[Federal Register Volume 59, Number 94 (Tuesday, May 17, 1994)]
[Unknown Section]
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From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11956]
[[Page Unknown]]
[Federal Register: May 17, 1994]
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FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL
Implementation Issues Arising From FASB Statement No. 114,
``Accounting by Creditors for Impairment of a Loan''
AGENCY: Federal Financial Institutions Examination Council.
ACTION: Request for comment.
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SUMMARY: The Federal Financial Institutions Examination Council
(FFIEC)\1\ is seeking public comment on certain issues arising from the
adoption by the Financial Accounting Standards Board of Statement No.
114 (FAS 114), ``Accounting by creditors for Impairment of a Loan.''
These issues include the character of the FAS 114 allowance (i.e.,
whether it should be a general allowance that is includible in Tier 2
capital, or a specific allowance that is not includible in Tier 2
capital) and whether regulatory nonaccrual rules should be maintained
for purposes of reporting on the Consolidated Reports of Condition and
Income (Call Report) filed by banks and the Thrift Financial Report
(TFR) filed by savings associations. After reviewing the public
comments and making final decisions on these issues, appropriate
changes will be made to the instructions for the Call Report and TFR
and other regulatory guidance to incorporate changes arising from the
adoption of FAS 114.
\1\The FFIEC consists of representatives from the Board of
Governors of the Federal Reserve System (FRB), the Federal Deposit
Insurance Corporation (FDIC), the Office of the Comptroller of the
Currency (OCC), the Office of Thrift Supervision (OTS) (referred to
as the ``agencies''), and the National Credit Union Administration.
However, this request for comment is not directed to credit unions.
Section 1006(c) of the Federal Financial Institutions Examination
Council Act requires the FFIEC to develop uniform reporting
standards for federally-supervised financial institutions.
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DATES: Comments must be received by July 1, 1994.
ADDRESSES: Comments should be directed to Joe M. Cleaver, Executive
Secretary, Federal Financial Institutions Examination Council, 2100
Pennsylvania, Avenue, NW, suite 200, Washington DC 20037. (Fax number
202-634-6556.) Comments will be available for public inspection during
regular business hours at the above address. Appointments to inspect
the comments are encouraged (202) 634-6526.
FOR FURTHER INFORMATION CONTACT:
At the FRB: Gerald A. Edwards, Jr., Assistant Director (202) 452-2741
or Charles H. Holm, Project Manager (202) 452-3502. For questions
pertaining to regulatory capital issues, Rhoger H. Pugh, Assistant
Director (202) 728-5883, or Kevin M. Bertsch, Senior Financial Analyst
(202) 452-5265.
At the FDIC: Robert F. Storch, Chief, Accounting Section, Division
of Supervision (202) 898-8906, or Doris L. Marsh, Examination
Specialist, Accounting Section, Division of Supervision (202) 898-8905.
At the OCC: Eugene W. Green, Deputy Chief Accountant, (202) 874-
4933, or Frank Carbone, National Bank Examiner (202) 874-5170.
At the OTS: Robert Fishman, Acting Deputy Assistant Director for
Supervision Policy (202) 906-5672, or Timothy Stier, Deputy Chief
Accountant (202) 906-5699.
SUPPLEMENTARY INFORMATION:
I. Summary of FAS 114
FAS 114 was adopted in May, 1993 by the Financial Accounting
Standards Board (FASB) and is effective for fiscal years beginning
after December 15, 1994. The statement applies to all creditors and to
all loans that are identified for evaluation of collectibility, except:
(1) large groups of smaller-balance homogeneous loans that are
collectively evaluated for impairment (such as credit card, residential
mortgage, and consumer installment loans); (2) loans that are measured
at fair value or at the lower of cost or fair value (such as loans held
for sale); (3) leases; and (4) debt securities.
Under this standard, a loan is impaired when it is probable that a
creditor will be unable to collect all amounts due (including interest
and principal) according to the contractual terms of a loan agreement.
When a loan is impaired, a creditor must measure the extent of that
impairment by determining the present value of expected future cash
flows discounted at the loan's effective interest rate, or as practical
expedients, either the loan's observable market price or the fair value
of the collateral of a loan if it is collateral dependent. Although a
creditor is generally allowed to use any of these three measurement
methods to determine the amount of impairment, a creditor must measure
impairment based on the fair value of collateral when the creditor
determines that foreclosure is probable. If the value of the impaired
loan (using the methods described in FAS 114) is less than the recorded
balance of the loan, a creditor must recognize the impairment by
creating a valuation allowance (referred to in the standard as an
``allowance for credit losses'') for the difference and recognizing a
corresponding bad debt expense.
The FASB has recently proposed to amend FAS 114 to eliminate
certain income recognition requirements specified in the standard to
permit institutions flexibility in deciding how income on impaired
loans should be reported. In addition, certain disclosures regarding
income recognition on impaired loans would be required under the
proposed amendment to FAS 114.
II. Regulatory Reporting Guidance Related to FAS 114
The FFIEC and the agencies are requiring institutions to adopt FAS
114 as of its effective date for purposes of reporting on the Call
Report and TFR. Furthermore, the agencies will permit early adoption.
Additional regulatory guidance regarding impaired, collateral dependent
loans and the adequacy of the allowance for loan and lease losses
(ALLL) is provided below, which the agencies plan to incorporate into
regulatory reporting and examination guidance, as appropriate.
The FFIEC and the agencies intend to adhere to the FAS 114
measurement standards discussed above for regulatory reporting purposes
in most cases. However, consistent with the ``Interagency Policy
Statement on the Review and Classification of Commercial Real Estate
Loans, ``issued on November 7, 1991, the FFIEC and the agencies will
expect institutions to measure impaired, collateral-dependent loans for
purposes of regulatory reports at the fair value of the collateral.\2\
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\2\This supervisory treatment would be applied to all
collateral-dependent loans, regardless of the type of collateral.
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FAS 114 does not address the overall adequacy of the ALLL. However,
in addition to requiring an allowance for credit losses for impaired
loans, FAS 114 requires each institution to continue to maintain an
allowance that complies with Statement of Financial Accounting
Standards No. 5 (FAS 5), ``Accounting for Contingencies.'' Thus,
consistent with existing regulatory policy, the ALLL should be adequate
to cover all estimated credit losses arising from the loan and lease
portfolio, including losses on loans that do not meet FAS 114's
impairment criterion.
The agencies do not plan to automatically require additional
allowances for credit losses for impaired loans over and above what is
required on these loans under FAS 114. However, an additional allowance
on impaired loans may be necessary based on consideration of
institution-specific factors, such as historical loss experience
compared with estimates of such losses, concerns about the reliability
of cash flow estimates, or the quality of an institution's loan review
function and controls over its process for estimating its FAS 114
allowance.
III. Issues for Comment
The adoption of FAS 114 may require changes in certain existing
regulatory reporting and capital requirements and in other supervisory
policies. The FFIEC is seeking comment on the specific reporting issues
described below.
1. The Character of the FAS 114 Allowance
Should that portion of an institution's allowance established
pursuant to FAS 114 be reported and considered as a specific allowance
and, thus, not be eligible for inclusion in Tier 2 capital under the
agencies' current capital rules? Alternatively, should the FAS 114
allowance be regarded as a general allowance which would be eligible
for inclusion in Tier 2 capital subject to existing limits?
The agencies' risk-based capital rules are based upon, and
consistent with, the Basle Accord.\3\ Under this international
framework and the agencies' rules, ``general allowances'' for loan and
lease losses that have been created against unidentified losses and
that are not ascribed to particular assets or groups of assets may be
included in Tier 2 capital subject to certain limitations.\4\ The
Accord also states that ``where, however, provisions or reserves have
been created against identified losses or in respect of an identified
deterioration in value of any asset or group or subsets of assets, they
are not freely available to meet unidentified losses which may
subsequently arise elsewhere in the portfolio and do not possess an
essential characteristic of capital. Such provisions or reserves should
not, therefore, be included in the capital base.'' Thus, if the
allowances established for a certain asset or group of assets in
accordance with FAS 114 are determined to be ``created against
identified losses or in respect of an identified deterioration in value
of any asset or group or subsets of assets,'' then they would be
reportable as ``specific allowances'' for purposes of the Call Report
and TFR and would not be eligible for inclusion in Tier 2 capital under
the Basle Accord or the current capital rules of the agencies.
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\3\The Basle Accord is a risk-based capital framework that was
proposed by the Basle Committee on Banking Supervision (Basle
Supervisors Committee) and endorsed by the Central Bank Governors of
the Group of Ten (G-10) countries in July, 1988.
\4\Under the agencies' capital rules, general allowances
includible in Tier 2 are limited to 1.25 percent of risk weighted
assets and an institution's Tier 2 capital cannot exceed its Tier 1
capital.
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Currently, the entire balance of the ALLL for banks and the general
valuation allowances for loans and leases (GVAs) for savings
associations are reported as general allowances and are includable in
Tier 2 capital, subject only to the limitations referenced above. A
rationale for this position on the ALLL has been that regulatory
charge-off policies require banks to promptly write off identified
deteriorations in the value of loans and thereby ``cleanse'' these
allowances. In the case of savings associations, specific valuation
allowances are reported separately from GVAs. Although the Securities
and Exchange Commission's (SEC) Industry Guide 3 requires the
allocation of the ALLL and GVAs to specific groups of loans in Form 10-
K annual reports in part to assist analysts in assessing the overall
adequacy of allowances, the agencies have determined that such
allocations are solely for disclosure purposes and are not ``created
against identified losses.'' In addition, the agencies have determined
that these disclosure requirements do not affect the availability of
these allowances to meet identified losses arising elsewhere in an
institution's portfolio.
The adoption of FAS 114 does not affect the necessity for banks to
cleanse their allowances through the prompt recognition of identified
losses. Furthermore, FAS 114 could be viewed as simply setting forth an
estimation technique similar to that prescribed by SEC Industry Guide
3. Thus, while the FAS 114 allowance would be separately disclosed, it
need not be viewed as ``created against identified losses or in respect
of an identified deterioration in value of any asset or group or
subsets of assets.'' Accordingly, allowances established pursuant to
FAS 114 could be viewed as general allowances.
On the other hand, FAS 114 requires that valuation allowances be
established for the amount by which the value of impaired loans as
determined by the analytical methods described in the standard (i.e.,
present or fair value) is less than the recorded balance of these
loans. This analysis may be viewed as more loan specific than previous
analytical methods used to estimate the ALLL and GVAs. Thus, FAS 114
could be viewed as requiring the establishment of specific allowances
to account for impairment in particular assets or groups of assets.
In order to be considered general allowances under the Basle
Accord, allowances must be freely available to absorb losses arising
anywhere in a loan portfolio. A determination of whether FAS 114
allowances are freely available to absorb losses should take into
account the requirement that, under the standard, the depletion of such
allowances through the charge-off of loans other than those for which
they were established requires the replenishment of these allowances.
On the other hand, this determination should also recognize that the
portion of an institution's allowance attributable to FAS 114 is not
precluded from being available to meet identified losses on any asset
in its portfolio.
While a decision on the character of the FAS 114 allowance has
relatively limited reporting implications, it has more important
implications for determining institutions' regulatory capital ratios.
If FAS 114 allowances are viewed as specific in nature and, thus,
inconsistent with the Basle Accord and the agencies' capital rules, the
FAS 114 allowance would be deducted from assets and none of it could be
included in regulatory capital.\5\ Certain institutions may have lower
regulatory capital ratios if the FAS 114 allowance is considered a
specific allowance rather than a general allowance.
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\5\Consistent with FAS 114 disclosure requirements, the agencies
plan to require supplemental reporting of the amount of FAS 114
allowances in regulatory reports.
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2. Maintenance of Nonaccrual Reporting Requirements
Should regulatory nonaccrual standards be maintained for loans
subject to FAS 114?
Under the longstanding reporting standards of the banking agencies
(OCC, FRB, and FDIC), banks are required to discontinue the accrual of
income on a loan when:
(a) The institution places the loan on a cash basis because of
deterioration in the financial condition of the borrower.
(b) The collection in full of contractual principle or interest is
not expected, or
(c) Principal or interest has been in default for 90 days or more
unless the loan is both well secured and in the process of collection.
This third nonaccrual criterion does not apply to 1-to-4 family
residential mortgages or consumer loans of banks. However, these
organizations are expected to establish appropriate policies for these
types of loans in order to prevent the overstatement of income. These
nonaccrual requirements prevent the accrual of income in advance of
payment on seriously delinquent loans. Savings associations follow
similar nonaccrual practices.\6\
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\6\Under existing generally accepted accounting principles
(GAAP) and regulatory reporting instructions, and institution should
consider the amount of any accrued but uncollected interest included
in its reported assets when estimating its ALLL or GVA.
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FAS 114 was viewed by many as superseding current regulatory
nonaccrual standards since it established a method to recognize income
based on an impaired loan's present value. However, FASB has recently
issued, for public comment, a proposal to eliminate the detailed
guidance in the statement on the recognition of income on impaired
loans. This proposal allows a creditor to use existing methods for
recognizing interest income on impaired loans. Thus, if this proposed
change is adopted, an institution's continued use of the regulatory
nonaccrual requirements for income recognition purposes would not be
inconsistent with FAS 114.
If FASB's proposed changes are adopted and the agencies retain
their nonaccrual rules for impaired loans, interest income recognized
from such loans would generally be limited to the amount of cash
interest received. However, to the extent that this limitation reduces
the amount of interest income that institutions would be able to
recognize on impaired loans, institutions would generally have a
corresponding reduction in the provision for credit losses necessary to
bring the values of impaired loans to their present values as defined
by FAS 114. Thus, the agencies do not believe that the retention of the
regulatory nonaccrual standards would in many cases materially affect
the total amount of income reported by institutions.\7\
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\7\On the other hand, in other cases, the total amount of income
reported under a FAS 114 approach without nonaccrual requirements
could materially differ from the total that would be reported if the
agencies' nonaccrual requirements apply in conjunction with FAS 114.
For example, such a difference could arise when loans are 90 days or
more past due but are not deemed to be impaired by the institution.
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The agencies have identified several reasons for maintaining their
existing nonaccrual requirements. First, retention of the nonaccrual
rules for impaired loans will maintain a framework so that institutions
report interest income on a consistent basis. GAAP generally has been
silent on whether the accrual of interest is appropriate on impaired
loans. As a result, the agencies' regulatory rules have been adopted by
institutions for purposes of both their regulatory reports and
financial statements and thus became GAAP in practice. Second,
nonaccrual policies would prohibit interest income from being
recognized on impaired loans for uncollected contractual interest.
Third, not all seriously delinquent loans would be subject to FAS 114
and the agencies would need to maintain some standard to ensure that
interest income is not overstated on these loans.\8\ Fourth, since
nonaccrual requirements are consistent with the current reporting
structure, institutions would not have to significantly change their
reporting systems and statistical consistency would be maintained for
all uses of these data by regulators, bankers, analysts, and others.
Fifth, FASB staff may undertake a project to determine the proper
recognition of income on impaired loans. Since such a project could
change the income recognition rules under GAAP within a few years,
retaining current nonaccrual standards could eliminate the possibility
that institutions might have to significantly change their internal
systems twice in a short period of time and could thus potentially
reduce reporting burden. Finally, if the current reporting requirements
for nonaccrual of interest income are retained, the agencies may not
have to make significant changes to existing reporting and disclosure
requirements for past due and impaired loans.
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\8\If the agencies retain their nonaccrual requirements for
loans subject to FAS 114, it would be less likely that total income
from certain past due loans could be overstated by the recognition
of uncollected contractual interest solely based on an expectation
of collection (as permitted under FAS 114).
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On the other hand, while retaining regulatory nonaccrual
requirements would not be inconsistent with GAAP, it could be viewed as
adding another element to accounting for impaired loans, and, thus,
could increase the complexity of implementing FAS 114. Furthermore, as
noted above, if the regulatory nonaccrual rules for impaired loans are
eliminated, the total amount of income reported under FAS 114 for many
impaired loans may be the same as if the regulatory nonacrual rules are
maintained.
3. Other Issues
In addition to the issues discussed above, the agencies seek
written comments on the following issues.
1. Comment is sought on (a) how much the adoption of FAS 114 is
expected to change overall allowance levels, and (b) what portion of
total overall allowances are expected to be related to impaired loans
evaluated pursuant to FAS 114.
2. Comment is sought on implementation issues arising from FAS 114
to the extent they relate to U.S. branches and agencies of foreign
banks. These entities are required to file quarterly the Report of
Assets and Liabilities of U.S. Branches and Agencies of Foreign Banks
(002 Report), which in many respects is similar to the bank Call
Report. The 002 Report requires U.S. branches and agencies of foreign
banks to report the amount of nonaccrual loans (see issue 2
``Maintenance of Nonaccrual Reporting Requirements'').
3. Comment is sought on how FAS 114 might affect an institution's
internal loan review process and its internal loan classification
system for loans subject to FAS 114. In this regard, the FFIEC notes
that according to the December 21, 1993, Interagency Policy Statement
on the Allowance for Loan and Lease Losses, each institution should
ensure that it has a formal credit grading system that can be
reconciled with the classification framework used by the agencies.
Dated: May 12, 1994.
Signed:
Keith J. Todd,
Assistant Executive Secretary, Federal Financial Institutions
Examination Council.
[FR Doc. 94-11956 Filed 5-16-94; 8:45 am]
BILLING CODE 6210-01-M
