have controls in 
place to consistently determine the allowance for loan and lease losses 
(ALLL) in accordance with the credit union's stated policies and 
procedures, generally accepted accounting principles (GAAP), and ALLL 
supervisory guidance.\2\ 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 the underlying 
controls, the board of directors should assure themselves that the 
policies specifically address the credit union'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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    \2\ A bibliography is attached that lists applicable ALLL GAAP 
guidance, interagency policy statements, and other reference 
materials that may assist in understanding and implementing an ALLL 
in accordance with GAAP. See ``Application of GAAP'' section 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 to be 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 credit union, the board of 
directors should have the methodology periodically validated and, if 
appropriate, revised. Further, the supervisory or audit committee \3\ 
should oversee and monitor the internal controls over the ALLL 
determination process.\4\
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    \3\ All credit unions should establish a supervisory or audit 
committee.
    \4\ Credit union supervisory or audit committees 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 NCUA has a long-standing examination policy that calls for 
examiners to review a credit union's lending and loan review functions 
and recommend improvements, if needed. Agency guidance assists a credit 
union in estimating and establishing a sufficientALLL supported by 
adequate documentation. Additionally, guidance requires operational and 
managerial standards that are appropriate for a credit union's size and 
the nature and scope of its activities.
    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.\5\ This IRPS 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 credit 
union practice.\6\
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    \5\ The documentation guidance within this IRPS is predominantly 
based upon the GAAP guidance from Financial Accounting Standards 
Board 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); and Chapter 6--Allowance 
for Loan Losses, the American Institute of Certified Public 
Accountants' (AICPA) Audit and Accounting Guide, Audits of Credit 
Unions 2000 edition (AICPA Audit Guide).
    \6\ Failure to maintain adequate supporting documentation does 
not relieve a credit union of its obligation to record an 
appropriate ALLL.
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    This guidance applies equally to all credit unions, regardless of 
the size. However, credit unions 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 credit union has a 
consistent and appropriate methodology. Thus, much of the supporting 
documentation required for a credit union with more complex products or 
portfolios may be combined into fewer supporting documents in a credit 
union with less complex products or portfolios. For example, simplified 
documentation can include spreadsheets, check lists, and other summary 
documents that many credit unions currently use. Illustrations B and D 
provide specific examples of how less complex credit unions may 
determine and document portions of their loan loss allowance.

Documentation Standards

    Appropriate written supporting documentation facilitates review of 
the ALLL process and reported amounts, builds discipline 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. 
A credit union 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.
    At a minimum, credit unions should maintain written supporting 
documentation for the following decisions, strategies, and processes:

1. Policies and procedures:
    a. Over the systems and controls that maintain an appropriate ALLL, 
and
    b. Over the ALLL methodology,
2. Loan grading system or process,
3. Summary or consolidation of the ALLL balance,
4. Validation of the ALLL methodology, and
5. Periodic adjustments to the ALLL process.

    The following sections of this IRPS provide guidance on significant 
aspects of ALLL methodologies and documentation practices. 
Specifically, this IRPS provides documentation guidance on:

1. Application of GAAP,

[[Page 54293]]

2. Policies and Procedures,
3. Methodology,
4. ALLL Under FASB Statement of Financial Accounting Standards No. 
114,Accounting by Creditors for Impairment of a Loan (FAS 114),
5. ALLL Under FASB Statement of Financial Accounting Standards No. 5, 
Accounting for Contingencies (FAS 5),
6. Consolidating the Loss Estimates, and
7. Validating the ALLL Methodology.

Application of GAAP

    An ALLL recorded pursuant to GAAP is a credit union'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.\7\ 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, a credit union may determine that 
the amount of loss falls within a range. A credit union should record 
its best estimate within the range of loan losses.\8\
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    \7\ This section 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). Credit unions 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, Audits of Credit Unions, 2000 edition 
(AICPA Audit Guide). Additionally, this section 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).
    \8\ 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.\9\ 
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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    \9\ Emerging Issues Taskforce (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, a credit union should consider all available information 
reflecting past events and current conditions, including the effect of 
existing environmental factors. The Illustration A provides an example 
of a credit union estimating a loan's impairment when the loan has been 
partially charged-off.\10\
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    \10\ The referenced ``gray box'' illustrations are presented to 
assist credit unions in evaluating how to implement the guidance 
provided in this document. The methods described in the 
illustrations may not be suitable for all credit unions 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.
[GRAPHIC] [TIFF OMITTED] TN26OC01.002


[[Page 54294]]


    Large groups of smaller-balance homogeneous loans that are 
collectively evaluated for impairment are not included in the scope of 
FAS 114.\11\ 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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    \11\ 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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    Credit unions 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 a credit union 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 addition ALLL amount.\12\
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    \12\ 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 credit unions may use different methods, there are 
certain common elements that should be included in any loan loss 
allowance methodology. Generally, a credit union's methodology 
should:\13\
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    \13\ Refer to paragraph 6.04-6.10 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 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 a credit union's best estimate of the ALLL. 
Accordingly, credit unions 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.\14\
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    \14\ For informational purposes, credit unions may want to refer 
to the guidance on materiality provided in SEC Staff Accounting 
Bulletin No. 99, Materiality.
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Policies and Procedures

    Credit unions use 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 credit union and its loan 
portfolio.
    In order for a credit union's ALLL methodology to be effective, the 
credit union'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 credit union'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 credit union'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 credit union's systematic methodology, 
which should be consistent with the credit union's accounting policies 
for determining its ALLL;\15\ and
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    \15\ Further explanation is presented in the Methodology section 
that appears beow.
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    (4) The system of internal controls used to ensure that the ALLL 
process is maintained in accordance with GAAP and supervisory guidance.
    An internal control system for the ALLL estimation process should:
    (1) Include measures to ensure the reliability and integrity of 
information and compliance with laws, regulations, and internal 
policies and procedures;
    (2) Reasonably ensure that the credit union's financial statements 
(including regulatory reports) are prepared in accordance with GAAP and 
ALLL supervisory guidance; and
    (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 a credit 
union's credit administration function, financial reporting group, 
management, board of directors, and others who are involved in the ALLL 
determination process 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 a credit union 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.
    A credit union's ALLL methodology is influenced by credit union-
specific factors, such as a credit union'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 a credit union should incorporate in its ALLL methodology. A 
summary of common elements was provided in Application of GAAP section 
of this IRPS.\16\
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    \16\ Also, refer to paragraph 6.04-6.10 of the AICPA Audit 
Guide, 2000 edition.
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Documentation of ALLL Methodology in Written Policies and Procedures
    A credit union's written policies and procedures should describe 
the primary

[[Page 54295]]

elements of the credit union's ALLL methodology, including portfolio 
segmentation and impairment measurement. In order for a credit union's 
ALLL methodology to be effective, the credit union'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
    (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 a credit 
union'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

    A credit union'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. Credit unions 
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 a credit union 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 B describes a practice used by a small credit union to 
document its FAS 114 measurement of impairment using a comprehensive 
worksheet. Q&A #1 and #2 in Appendix A provide examples of applying and 
documenting impairment measurement methods under FAS 114.
    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 a credit union whose loan 
portfolio includes fully collateralized loans and describes the 
documentation maintained by that credit union to support its conclusion 
that no ALLL was needed for those loans.
[GRAPHIC] [TIFF OMITTED] TN26OC01.003


[[Page 54296]]



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. Credit unions 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 credit unions 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 credit unions offering a narrow range of loan products. Larger 
credit unions typically offer a more diverse and complex mix of loan 
products. Such credit unions 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, a credit union 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, credit unions 
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 C presents an example in which a 
credit union refined its segmentation method to more effectively 
consider risk factors and maintains documentation to support this 
change.
    Credit unions use a variety of documents to support the 
segmentation of their portfolios.
[GRAPHIC] [TIFF OMITTED] TN26OC01.004

    Some of these documents include:
     Loan trial balances by categories and types of loans,
     Management reports about the mix of loans in the 
portfolio,
     Delinquency and nonaccrual reports, and
     A summary presentation of the results of an internal or 
external loan grading review.
    Reports generated to assess the profitability of a loan product 
line may be useful in identifying areas in which to further segment the 
portfolio.
Estimating Loss on Groups of Loans
    Based on the segmentation of the portfolio, a credit union should 
estimate the FAS 5 portion of the ALLL. For those segments that require 
an ALLL,\17\ the credit union 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 credit union 
should follow a systematic and consistently applied approach to select 
the most appropriate loss measurement methods and support its 
conclusions and rationale with written documentation. Regardless of the 
method used to measure losses, a credit union 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.\18\
---------------------------------------------------------------------------

    \17\ 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 credit union.
    \18\ 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 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 credit union does not have loss experience of its 
own, it may be appropriate to reference the loss experience of other 
credit unions, provided that the credit union demonstrates that the 
attributes of the loans in its portfolio segment are similar to those 
of the loans included in the portfolio of the credit union providing 
the loss experience.\19\ Credit unions 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, credit unions 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

[[Page 54297]]

losses. An example of how a small credit union performs a comprehensive 
historical loss analysis is provided as the first item in Illustration 
D.
---------------------------------------------------------------------------

    \19\ Refer to paragraph 23 of FAS 5.
    [GRAPHIC] [TIFF OMITTED] TN26OC01.005
    
    Before employing a loss estimation model, a credit union 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, credit unions 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.
    In developing loss measurements, credit unions should consider the 
impact of current environmental factors and then document which factors 
were used in the analysis and how those factors affect the loss 
measurements. Factors that should be considered in developing loss 
measurements include the following:\20\
---------------------------------------------------------------------------

    \20\ Refer to paragraph 6.08 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 credit union 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 D provides an example of how a 
credit union adjusts its business 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 credit union's process for determining and 
documenting an ALLL for loans that are not individually impaired but 
have characteristics indicating there are loan losses on a group basis.

Consolidating the Loss Estimates

    To verify that ALLL balances are presented fairly in accordance 
with GAAP and are auditable, management should prepare a document that 
summarizes the amount to be reported in the financial statements for 
the ALLL. The board of directors should review and approve this 
summary.
    Common elements in such summaries include:
    (1) An estimate of the probable loss or range of loss incurred for 
each category evaluated (e.g., individually evaluated impaired loans, 
homogeneous pools, and other groups of loans that are collectively 
evaluated for impairment);
    (2) The aggregate probable loss estimated using the credit union's 
methodology;
    (3) A summary of the current ALLL balance;
    (4) The amount, if any, by which the ALLL is to be adjusted;\21\ 
and
---------------------------------------------------------------------------

    \21\ 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 sub-schedules of loss estimates that reconcile to 
the summary schedule.
    Illustration E describes how a credit union documents its estimated 
ALLL by

[[Page 54298]]

adding comprehensive explanations to its summary schedule.
[GRAPHIC] [TIFF OMITTED] TN26OC01.006

    Generally, a credit union'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

    A credit union's ALLL methodology is considered valid when it 
accurately estimates the amount of loss contained in the portfolio. 
Thus, the credit union'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, a credit union's directors should establish 
internal control policies, appropriate for the size of the credit union 
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, credit unions 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 
credit union'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 NCUA's 
views, as set forth in this IRPS, about the types of decisions, 
determinations, and processes a credit union should document with 
respect to itsALLL methodology and amounts; and (2) to illustrate 
the types of ALLL documentation and processes a credit union 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. Credit unions are expected to apply the 
guidance in this IRPS to their individual facts, circumstances, and 
situations. If a credit union's fact pattern differs from the fact 
patterns incorporated in the following Q&As, the credit union may 
decide to prepare and maintain different

[[Page 54299]]

types of documentation than did the credit unions depicted in these 
Q&As.

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

    Facts: Approximately one-third of Credit Union A's business loan 
portfolio consists of large balance, non-homogeneous loans. Due to 
their large individual balances, these loans meet the criteria under 
Credit Union A's policies and procedures for individual review for 
impairment under FAS 114. Upon review of the large balance loans, 
Credit Union A determines that certain of the loans are impaired as 
defined by FAS 114.
    Question: For the business loans reviewed under FAS 114 that are 
individually impaired, how should Credit Union 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, 
Credit Union 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 Credit Union 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 business loans for the past five years.
    Credit Union A should maintain, as sufficient, objective 
evidence, written documentation to support its measurement of loan 
impairment under FAS 114. If Credit Union 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 factors\1\ and other information reflecting past 
events and current conditions. When Credit Union A uses the fair 
value of collateral to measure impairment, Credit Union A should 
document how it determined the fair value, including the use of 
appraisals, valuation assumptions and calculations, the supporting 
rationale for adjustments to appraised values, if any, and the 
determination of costs to sell, if applicable, appraisal quality, 
and the expertise and independence of the appraiser. Similarly, 
Credit Union A should document the amount, source, and date of the 
observable market price of a loan, if that method of measuring loan 
impairment is used.
---------------------------------------------------------------------------

    \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: Credit Union B has a $750,000 loan outstanding to Member 
X that is secured by real estate, which Credit Union B individually 
evaluates under FAS 114 due to the loan's size. Member X is 
delinquent in its loan payments under the terms of the loan 
agreement. Accordingly, Credit Union B determines that its loan to 
Member X is impaired, as defined by FAS 114. Because the loan is 
collateral dependent, Credit Union B measures impairment of the loan 
based on the fair value of the collateral. Credit Union 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 $900,000.
    Credit Union 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 Credit Union 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 $575,000. Given that the recorded 
investment in the loan is $750,000, Credit Union B concludes that 
the loan is impaired by $175,000 and records an allowance for loan 
losses of $175,000.
---------------------------------------------------------------------------

    \2\ When reviewing collateral dependent loans, Credit Uniion 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 Credit Union B 
maintain to support its determination of the allowance for loan 
losses of $175,000 for the loan to Member X?
    Interpretive Response: Credit Union B should document that it 
measured impairment of the loan to Member X by using the fair value 
of the loan's collateral, less costs to sell, which it estimated to 
be $575,000. This documentation should include the credit union's 
rationale and basis for the $575,000 valuation, including the 
revised valuation assumptions it used, the valuation calculation, 
and the determination of costs to sell, if applicable.
    Because Credit Union B arrived at the valuation of $575,000 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 $900,000 eighteen 
months ago to $575,000 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: Credit Union C has $500,000 in business loans that are 
fully collateralized by purchased business equipment. The loan 
agreement for each of these loans requires the borrower to provide 
qualifying collateral sufficient to fully secure each loan. The 
member borrowers have physical control of the collateral. Credit 
Union C perfected its security interest in the collateral when the 
funds were originally distributed. On an annual basis,Credit Union C 
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. Semiannually or more frequently as needed, 
the Credit Union C's credit administration function physically 
inspects the equipment. If there are any collateral deficiencies, 
CreditUnion C notifies the borrower and requests that the borrower 
immediately remedy the deficiency. Due in part to its efficient 
operation, Credit Union C has historically not incurred any material 
losses on these loans. Credit Union C believes these loans are 
fully-collateralized and therefore does not maintain any ALLL 
balance for these loans.
    Question: What documentation does Credit Union C maintain to 
adequately support its determination that no allowance is needed for 
this group of loans?
    Interpretive Response: Credit Union C's management summary of 
the ALLL includes documentation indicating that, in accordance with 
the credit union's ALLL policy, the collateral protection on these 
loans has been verified by the credit union, no probable loss has 
been incurred, and no ALLL is necessary. Documentation in Credit 
Union C's loan files includes the two independent market quotes 
obtained annually for each loan's collateral amount, the documents 
evidencing the perfection of the security interest in the 
collateral, and other relevant supporting documents. Additionally, 
Credit Union C's ALLL policy includes a discussion of how to 
determine when a loan is considered ``fully collateralized'' and 
does not require an ALLL. Credit Union C's policy requires the 
following factors to be considered and the credit union'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 credit union or other third party inspection 
of the collateral;
    4. Historical losses on similar loans;
    5. Confidence in the credit union'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.
    6. Other factors as appropriate for the loan type

[[Page 54300]]

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

    Facts: Credit Union D's field of membership (lending area) 
includes a metropolitan area that is financially dependent upon the 
profitability of a number of sponsor 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 sponsor manufacturing firms declared 
bankruptcy. The foreign suppliers have subsequently increased prices 
and the sponsor 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 sponsor manufacturing businesses are 
experiencing financial difficulties and have recently announced 
downsizing plans.
    Although Credit Union D has yet to confirm an increase in its 
loss experience as a result of these events, management knows that 
the credit union lends to a significant number of member's for 
business and individual purposes whose repayment ability depends 
upon the long-term viability of the sponsor manufacturing 
businesses. Credit Union D's management has identified particular 
segments of its business and consumer member bases that include 
member borrowers highly dependent upon sales or salary from the 
sponsor manufacturing businesses. Credit Union 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, Credit Union D has experienced similar business and 
lending conditions in the past that it can compare to current 
conditions.
    Question: How should Credit Union D document its support for the 
loss rate adjustments that result from considering these 
manufacturing firms' financial downturns?
    Interpretive Response: Credit Union D should document its 
identification of the particular segments of its business and 
consumer loan portfolio for which it is probable that the sponsor 
manufacturing business' financial downturn has resulted in loan 
losses. In addition, Credit Union D should document its analysis 
that resulted in the adjustments to the loss rates for the affected 
portfolio segments. As part of its documentation, Credit Union D 
maintains copies of the documents supporting the analysis, including 
relevant newspaper articles, economic reports, and economic data, 
and notes from discussions with individual member borrowers.
    Because in this case Credit Union 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, Credit Union D creates a 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: Credit Union E has outstanding loans of $875,000 to 
Member Y and $725,000 to Member Z, both of which are paying as 
agreed upon in the loan documents. The credit union's ALLL policy 
specifies that all loans greater than $700,000 must be individually 
reviewed for impairment under FAS 114. Member Y's financial 
statements reflect a strong net worth, good profits, and ongoing 
ability to meet debt service requirements. In contrast, recent 
information indicates Member Z's profitability is declining and its 
cash flow is tight. Accordingly, this loan is rated substandard 
under the credit union's loan grading system. Despite its concern, 
management believes Member Z will resolve its problems and 
determines that neither loan is individually impaired as defined by 
FAS 114.
    Credit Union 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 Member Y has risk characteristics similar 
to the loans included in Segment 1 and the loan to Member 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, Credit Union E 
includes its loans to Member Y and Member Z in the groups of loans 
with similar characteristics (i.e., Segment 1 for Member Y's loan 
and Segment 2 for Member 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 credit union's probable loan losses in these segments.
    Question: How does Credit Union E adequately support and 
document an ALLL under FAS 5 for these loans that were individually 
reviewed for impairment but are not considered individually 
impaired?
    Interpretive Response: As part of Credit Union E's effective 
ALLL methodology, it documents the decision to include its loans to 
Member Y and Member 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. Credit Union 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 credit union 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: Credit Union 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 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 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 Credit Union F's documentation practices related 
to the balance of its loan loss allowance appropriate?
    Interpretive Response: No. A credit union 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 credit 
unions subject to external audit, this documentation should also be 
made available to the supervisory committee and its independent 
accountants. If changes frequently occur during management or 
committee reviews of the ALLL, management may find it appropriate to 
analyze the reasons for the frequent changes and to reassess the 
methodology the credit union uses.

Bibliography

GAAP and Auditing Guidance

American Institute of Certified Public Accountants' Audit and 
Accounting Guide, Audits of Credit Unions, 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

[[Page 54301]]

and No. 114 to a Loan Portfolio (EITF Topic D-80 and attachments), 
discussed on May 19-20, 1999
Financial Accounting Standards Board Interpretation No. 14, 
Reasonable Estimation of the Amount of a Loss (An Interpretation of 
FASB Statement No. 5)
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 5, Accounting for Contingencies
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 114, Accounting by Creditors for Impairment 
of A Loan (An Amendment of FASB Statements No. 5 and 15)
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 118, Accounting by Creditors for Impairment 
of a Loan--Income Recognition and Disclosures (An Amendment of FASB 
Statement No. 114)
Financial Accounting Standards Board Statement of Financial 
Accounting Standards No. 140, Accounting for Transfers and Servicing 
of Financial Assets and Extinguishments of Liabilities--a 
Replacement of FASB Statement No. 125

Regulatory Guidance

Interagency Policy Statement on the Allowance for Loan and Lease 
Losses (ALLL), December 21, 1993
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

[FR Doc. 01-26935 Filed 10-25-01; 8:45 am]
BILLING CODE 7535-01-U