New guidelines for allowances for loan losses

Staff Accounting Bulletin No. 102, Loan Loss Allowance Methodology and Documentation, provides a key interpretation of a 1986 SEC reporting release. The FFIEC subsequently issued a policy statement on the design and implementation of ALLL methodologies and documentation. This article explores both issuances.

International accounting standards continue to evolve. For the banking industry the Basel Committee of the Bank for International Settlements first proposed international capital standards, known as the Basel Accord, in 1988; this Accord is currently under revision with "Basel II" expected to be implemented some time during 2005. Such standards have significantly improved the stability of the international banking system. However, financial institutions must also continue to focus on and follow other accounting standards and guidelines, such as those issued by the Securities and Exchange Commission (SEC) and the Federal Financial Institutions Examination Council (EFIEC).

In July 2001, the Office of the Chief Accountant and the Division of Corporation Finance of the SEC issued Staff Accounting Bulletin (SAB) No. 102, Loan Loss Allowance Methodology and Documentation, to provide SEC staff views on developing, documenting, and applying a systematic loan-loss-allowance methodology. This SAB provided a key interpretation of the SEC's Financial Reporting Release (FRR) No. 28 (issued in December 1986) to determine allowances for loan and lease losses in accordance with generally accepted accounting principles (GAAP). Concurrently, the FFIEC issued a "Policy Statement on Allowance for Loan and Lease Losses (ALLL) Methodologies and Documentation for Banks and Savings Institutions." The Policy Statement, issued in consultation with the SEC staff, provides guidance on the design and implementation of ALLL methodologies and documentation practices. SAB No. 102 and the Policy Statement contain parallel guidance on loan loss methodologies.

SAB 102

SAB No. 102 focuses on the documentation that the SEC staff normally expects registrants (entities) to prepare and maintain in support of their allowances for loan losses, and it applies to entities that are creditors in loan transactions that individually or aggregately materially affect the entity's financial statements. SEC staff had found that loan loss estimates underlying FRR No. 28 were developed with no disciplined methodology nor adequate documentation, which can undermine the credibility of an institution's financial statements. However, some lack of discipline continues in the establishment of allowances for loan losses and related documentation.

In a review of filings, the SEC staff has noted that in many cases the statistical data reported in the entity's MD&A related to trends in the quality of loan portfolios did not correspond to information reported in the financial statements. A number of registrants showed a lack of reasoned analysis or discipline in the calculation of loan loss allowance. Other registrants reported the assessment of significant loans for impairment, yet they could not produce documentation as to how the loans were evaluated or how the impairment was measured.

While the SAB should help entities improve their systematic methodologies to estimate loan loss allowances and to provide supporting documentation, it does not change any of the accounting profession's existing rules on accounting for loan loss provisions or allowances. SABs are not official SEC rules; rather, they offer interpretations and practices followed by staff of the SEC's Office of the Chief Accountant and the Division of Corporation Finance in administering the disclosure requirements of the federal securities laws.

The SAB draws upon existing guidance from SEC rules and interpretations, generally accepted accounting principles, and generally accepted auditing standards to explain certain views of the staff in applying existing guidance related to methodologies and documentation. Staff views are organized into the following topical areas:

1. A summary of current loan-loss-allowance guidance under generally accepted accounting principles and under SEC rules and interpretations.

2. General factors or elements for registrants to consider in developing and documenting their loan-loss-allowance methodologies, including their written policies and procedures.

3. Staff expectations for measuring and documenting loan impairment under Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan.

4. Staff expectations for measuring and documenting loan impairment under FASB Statement of Financial Accounting Standards No. 5, Accounting for Contingencies.

5. Staff expectations related to registrants' documentation of the results of their systematic loan loss methodology.

6. General guidance to registrants on validating, and documenting the validation of, their systematic loan loss.

The SEC has responded in the SAB that methodologies to calculate loan loss allowances should include management's current judgments as to the credit quality of the loan portfolio by considering such factors as size, organizational structure, business environment and strategy, management style, loan portfolio characteristics, administration procedures, and management information systems. The staff has reported that a registrant's loan-loss-allowance methodology would generally:

* Include a detailed analysis of the loan portfolio, performed on a regular basis.

* Consider all loans (whether on an individual or group basis).

* Identify loans to be evaluated for impairment on an individual basis under SFAS No. 114, and segment the remainder of the portfolio into groups of loans with similar risk characteristics for evaluation and analysis under SFAS No. 5.

* Consider all known key internal and external factors that may affect loan collectibility.

* Be applied consistently but modified for new factors affecting collectibility.

* Consider the particular risks inherent in different kinds of lending.

* Consider current collateral values (less costs to sell), where applicable.

* Require that analyses, estimates, reviews, and other methodology functions be performed by competent and well-trained personnel.

* Be well documented, in writing, clearly explaining the supporting analyses and rationale.

* Be based on current and reliable data.

* Include a systematic and logical method to consolidate the loss estimates, and ensure the loan-loss-allowance balance is recorded in accordance with GAAP.

In addition, the SEC considers it necessary to have appropriate written supporting documentation for the loan loss that aids in the review of the loan-loss-allowance process. The staff has reported that entities should maintain written documentation for the following decisions, strategies and processes:

* Policies and procedures:

* over the systems and controls that maintain appropriate loan loss allowances; and

* over the loan-loss-allowance methodology.

* Loan grading system or process.

* Summary or consolidation of the loan-loss-allowance balance.

* Validation of the loan-loss-allowance methodology.

* Periodic adjustments to the loan-loss-allowance process.

Many procedures are available to validate the reasonableness of an entity's loan loss allowance. The procedures would normally include:

* A review of trends in loan volume, delinquencies, restructurings, and concentrations.

* A review of previous charge-off and recovery history, including an evaluation of the timeliness of the entries to record both the charge-offs and the recoveries.

* A review, on a test basis, by a party that is independent of the loan-loss-allowance estimation process. Source documents and underlying assumptions would determine whether the established methodology develops reasonable loss estimates.

* An evaluation of the appraisal process of the underlying collateral by periodic comparison of the appraised value to the actual sales price on selected properties sold.

The SEC also provides interpretative responses to fact patterns dealing with the measurement and documentation of loan losses under both FASB No. 114 and FASB No. 5. The reader is recommended to refer to the SAB for the specific facts and the SEC's responses.

Federal Financial Institutions Examination Council Policy Statement

The Policy Statement, developed in consultation with the SEC staff, provides guidance on designing and implementing ALLL methodologies and supporting documentation practices by:

1. Clarifying that boards of directors of all applicable banks and savings institutions should ensure that adequate controls are in place to determine the appropriate level of the ALLL.

2. Stating that the ALLL processes must be thorough, disciplined, consistently applied, and incorporate management's current judgment about the quality of the loan portfolio.

3. Emphasizing that financial institutions maintain and support documentation for the ALLL that is consistent with their stated policies and procedures, GAAP, and applicable supervisory guidance.

4. Providing guidance to maintain and document policies and procedures that are tailored appropriately to the institution's size and complexity and its loan portfolio.

Similar to SAB 102, the Policy Statement includes many illustrations of potentially useful implementation practices, a summary of applicable GAAP guidance, and many reference citations. Moreover, similar to SAB 102, the Policy Statement does not change existing, authoritative GAAP or other authoritative accounting guidance and recognizes that estimating appropriate allowances entails much management judgment, which is inherently imprecise. Accordingly, financial institutions should use their best estimate to disclose the range within which such losses fall.

Conclusion

Both publicly and privately held financial institutions should recognize the provisions of the new SAB--as an indication of current and future policies for accounting for allowances for loan losses.

Reinstein is the George Husband Professor of Accounting, Wayne State University, Detroit, Michigan; Weirich is professor of Accounting, College of Business Administration, Central Michigan University, Mt. Pleasant, Michigan.

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