[Federal Register Volume 67, Number 103 (Wednesday, May 29, 2002)]
[Notices]
[Pages 37445-37459]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-12790]


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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 final interpretive ruling and policy statement (IRPS) 
02-3.

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SUMMARY: The National Credit Union Administration (NCUA) is adopting an 
Interpretive Ruling and Policy Statement on Allowance for Loan and 
Lease Losses(ALLL) Methodologies and Documentation for Federally-
Insured Credit Unions (the 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 to clarify the NCUA's expectations regarding 
methodologies and documentation support for the ALLL. This IRPS is 
intended to provide the necessary parallel guidance for federally-
insured credit unions.
    The 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: The IRPS is effective May 29, 2002.

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

    [sbull] Credit union management is responsible for establishing an 
appropriate ALLL and documenting their methodology.
    [sbull] Credit union methodologies should conform to generally 
accepted accounting principles (GAAP).
    [sbull] 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.
    [sbull] The Statement of Financial Accounting Standard (FAS) 5 
discussions throughout this document will be most relevant to the 
majority of credit unions.
    [sbull] Independent review of management's methodology and 
documentation practices by the supervisory committee, internal or 
external auditors is emphasized.
    [sbull] 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 ReserveBoard, 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:
    [sbull] Appropriate methodologies and supporting documentation, and
    [sbull] Enhanced disclosures.

[[Page 37446]]

    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 Accounting Bulletin No. 102.\1\ 
This 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 losses in a 
loan portfolio.
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    This 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 IRPS does not change existing accounting guidance in, or modify 
the documentation requirements of, GAAP. It is intended to supplement, 
not replace, current guidance. The 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 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 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

    The NCUA sought public comment on a proposed IRPS on ALLL 
methodologies and documentation practices for credit unions on October 
26, 2001 (66 FR 54290). The proposal indicated that the purpose of the 
policy statement was to provide federally-insured credit unions with 
enhanced guidance on appropriate ALLL methodologies and documentation 
practices.
    The proposed IRPS explained that the board of directors of each 
federally-insured credit union is responsible for ensuring that 
controls are in place to determine the appropriate level of the ALLL. 
It also emphasized 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 described significant aspects of ALLL 
methodologies and documentation practices. Specifically, the proposal 
provided guidance on maintaining and documenting policies and 
procedures that are appropriately tailored to the size and complexity 
of the credit union and its loan portfolio. The proposed IRPS stated 
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 discussed the methodology and documentation 
needed to support ALLL estimates prepared in accordance with GAAP, 
which requires loss estimates based upon reviews of individual loans 
and groups of loans. The proposal stated that after determining the 
allowance on individually reviewed loans and groups of loans, 
management should consolidate those loss estimates and summarize the 
amount to be reported in the financial statements for the ALLL. To 
verify that the ALLL methodology is 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 included 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 
provided 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. Discussion of Public Comments

A. General Comments

    The NCUA received thirteen letters commenting on the proposed IRPS. 
Five of the letters were received from credit unions; four were 
received from credit union league groups; two letters were from credit 
union trade groups; one letter was from another credit union group; and 
one letter came from a banking trade group.
    Overall, eight of the thirteen commenters supported the IRPS: three 
favoring the IRPS and welcoming the guidance and policy clarification; 
five others supporting the IRPS but expressing cautious approval. One 
of the eight summarized the flavor of the comments well in pointing out 
that the IRPS was an enhancement to current guidelines; provided a 
given framework without endorsing a fixed formula; and provided 
valuable discussion points on generally accepted accounting principles 
(GAAP). Another of the eight welcomed the IRPS guidance as offering 
areas of policy clarification. One commenter welcomed the IRPS guidance 
arguing that a new process is needed to replace the outdated historical 
loss approach. Other favorable comments included approval of the useful 
appendix illustrations; appreciation for the discussion points on FAS 5 
and FAS 114 as particularly helpful; and acknowledgement that the 
policy recognized that credit unions with homogeneous pools of consumer 
loans should have a lesser burden. A banking trade group supported the 
effort and encouraged the NCUA to issue identical guidance to credit 
unions as the other regulators issue for banks.
    One commenter was unclear in setting forth his position as either 
favoring or opposing the IRPS. Another commenter expressed the view 
that current practices within its credit union satisfied the major 
points in the IRPS. He understood that the guidance did not attempt to 
expand current GAAP requirements and allowed credit unions to continue 
to use judgment in implementing loan loss estimation methodologies that 
are appropriate to individual credit unions.
    The NCUA believes that credit unions currently complying with GAAP 
should not need to dedicate additional resources to create or support 
the ALLL

[[Page 37447]]

included in their regulatory reports. The NCUA has expected credit 
unions to follow GAAP, as it applies to the ALLL, for regulatory 
reporting purposes for a number of years. The IRPS is consistent with 
existing GAAP, which requires that allowances be well documented, with 
clear explanations of the supporting analysis and rationale. The NCUA 
encourages credit unions to carefully evaluate their current ALLL 
methodologies and supporting documentation practices as well as other 
credit risk management practices and reports before making significant 
changes to their current practices or creating new processes, reports, 
or other supporting documents in order to follow this guidance.
    Two of the thirteen commenters opposed the change outright both 
arguing it would impose a regulatory burden without a corresponding 
benefit. One of these categorized the IRPS as an extensive policy 
change and the other objected to the documentation requirements. These 
comments are discussed more fully below in the section dealing with 
``IRPS Burden on Small Credit Unions''.
    The remaining commenter expressed caution and anticipated overly-
zealous agency enforcement of the IRPS, fearing that the examiners 
would likely challenge the ALLL result even when the methodology had 
been validated by a third party. The NCUA plans several initiatives to 
update examiner directives and train examiners in the less familiar 
aspects of the IRPS. The Board does not anticipate an unreasonable 
enforcement of the IRPS with regard to affected credit unions.

B. Board Approval Requirement

    The proposed IRPS required that 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. The NCUA did not 
intend through this language to expand the board of directors 
responsibilities beyond those that currently exist.
    Two commenters that favored the IRPS proposal and one that opposed 
it objected to the referenced language. One of these three stated that 
it was inappropriate to require the board of directors by regulatory 
ruling to provide such approvals. Another suggested it was unwise to 
add responsibilities on credit union boards of directors at a time when 
attracting qualified volunteers was becoming increasingly difficult. 
Each argued that boards should have oversight over the methodology 
used, periodically validating the methodology and ensuring it was 
revised when appropriate; but, otherwise, not be required to provide 
approvals.
    At present, boards of directors are responsible for approving ALLL 
policies and attesting to the validity of the regulatory reports, which 
includes the ALLL. While the board of directors has ultimate 
responsibility for these functions, daily administration of policies 
and recordkeeping may be delegated to operating management. The IRPS 
includes the statement that the scope of board of directors' 
responsibilities is not changed or expanded with the issuance of this 
Policy Statement.

C. Independent Review of ALLL

    The proposed IRPS required that credit union policies governing the 
ALLL methodology 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. Further, the 
supervisory or audit committee should oversee and monitor the internal 
controls over the ALLL determination process.
    Three commenters request modifications to the IRPS language. One 
opposed this provision outright arguing that an independent review 
carries little or no weight at the examiner level. One argued that 
since the supervisory committee could delegate these functions to the 
internal or external auditor, the IRPS should acknowledge that fact. 
The third stated it was inappropriate and unnecessary to require, by 
regulatory ruling, that the oversight and monitoring of the internal 
controls over the ALLL determination process is a specific 
responsibility of the supervisory committee.
    The NCUA did not intend through this language to expand the 
supervisory committee's responsibilities beyond those that currently 
exist. The supervisory committee's responsibilities with regard to 
oversight and monitoring of the internal controls over the ALLL 
determination process are already encompassed within its general 
responsibilities set forth in [sect] 715.3 of the NCUA Rules and 
Regulations. The IRPS simply highlights and reinforces the supervisory 
committee's role (which may be delegated to the internal or external 
auditor) with regard to the ALLL estimation process and specifically, 
its role in the independent review of management's implementation of 
the board's policies with regard to the process. The Board believes the 
IRPS guidance would be deficient if it failed to mention and reinforce 
this role.

D. IRPS Burden On Small Credit Unions

    The IRPS provided in several places that credit unions currently 
complying with GAAP should not need to dedicate additional resources to 
create or support the ALLL included in regulatory reports. Essentially, 
those credit unions currently following GAAP should not be greatly 
affected by the IRPS nor find their current practices in need of 
substantial change.
    One commenter acknowledged that the current practices within his 
credit union satisfy the major points in the IRPS. However, two other 
commenters did not agree: one of these, opposed to the IRPS generally, 
argued that the additional regulatory burden it will impose is without 
a corresponding benefit. The other commenter objected that the IRPS 
imposes a needless burden to credit unions; that the ALLL within credit 
unions is not systemically deficient; and that they support a simpler 
rule without adding new burden to credit union management and board 
members. Further, this commenter opposed a particular methodology.
    The IRPS provides throughout that if a credit union is currently 
complying with GAAP in its ALLL estimation practices and methodology, 
the IRPS will not substantially change current practice. The guidance 
in the IRPS includes a broad description of the steps taken during the 
ALLL estimation process that must be documented. The types of 
documentation described in the examples illustrate that management has 
considerable flexibility in determining the appropriate level and type 
of supporting documentation given the type of loans and associated 
credit risks being evaluated. Additionally, the guidance specifically 
states that credit unions with less complex products or portfolios may 
consider combining some of the procedures outlined in the proposed 
guidance. Furthermore, when appropriate, these credit unions may use 
documentation that is already being generated for other purposes to 
support their ALLLs. The NCUA believes these suggestions will assist 
these credit unions in supporting their ALLLs without any unnecessary 
burden.

E. Statement of Financial Accounting Standard (FAS) 5

    The proposed IRPS included a discussion of relevant GAAP 
particularly FAS 5 and FAS 114, and provides illustrations of how the 
two standards work in tandem.
    One commenter suggested that small credit unions should not have to 
apply either FAS 5 or FAS 114, but that NCUA

[[Page 37448]]

should develop a simplistic methodology for their use. FAS 5 and FAS 
114 comprise GAAP and all credit unions must comply with GAAP in their 
ALLL estimation process: credit unions under $10 million in assets must 
comply with GAAP in their ALLL estimation process in order to meet full 
and fair disclosure requirements of the NCUA Rules and Regulations; in 
addition, credit unions with $10 million or more in assets must comply 
with GAAP under requirements of the Federal Credit Union Act as amended 
by the Credit Union Membership Access Act. However, the IRPS does 
concede a lesser methodology and documentation burden for less complex 
credit unions.
    Another commenter, generally favoring the IRPS, acknowledged that 
the IRPS approach is technically accurate but argued that it does not 
protect the National Credit Union Share Insurance Fund (NCUSIF) by 
building a cushion in good times to cover losses in bad times. The 
commenter is correct. The GAAP rules, aimed at fair presentation of 
financial statements, are predicated on an ``incurred loss'' accounting 
model for estimating loan losses rather than an ``expected loss'' 
model; the latter model is arguably more favorable in cushioning 
against future losses. Nonetheless, the entireALLL must be determined 
in accordance with GAAP and supported with adequate documentation. 
Credit unions are already required to follow GAAP (incurred loss model) 
when determining the ALLL and the guidance does not change existing 
GAAP; therefore, following this IRPS should not result in material 
adjustments to the ALLL by credit unions currently following GAAP.
    A third commenter addressed the requirement that homogeneous pools 
be segmented based on predominant risk characteristics. The commenter 
expressed concern about the examiners interpretation of this provision 
and strongly advocated for additional examiner guidance. This commenter 
also suggested the final IRPS omit the paragraph dealing with loss 
estimation models. The NCUA agrees that examiner guidance will be 
needed and will be following the issuance of this IRPS with Examiner 
Guide revisions and examiner education to ensure the smooth 
implementation of this policy. The Board considered the elimination of 
the loss estimation models paragraph but determined there was merit to 
segments of the credit union population in retaining the paragraph.
    A final commenter wanted the NCUA to emphasize that obtaining an 
appropriate ALLL that correctly recognizes risk is more important than 
the minute details of the methodology. The NCUA agrees but acknowledges 
that a sound methodology ensures an appropriate ALLL. This commenter 
also wants NCUA to recognize in the guidance that many credit unions 
are already abiding by these practices. The NCUA agrees this statement 
is true and believes the guidance recognizes this fact.

F. Statement of Financial Accounting Standard (FAS) 114

    The proposed IRPS discussed GAAP generally and FAS 114 
specifically. FAS 114 deals with individual classification of large-
balance, non-homogeneous loans which for credit unions will 
predominantly consist of business and agricultural loans.
    One commenter suggested that rarely will a credit union have such a 
loan, and if they do, it is unlikely they will have the means to 
analyze and calculate the present value of future cash flows. He 
believes FAS 114 is intended to provide job security to CPAs. This 
commenter further suggested that the vast majority of credit unions 
will have loans within the scope of FAS 5, i.e., smaller balance, 
homogeneous pools of consumer loans. He encouraged parameters defining 
``larger balance'' for each of consumer loans and commercial loans. The 
NCUA agrees that the vast majority of credit unions will have loans 
within the scope of FAS 5 and that it will be only the most complex 
credit unions that may have a large balance business loan within the 
scope of FAS 114 requiring individual classification. Nonetheless, the 
NCUA resists setting parameters defining ``larger balance'' as to do so 
would eliminate the intended discretion the Financial Accounting 
Standards Board (FASB) preserved in promulgating FAS 114.The IRPS 
includes illustrations to help guide a credit union's judgment as it 
implements the guidance.
    In the Q&A Appendix to the IRPS, question 2 discusses ``a 
$750,000 loan outstanding that is secured by real estate, which Credit 
Union B individually evaluates under FAS 114 due to the loan's size 
(emphasis added).'' The example was originally published by the banking 
agencies as collateralized at $10 million. When drafting the 
proposedIRPS, NCUA staff reduced the dollar threshold from the $10 
million level to make the example more realistic in relation to a 
credit union. Clearly only large balance, non-homogeneous loans are 
scoped within FAS 114, and since rarely would a credit union have a 
large balance, real estate-secured loan within the scope of FAS 114 
unless it were a business loan, staff have concluded that the 
collateral value reduction included when drafting the proposed rule has 
proved misleading to readers of the IRPS in a proper interpretation of 
FAS 114. Accordingly, the dollar threshold for real estate collateral 
in the Q&A example for purposes of applying FAS 114 has been raised to 
the $10 million threshold consistent with the banking agencies similar 
policy statement.

G. Miscellaneous

    The proposed IRPS mentioned that the American Institute of 
Certified PublicAccountants (AICPA) is drafting and intends to issue a 
Statement of Position setting forth further GAAP with regard to the 
ALLL. Two commenters suggest the NCUA wait to issue its final IRPS 
until the AICPA issues its final SOP. Because the IRPS provides 
beneficial clarifying guidance within existing GAAP, and since the SOP 
document has yet to be advanced through the accounting standard-setting 
due process, NCUA chooses to proceed with issuing this IRPS. The AICPA 
continues to develop its guidance, and the NCUA along with the banking 
agencies are closely monitoring and actively contributing to that 
process.
    One commenter objected to footnote language that seemed to obligate 
all insured credit unions to have a supervisory or audit committee. 
They argued the footnote language is inconsistent with the construction 
of Title II of the Federal Credit Union Act and applicable parts of the 
NCUA Rules and Regulations. Because of differing state requirements and 
the fact that some state credit unions have audit committees rather 
than supervisory committees, the footnote has been amended to provide 
that while federal credit unions are required to establish a 
supervisory committee; and while state chartered credit unions are 
encouraged to have either a supervisory or audit committee, in credit 
unions without either a supervisory or an audit committee, the board of 
directors retains this responsibility. The revised footnote more 
closely parallels a similar footnote included in the banking agencies' 
related final interagency policy statement.
    One commenter noted that, for purposes of the Regulatory 
Flexibility Act (RFA), the Board considers credit unions under $1 
million in assets to be small credit unions. The commenter suggested 
that the Board use a threshold of $10 million instead of $1 million. In 
suggesting that the threshold be raised, they argue that credit unions 
under $10 million do not need to comply with

[[Page 37449]]

GAAP in funding the ALLL. NCUA regulations mandate, however, that 
credit unions under $1 million be considered as small for purposes of 
the RFA. See 12 CFR 791.8(a) and Interpretive Ruling and Policy 
Statement 87-2. Additionally, all credit unions regardless of asset 
size must comply with GAAP in funding the allowance as discussed above 
in the section dealing with FAS 5.

V. 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 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 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 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 IRPS applies to all credit unions, but does not have 
substantial direct effect on the states, on the relationship between 
the national government and the states, or on the distribution of power 
and responsibilities among the various levels of government. NCUA has 
determined that this IRPS does not constitute a policy that has 
federalism implications for purposes of the executive order.

    By the National Credit Union Administration Board, on May 16, 
2002.
Becky Baker,
Secretary of the Board.

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

    IRPS 02-3 is as follows:

Interpretive Ruling and Policy Statement No. 02-3

Allowance for Loan and Lease Losses Methodologies and Documentation for 
Federally-Insured Credit Unions (IRPS 02-3)

    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.\1\ To fulfill this responsibility, boards of 
directors instruct management to develop and maintain an appropriate, 
systematic, and consistently applied process to determine the amounts 
of the ALLL and provisions for loan losses. Management should create 
and implement suitable policies and procedures to communicate the ALLL 
process internally to all applicable personnel. Regardless of who 
develops and implements these policies, procedures, and 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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    \1\ 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 \2\ 
should oversee and monitor the internal controls over the ALLL 
determination process. \3\
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    \2\ All federal credit unions must establish a supervisory 
committee. If a federally insured state chartered credit union does 
not have either a supervisory or audit committee, the board of 
directors retains this responsibility.
    \3\ 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 sufficient ALLL 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. \4\ 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

[[Page 37450]]

guidance is generally an unsafe and unsound credit union practice. \5\
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    \4\ 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).
    \5\ Failure to maintain adequate supporting documentation does 
not relieve a credit union of its obligation torecord 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 ALLL.

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,
    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.\6\ 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.\7\
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    \6\ 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).
    \7\ 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).
---------------------------------------------------------------------------

    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.\8\ 
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.
---------------------------------------------------------------------------

    \8\ 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.
---------------------------------------------------------------------------

    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.\9\
---------------------------------------------------------------------------

    \9\ 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.
---------------------------------------------------------------------------

    Large groups of smaller-balance homogeneous loans that are 
collectively evaluated for impairment are not included in the scope of 
FAS 114.\10\ 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.
---------------------------------------------------------------------------

    \10\ 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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[[Page 37451]]

[GRAPHIC] [TIFF OMITTED] TN29MY02.013

    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 additional ALLL amount.\11\
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    \11\ 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.
---------------------------------------------------------------------------

    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:\12\
---------------------------------------------------------------------------

    \12\ Refer to paragraph 6.04-6.10 of the AICPA Audit Guide.
---------------------------------------------------------------------------

    1. Include a detailed analysis of the loan portfolio, performed on 
a regular basis;
    2. Consider all loans (whether on an individual or group basis);
    3. Identify loans to be evaluated for impairment on an individual 
basis under FAS 114 and segment the remainder of the portfolio into 
groups of loans with similar risk characteristics for evaluation and 
analysis under FAS 5;
    4. Consider all known relevant internal and external factors that 
may affect loan collectibility;
    5. Be applied consistently but, when appropriate, be modified for 
new factors affecting collectibility;
    6. Consider the particular risks inherent in different kinds of 
lending;
    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.\13\
---------------------------------------------------------------------------

    \13\ For informational purposes, credit unions may want to refer 
to the guidance on materiality provided in SEC Staff Accounting 
Bulletin No. 99, Materiality.
---------------------------------------------------------------------------

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;\14\ and
---------------------------------------------------------------------------

    \14\ Further explanation is presented in the Methodology section 
that appears below.
---------------------------------------------------------------------------

    (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

[[Page 37452]]

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.\15\
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    \15\ Also, refer to paragraph 6.04-6.10 of the AICPA Audit 
Guide, 2000 edition.
---------------------------------------------------------------------------

Documentation of ALLL Methodology in Written Policies and Procedures

    A credit union's written policies and procedures should describe 
the primary 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

[[Page 37453]]

maintained by that credit union to support its conclusion that no ALLL 
was needed for those loans.
[GRAPHIC] [TIFF OMITTED] TN29MY02.014

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 only in 
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] TN29MY02.015

    Some of these documents include:
    [sbull] Loan trial balances by categories and types of loans,
    [sbull] Management reports about the mix of loans in the portfolio,
    [sbull] Delinquency and nonaccrual reports, and

[[Page 37454]]

    [sbull] 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,\16\ 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.\17\
---------------------------------------------------------------------------

    \16\ An example of a loan segment that does not generally 
require an ALLL is loans that are fully secured bydeposits 
maintained at the lending credit union.
    \17\ 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.\18\ 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 losses. An example of how a small credit union performs a 
comprehensive historical loss analysis is provided as the first item in 
Illustration D.
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    \18\ Refer to paragraph 23 of FAS 5.
    [GRAPHIC] [TIFF OMITTED] TN29MY02.016
    
    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:\19\
---------------------------------------------------------------------------

    \19\ 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,

[[Page 37455]]

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; \20\ 
and
---------------------------------------------------------------------------

    \20\ 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 adding comprehensive explanations to its summary schedule.
[GRAPHIC] [TIFF OMITTED] TN29MY02.017

    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

[[Page 37456]]

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 its ALLL 
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 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. IfCredit 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 $10 million 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 $12 million.
    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

[[Page 37457]]

adjusting the collateral valuation assumptions, the credit review 
department determines that the current estimated fair value of the 
collateral, less costs to sell, is $8 million. Given that the recorded 
investment in the loan is $10 million, Credit Union B concludes that 
the loan is impaired by $2 million and records an allowance for loan 
losses of $2 million.
---------------------------------------------------------------------------

    \2\ When reviewing collateral dependent loans, Credit Union 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.
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    Question: What type of documentation should Credit Union B maintain 
to support its determination of the allowance for loan losses of $2 
million 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 $8 
million. This documentation should include the credit union'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 Credit Union B arrived at the 
valuation of $8 million by modifying an earlier appraisal, it should 
document its rationale and basis for the changes it made to the 
valuation assumptions that resulted in the collateral value declining 
from $12 million eighteen months ago to $8 million in the current 
period.\3\
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    \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.
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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, Credit Union 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

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

[[Page 37458]]

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\
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    \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.
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    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 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.

[[Page 37459]]

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. 02-12790 Filed 5-28-02; 8:45 am]
BILLING CODE 7535-01-P