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Loan Losses â€" Draft SOP

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  • 1. DRAFT 6-7-01 PROPOSED STATEMENT OF POSITION Allowance for Credit Losses TABLE OF CONTENTS Paragraph Number INTRODUCTION..................................................................................................................... 1 SCOPE........................................................................................................................................5 CONCLUSIONS........................................................................................................................6 Loan Impairment Concepts.........................................................................................6 Components of the Allowance for Credit Losses...................................................... 9 Individual Loan Impairment......................................................................................10 Collective Loan Impairment.......................................................................................14 Disclosures....................................................................................................................28 EFFECTIVE DATE AND TRANSITION............................................................................ 29 APPENDIX A - Background Information and Basis for Conclusions APPENDIX B - Illustrative Conceptual Guidance APPENDIX C - Illustrative Application Guidance APPENDIX D - Illustrative Disclosure Guidance APPENDIX E - Amendments to Existing AICPA Pronouncements APPENDIX F - Glossary 1
  • 2. DRAFT 6-7-01 1.This Statement of Position (SOP) addresses the accounting by creditors for the allowance for credit losses related to loans. It provides guidance on how such entities should determine the allowance for credit losses in accordance with Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan (as amended by FASB Statement No. 118, Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures), and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss. 2.The allowance for credit losses is a valuation account used by creditors to recognize impairment of a creditor's recorded investment in loans1, 2 on its balance sheet before losses have been confirmed. The balance in this account on any reporting date is an accounting estimate of probable but unconfirmed asset impairment in the creditor's loan portfolio as of the date of the financial statements. 1 Footnote 17 of FASB Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, states that “The recorded investment in the receivable is the face amount increased or decreased by applicable accrued interest and unamortized premium, discount, finance charges, or acquisition costs and may also reflect a previous write-down of the investment.” 2 FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, paragraph 22(b) requires adjustment of the carrying amount of a hedged loan, as follows: “The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings." Paragraph 27 of FASB Statement No. 133 states that "impairment requirements [in generally accepted accounting principles for assessing impairment for a type of asset] shall be applied after hedge accounting has been applied for the period and the carrying amount of the hedged asset has been adjusted pursuant to paragraph 22 of this Statement." If an entity adjusts the carrying amount of a loan pursuant to paragraph 22 of FASB Statement No. 133 for gain or loss attributable to a hedged risk of (a) changes in the overall fair value of the loan or (b) changes in its fair value attributable to changes in the obligor's creditworthiness, no allowance for credit losses should be provided for that loan. FASB Derivatives Implementation Group Issue No. F4, “Fair Value Hedges: Interaction of Statement 133 and Statement 114," provides additional implementation guidance on the measurement of impairment of the recorded investment in a hedged loan. 2
  • 3. DRAFT 6-7-01 3.Some believe the latitude afforded by existing authoritative literature related to the allowance for credit losses is too significant, allowing excessive flexibility in the application of that literature. Others believe allowances for credit losses currently tend to reflect the past credit quality of a loan portfolio rather than the current credit quality of a loan portfolio. They suggest that a provision for credit losses is often inappropriately increased in periods of improving credit quality and earnings and reduced in periods of declining credit quality and earnings. Still others have expressed concerns regarding compliance with existing generally accepted accounting principles (GAAP) with respect to accounting for the allowance for credit losses; the adequacy of documentation supporting a reported allowance for credit losses; and the sufficiency of financial statement disclosures related to the allowance for credit losses. Most critics of current accounting practice agree, however, that shortcomings in financial reporting of the allowance for credit losses appear to stem, in part, from a lack of sufficient guidance in the authoritative literature. Accordingly, the AICPA Accounting Standards Executive Committee (AcSEC) undertook this project to provide further authoritative guidance on accounting for the allowance for credit losses and to enhance financial statement disclosures related to the allowance for credit losses in order to improve the transparency of financial reporting. 4.AcSEC believes that this SOP will improve practice regarding the accounting for the allowance for credit losses and that it will result in a more narrow and consistent application of GAAP. Further, all other things being equal, AcSEC believes this SOP will result in creditors increasing their provision for credit losses in periods of weakening portfolio credit quality and decreasing their provision for credit losses in periods of improving portfolio credit quality, thus 3
  • 4. DRAFT 6-7-01 addressing what AcSEC believes was a significant criticism of the application of current guidance. SCOPE 5.This SOP applies to creditors and addresses the recognition and measurement by creditors of the allowance for credit losses related to all “loans,” as that term is defined in FASB Statement No. 114,3 except for those loans specifically mentioned in paragraph 6(b), 6(c), and 6(d) of FASB Statement No. 114. Accordingly, this SOP does not address accounting for— • Loans that are measured at fair value or at the lower of cost or fair value. • Leases accounted for in accordance with, FASB Statement No. 13, Accounting for Leases. • Debt securities as defined in FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. • Loans that are accounts receivable with terms equal to or less than one year (for example, trade receivables). 3 FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan, paragraph 4 defines a loan as "a contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor's statement of financial position. Examples include but are not limited to accounts receivable (with terms exceeding one year) and notes receivable.” 4
  • 5. DRAFT 6-7-01 CONCLUSIONS Loan Impairment Concepts 6.FASB Statement No. 5 requires the accrual of a loss when it is probable4 that an asset has been impaired and the amount of the loss can be reasonably estimated.5 FASB Statement No. 114, paragraph 8 defines a loan as being impaired when, “based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.” An allowance for credit losses should be established only if an assessment of current information indicates that it is probable that an asset was impaired as of the balance sheet date and the amount of the loss can be reasonably estimated. Current information should only include facts and circumstances relevant to the current period and use of current information to project future events is inappropriate. 7.The fundamental objective of existing GAAP for the allowance for credit losses is for a creditor to recognize and measure loan impairment in the period the impairment occurs and in 4 Probable is used in this SOP with the same meaning as in FASB Statement No. 5, Accounting for Contingencies, which defines probable as an area within a range of likelihood that a future event or events will occur confirming the fact of the loss. That range is from probable to remote, as follows: Probable. The future event or events are likely to occur. Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely. Remote. The chance of the future event or events occurring is slight. The term probable is described further in paragraph 84 of FASB Statement No. 5, which states: The conditions for accrual in paragraph 8 [of FASB Statement No. 5] are not inconsistent with the accounting concept of conservatism. These conditions are not intended to be so rigid that they require virtual certainty before a loss is accrued. They require only that it be probable that an asset has been impaired or a liability has been incurred and that the amount of loss be reasonably estimable. 5 FASB Statement No. 5, paragraph 8 states: An estimated loss from a loss contingency (as defined in paragraph 1) shall be accrued by a charge to income if both of the following conditions are met: a. Information available prior to the issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss. b. The amount of the loss can be reasonably estimated. 5
  • 6. DRAFT 6-7-01 the amount of the impairment that occurred. Impairment should not be recognized before it is probable impairment has occurred, even though it may be probable that impairment will occur in the future. Conversely, recognition of asset impairment should not be deferred to periods after the period in which the impairment has occurred if the amount of impairment can be reasonably estimated. Arriving at an appropriate allowance involves a significant degree of management judgment and is inevitably an imprecise process. Credit loss estimation processes require many discrete judgments, which result in recognition of an overall allowance for credit losses. The allowance for credit losses estimation process may result in either a specific number representing the impairment estimate or a range of possible losses. In accordance with FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss, a creditor should recognize its best estimate within its estimated range of credit losses, or if no amount within its range is a better estimate than any other amount, the creditor should recognize the minimum amount within the range.6 In determining its best estimate, management should take into account all available information existing as of the balance sheet date, including credit quality, current trends, indicative of current conditions and not projections, and existing environmental factors (for example, industry, geographical, and economic factors). A creditor should not default to the minimum amount within the range in order to avoid recognizing its best estimate within the range. 8.FASB Statement No. 5 notes in paragraph 59 that "Attribution of a loss to events or activities of the current or prior periods is an element of asset impairment." Occasionally, a creditor may be able to identify a single, distinct event that caused an individual loan or a pool (portfolio or 6 Paragraph 10 of FASB Statement No. 5 requires disclosure of the additional exposure to loss if there is at least a reasonable possibility of loss in excess of the amount accrued. 6
  • 7. DRAFT 6-7-01 specific category) of loans to be impaired. In most cases, however, a creditor will be unable to identify a single, distinct event that caused the impairment; rather, there will be an accumulation or series of events that have occurred resulting in the impairment of an individual loan or a pool of loans. Creditors must make many significant judgments regarding the credit risk within their portfolio to arrive at their allowance for credit losses. These judgments attempt to measure the numerous credit risk characteristics within the loan portfolio evidencing asset impairment. Each credit risk characteristic or “component” should be recognized and measured pursuant to either FASB Statements No. 114 or 5. Components of the Allowance for Credit Losses 9. FASB Statement No. 114 provides guidance on accounting for credit losses associated with the component related to individually impaired loans. FASB Statement No. 5 provides guidance on accounting for credit losses associated with components of pools of loans that are either outside the scope of FASB Statement No. 114 or that are not considered individually impaired pursuant to FASB Statement No. 114. The allowance for credit losses reported on a creditor's balance sheet should consist only of (a) a component for individual loan impairment recognized and measured pursuant to FASB Statement No. 114 and (b) one or more components of collective loan impairment recognized pursuant to FASB Statement No. 5 and measured in accordance with the guidance in this SOP. No other components should be recognized. Individual Loan Impairment 7
  • 8. DRAFT 6-7-01 10.If a creditor reviews or grades an individual loan as part of a credit risk evaluation or grading process,7 that loan has been “identified for evaluation” within the meaning of paragraph 6 of FASB Statement No. 114. Loans identified for evaluation for impairment are, with certain exceptions,8 within the scope of FASB Statement No. 114. 11.When a loan has been identified for evaluation pursuant to paragraph 10 of this SOP, a creditor should make an explicit decision as to whether or not the loan is individually impaired in accordance with paragraph 8 of FASB Statement No. 114. Creditors should measure impairment of individual loans in accordance with paragraphs 12 through 16 of FASB Statement No. 114. 12.If a creditor determines that an individual loan that was specifically identified for evaluation is impaired, the amount of the allowance for credit losses determined pursuant to FASB Statement No. 114 may not be supplemented by an allowance for credit losses determined pursuant to FASB Statement No. 5, even if the measurement of impairment under FASB Statement No. 114 results in no allowance for credit losses.9 7 Terms defined in the glossary are set in boldface type the first time they appear in this SOP. 8 FASB Statement No. 114, paragraph 6 excludes the following from the scope of the Statement: • Large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment • Loans that are measured at fair value or at the lower of cost or fair value • Leases, as defined in FASB Statement No. 13, Accounting for Leases • Debt securities as defined in FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities 9 A loan can be impaired in accordance with FASB Statement No. 114 and yet the measurement of impairment under Statement No. 114 may result in no allowance for credit losses, for example, if it is probable the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement but the loan is collateral dependent and is fully collateralized. 8
  • 9. DRAFT 6-7-01 13.If a creditor determines that an individual loan that was specifically identified for evaluation is not impaired, the creditor should determine whether the loan has specific characteristics that indicate that there would be impairment in a group of loans with those characteristics. If the loan has such characteristics, it should be included in a pool of loans that is collectively evaluated for impairment (“collective loan impairment”) in accordance with FASB Statement No. 5 paragraph 22.10 Collective Loan Impairment 14. A creditor should group into pools based on similar credit risk characteristics all loans other than those loans that were individually evaluated for impairment and were either (a) determined to be individually impaired or (b) were determined not to be individually impaired, but did not have specific characteristics that indicate that there would impairment in a group of loans with those characteristics. Those pools of loans should be evaluated by a creditor for collective loan impairment.11 15. FASB Statement No. 5 paragraph 22 states “[t]hose conditions may be considered in relation to individual receivables or in relation to groups of similar types of receivables.” Further, FASB Statement No. 114 amended FASB Statement No. 5 to define impairment as the inability to comply with contractual principal and interest payments. For purposes of recognition 10 FASB Statement No. 114 states in paragraph 7 that, "In addition to the allowance calculated in accordance with this Statement, a creditor should continue to recognize an allowance for credit losses necessary to comply with Statement 5.” 11 Pools of loans generally include loans that are in various stages of their contractual life, including loans that were originated recently. Originating a loan does not, in and of itself, satisfy the loss recognition criteria of FASB Statement No. 5, unless there is a faulty credit underwriting decision or fraud. AcSEC has noted that many estimation methodologies use averaging techniques for measuring collective loan impairment that include recently originated loans in the pools. AcSEC believes such methodologies are generally acceptable because it is the pool of loans being evaluated for impairment, not the individual loans in the pool. 9
  • 10. DRAFT 6-7-01 and measurement, a creditor should consider a pool of loans with similar credit risk characteristics to be a single asset under FASB Statement No. 5 and this SOP. Thus, a creditor should make its determination of impairment recognition and measurement by reference to the pool of loans rather than to the individual receivables contained in the pool. 16.FASB Statement No. 5 requires creditors to consider all available information in recognizing and measuring asset impairment. When considering all available information, creditors should assess which data is the most relevant in assessing the reasonableness of the allowance for credit losses. The most relevant data should be used in assessing the similar credit risk characteristics within the portfolio of loans. This data or set of data is referred to as observable data for purposes of this SOP and is required to support an estimate of collective loan impairment. 17.A component of collective loan impairment may be supported by one set of observable data or by multiple sets of observable data. For purposes of recognition and measurement pursuant to this SOP, observable data should be relevant to the recognition and measurement of asset impairment. Observable data are relevant only if they are representative of the similar credit risk characteristics in the component of collective loan impairment for the specific creditor. Creditors should make a reasonable effort to obtain observable data to support their components of collective loan impairment. 18.Observable data are necessary to enable a creditor to make a more objective and consistent assessment of the impairment in a component of collective loan impairment from period to 10
  • 11. DRAFT 6-7-01 period. An objective and consistent assessment would require that the same kind of observable data be obtainable from period to period. Accordingly, creditors should support components of collective loan impairment with relevant observable data that are available currently and are expected also to be available in the future. A creditor may be unable to identify the requisite observable data relevant to the component of collective loan impairment (for example, expected losses to borrowers significantly affected by a natural disaster). In such cases, recognition of asset impairment would be inappropriate and the creditor should identify the similar credit risk characteristics for disclosure pursuant to paragraph 10 of FASB Statement No. 5. 19.Following are examples of components of collective loan impairment and of observable data that may support them. Each of the components described below may be one of multiple components relating to a creditor’s collective loan impairment estimate. • Component: historical loss experience for credit-risk-graded loans or loans grouped by industry that are not individually impaired in accordance with FASB Statement No. 114; Observable data: charge-off data12 for the particular credit risk grade or industry grouping • Component: adjustment for loans to health care providers that are affected by Medicare repricing by Congress; Observable data: sector operating cash flow as reported for public physician health-care practices • Component: adjustment for consumer loans affected by a change in bankruptcy rates; Observable data: publicly available bankruptcy data 12 Charge-offs are often used by creditors as a substitute for confirmed losses. 11
  • 12. DRAFT 6-7-01 20. The relevance of the observable data to the assessment of a component of collective loan impairment should be assessed at each balance sheet date. Observable data may become more or less relevant as circumstances change. Additionally, more relevant and directly representative observable data may become available. Creditors should change the observable data they consider only if changes in the environment indicate that other observable data have become more relevant or if new observable data that are more relevant and directly representative of the component of collective loan impairment become available. 12
  • 13. 21.A component of collective loan impairment based on historical loss experience is presumed to be the primary basis for the recognition and measurement of collective loan impairment for pools of loans. In most instances, however, historical loss experience, without adjustment, would not be representative of current impairment of a pool of loans because circumstances change. Historical loss experience may need to be adjusted to reflect the effects of current conditions that did not affect the period on which the historical loss experience is based. Further, historical loss experience may need to be adjusted to remove the effects of conditions in the historical period that do not exist currently. For example, changes in the business climate in a particular industry to which the creditor has loans outstanding or changes in economic conditions affecting consumer borrowers in a particular region would call for an adjustment. 22.Asset impairment estimated based on historical loss experience related to a pool of loans with similar credit risk characteristics, for example, loans with the same credit risk grade, should be considered a separate component of collective loan impairment. Each adjustment to a historical loss experience component of collective loan impairment should be considered a separate component of collective loan impairment, thus multiple components of collective loan impairment are possible for the same pool of loans. However, multiple components of collective loan impairment should not result in double-counting loss amounts associated with pools of loans.
  • 14. DRAFT 6-7-01 23.FASB Statement No. 114 measurement principles should be applied to the measurement of components of the allowance for credit losses recognized pursuant to FASB Statement No. 5, that is, components of collective loan impairment.13 In applying the measurement principles of FASB Statement No. 114 to those components, the present value of expected future cash flows will, in most cases, be the most appropriate measure of impairment. Guidance on estimating expected future cash flows is set forth in paragraph 15 of FASB Statement No. 114, which states in part that the estimated cash flows "shall be the creditor's best estimate based on reasonable and supportable assumptions and projections."14 In discounting the expected future cash flows, creditors should use the weighted average effective interest rate of the loans within the component of the collective loan impairment. The practical expedients provided by FASB Statement No. 114 may, in certain instances, provide appropriate measures of collective loan impairment. 24.Expected future cash flows for a component of collective loan impairment should be estimated based on the current observable data and should not project changes in the observable data that may occur in the future. The estimate of expected future cash flows will rarely be a direct mathematical function of the observable data; rather, significant judgment will usually be needed to develop the estimate. However, changes in expected future cash flow estimates 13 FASB Statement No. 114, paragraph 13 states, in part: When a loan is impaired..., a creditor shall measure impairment based on the present value of expected 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 the collateral if the loan is collateral dependent. Regardless of the measurement method, a creditor shall measure impairment based on the fair value of the collateral when the creditor determines that foreclosure is probable. 14 Many insured depository institutions currently measure collective loan impairment components by predicting principal and interest amounts that will not be repaid. Generally, those approaches assume that principal and interest are paid as agreed until the culmination of the ultimate loss. To be reasonable substitutes for FASB Statement No. 114 measurements, those methods must include discounting of expected future cash flows - 14 -
  • 15. DRAFT 6-7-01 should be directionally consistent with changes in the related observable data from period to period. For example, if the change in the observable data indicates a deterioration in the credit quality of a pool of loans, the component of collective loan impairment related to that pool of loans would become larger as a percentage of the pool of loans under assessment. Conversely, if the change in the observable data indicates an improvement in the credit quality of a pool of loans, the component of collective loan impairment related to that pool of loans would become smaller as a percentage of the pool of loans under assessment. 25.The measurement of a component of collective loan impairment may utilize multiple sets of observable data. Consistent with the guidance in FASB Statement No. 114, the weight of each observable data set on the assumptions and projections utilized to estimate expected future cash flows should be commensurate with the extent to which the observable data can be verified objectively. 26.As discussed in paragraph 7 of this SOP, a creditor should assess the likelihood of possible outcomes in determining its best estimate of expected future cash flows. A creditor’s selection of its best estimate within a range should be based on judgment parameters that are applied in a consistent manner. Changes in the creditor’s assessment of the likelihood of possible outcomes should be directionally consistent with changes in the observable data from period to period. 27.Creditors that have no experience or insufficient experience in certain lending products or markets should use peer group experience to develop collective loan impairment estimates. In - 15 -
  • 16. DRAFT 6-7-01 order for the peer group experience to be the basis for a reasonable estimate, the specific peer group portfolio must be comparable to the creditor's own portfolio. Comparability should be supported by an analysis regarding borrower and loan types. Collective loan impairment based on peer group experience should not be recognized if a comparable peer group cannot be identified. In those circumstances, disclosure would be required pursuant to paragraph 10 of FASB Statement No. 5. If a creditor has experience of its own, the creditor’s experience should be utilized to estimate the allowance for credit losses. 15 Disclosures 28.A creditor should disclose the following information:16 a. The methodology for determining each significant17 component of the allowance for credit losses. The disclosure should include sufficient narrative information to enable users of the financial statements to understand critical aspects of the methodology and the breadth and depth of the process. b. The accounting recognition and measurement policies and methods used by the creditor for each significant component of its allowance for credit losses. The disclosure should include the following: 15 AcSEC supports the use of peer group experience by new lending operations and by established lending operations for new lending products. However, AcSEC expects that peer group experience will be used in limited circumstances. AcSEC believes that two to three years of lending experience normally would provide data that are more relevant than peer group data. A creditor with sufficient experience of its own should use that experience as the observable data supporting the recognition and measurement of its allowance for credit losses 16 The disclosures set forth is this SOP are intended to be incremental to existing disclosure requirements and are not intended to replace or eliminate any existing requirements. 17 Significant is defined for this purpose as 5 percent of the allowance for credit losses. Insignificant components may not exceed 15% in aggregate. - 16 -
  • 17. DRAFT 6-7-01 i. A general description of each significant component of the allowance for credit losses. ii. An explanation of the types of loans evaluated individually for impairment and the types of loans evaluated collectively for impairment (pools of loans). iii. For pools of loans, a description of the credit risk evaluation processes used (credit risk-grading schemes, credit scoring models, industry, collateral, geography, and so forth), if applicable, and the similar credit risk characteristics associated with each pool or category of credit risk-graded loans. iv. A description of the observable data that are the principal drivers of the measurement of the component, and significant changes in the types of observable data for all periods presented. c. The recorded amount of each significant component of the allowance for credit losses by loan type as of each balance sheet date. This information should be presented in sufficient detail to allow users to understand the component distinctions. For example, if a creditor has established an allowance for credit losses component for each pool of credit risk-graded loans that is based on historical loss experience, the creditor should disclose the amount of that component and the recorded investment in each pool of credit risk-graded loans resulting from the creditor’s credit risk evaluation process. EFFECTIVE DATE AND TRANSITION 29. The provisions of this SOP are effective for financial statements issued for fiscal years beginning after December 15, 2002. Earlier application of this SOP is permitted. - 17 -
  • 18. DRAFT 6-7-01 30.Although the effect of initially applying the provisions of this SOP will, in individual cases, have elements of a change in accounting principle and of a change in accounting estimate, those elements often will be inseparable. Consequently, the entire effect of initially applying the provisions of this SOP should be reported as a change in accounting estimate [Accounting Principles Board (APB) Opinion No. 20, Accounting Changes, paragraphs 31 through 33]. Previously issued financial statements should not be restated. - 18 -
  • 19. DRAFT 6-7-01 APPENDIX A — Background Information and Basis for Conclusions A.1 Existing authoritative accounting literature that relates to accounting for the allowance for credit losses includes FASB Statement No. 5, Accounting for Contingencies, FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan (as amended by FASB Statement No. 118, Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures ), and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss. In addition, the AICPA Audit and Accounting Guide, Banks and Savings Institutions (Audit Guide) and the April 12, 1999 FASB Viewpoints article, Application of FASB Statements 5 and 114 to a Loan Portfolio,18 provide additional guidance on how creditors should use the aforementioned Statements in determining their allowance for credit losses. However, the existing authoritative literature is unclear in some respects. That lack of clarity has allowed creditors excessive flexibility in the determination of asset impairment and the amount to record as an allowance for credit losses. A.2 FASB Statements No. 5 and 114 (as amended) and the Audit Guide, as well as non- GAAP guidance, such as the SEC's Industry Guide 3, Statistical Disclosure by Bank Holding Companies, require that certain disclosures be made for the allowance for credit losses. Others have raised concerns regarding whether adequate disclosure is being made about creditors' loan portfolios and the related allowances for credit losses. 18 The FASB Viewpoints article is reproduced as an appendix to EITF Topic D-80, “Application of FASB Statements No. 5 and No. 114 to a Loan Portfolio.” - 19 -
  • 20. DRAFT 6-7-01 A.3 AcSEC developed this SOP to narrow the wide spectrum of practices and interpretations of existing literature and to improve the transparency of financial reporting by improving required disclosures regarding the allowance for credit losses. BASIS FOR CONCLUSIONS Scope A.4 This SOP addresses the recognition and measurement by creditors of the allowance for credit losses in accordance with FASB Statements No. 5 and 114, as amended. It applies to all loans, as that term is defined in FASB Statement No. 114, except for those loans specifically mentioned in paragraph 6(b), 6(c), and 6(d) of FASB Statement No. 114. Thus, this SOP applies to all receivables (which, pursuant to the definition of a loan in FASB Statement No. 114, encompasses credit card receivables of financial institutions and other financial services entities that engage in lending activities). However, this SOP does not address loans that are accounts receivable with terms equal to or less than one year (for example, trade receivables), even though FASB Statement No. 5 applies to all receivables. Short-term accounts receivable are currently reported at their net realizable value, which is the undiscounted amount of cash, or its equivalent into which an asset is expected to be converted in due course of business less direct costs, if any, necessary to make that conversion. A reexamination of that practice is beyond the scope of this SOP. Furthermore, AcSEC was concerned that the costs of applying this SOP's disclosure - 20 -
  • 21. DRAFT 6-7-01 requirements by commercial enterprises extending short-term trade credit would exceed the benefits. Thus, for both conceptual and practical reasons, AcSEC has limited the scope of this SOP to accounting for loans as that term is defined in FASB Statement No. 114. Loan Impairment Concepts A.5 FASB Statement No. 5, which sets forth the principles underlying accrual of loss contingencies, paragraph 8 states as a condition precedent to the recognition of the impairment of an asset that it must be probable that the asset had been impaired as of the date of the financial statements (not that it is probable that a loss will ultimately be incurred and realized). FASB Statement No. 114 defines a loan as being impaired when “based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.” A.6 FASB Statement No. 5 states in paragraph 59 that “Attribution of a loss to events or activities of the current or prior periods is an element of asset impairment or liability incurrence.” Some may interpret that statement to prohibit the recognition of asset impairment or loss incurrence unless a single, distinct past event can be identified as having given rise to asset impairment or a liability. AcSEC believes, however, that it is seldom possible to identify a single, distinct past event that gives rise to impairment of a loan. Thus, AcSEC concluded that it could not require creditors to specifically identify a loss-causing event in order to justify the recognition of impairment. - 21 -
  • 22. DRAFT 6-7-01 A.7 AcSEC notes that paragraph 84 of FASB Statement No. 5 states that the conditions for recognition of a loss are not intended to be so rigid that they require virtual certainty before a loss is accrued. AcSEC also notes that FASB Statement No. 5, as amended, states in paragraph 23 that "if, based on current information and events, it is probable that the enterprise will be unable to collect all amounts due according to the contractual terms of the receivable, the condition in paragraph 8(a) [it is probable that an asset has been impaired at the date of the financial statements] is met." AcSEC believes those statements support AcSEC's view that it is not necessary to identify a single, distinct past event that caused a credit loss in order to recognize the impairment of a loan or group of loans. Rather, it is sufficient to have reasonable evidence that the loan or pool of loans is impaired. Components of the Allowance for Credit Losses A.8 This SOP requires that the reported allowance for credit losses include only those components that are determined pursuant to either FASB Statement No. 5 or FASB Statement No. 114. The FASB Statement No. 114 component results in a specific loss allocation for loans individually reviewed for impairment, and no "add-on" or other incremental amounts may be recognized for those loans. FASB Statement No. 5 governs the recognition of allowances for credit losses related to pools of loans that are evaluated collectively for impairment. - 22 -
  • 23. DRAFT 6-7-01 A.9 In developing this SOP, AcSEC debated whether to prohibit the recognition of what are commonly referred to as "unallocated" components19 of the overall reported allowance for credit losses. It became apparent, however, that the term unallocated is used in practice with various meanings. For example, some refer to adjustments to historical loss factors as unallocated while others believe that those adjustments are an element of the allocated allowance for credit losses. Still others believe unallocated refers to allowances for credit losses not attributable to individual loans. AcSEC became convinced that it was not feasible to develop a satisfactory definition of an unallocated component and was concerned that prohibiting "unallocated" components of the allowance for credit losses would result in definitional debates over subjective terminology. A.10 AcSEC concluded that the allowance for credit losses reported on a creditor's balance sheet should consist only of (a) a component for individual loan impairment recognized and measured pursuant to FASB Statement No. 114 and (b) one or more components of collective loan impairment recognized pursuant to FASB Statement No. 5 and measured in accordance with the guidance in this SOP. This SOP prohibits the recognition of collective impairment components of an allowance for credit losses that do not meet the recognition and measurement criteria of paragraph 8 of FASB Statement No. 5 and of this SOP. 19 Those components are also referred to in practice as supplemental, general, unassigned, or general contingency reserves. - 23 -
  • 24. DRAFT 6-7-01 Individual Loan Impairment A.11 FASB Statement No. 114 applies to all loans that are "identified for evaluation," with certain exceptions. Paragraph 7 of FASB Statement No. 114 does not specify how a creditor should identify loans that are to be evaluated for collectibility. It states that a creditor should "apply its normal loan review procedures in making that judgment." A.12 Industry practice for financial services companies generally includes reviewing loans individually as part of a creditors’ normal credit-risk evaluation process for purposes of evaluating the collectibility of those loans. As a result of performing that evaluation of collectibility, creditors often place individual loans into risk grading categories based on the identified likelihood of collectibility (or risk of loss). AcSEC believes that, when a creditor reviews an individual loan, such as part of a credit-risk evaluation process, the creditor has identified the loan for evaluation under FASB Statement No. 114 and is, therefore, subject to the provisions of FASB Statement No. 114. AcSEC notes that different segments of the financial services industry employ different techniques for estimating asset or loan impairment. Any process that specifically addresses the degree of repayment ability of a specific borrower is a process that meets the FASB Statement No. 114 definition of “identified for evaluation”. A.13 A creditor should, therefore, explicitly conclude as to whether or not the loan is impaired. If the creditor determines that an individual loan is impaired, it should measure the - 24 -
  • 25. DRAFT 6-7-01 amount of impairment pursuant to the measurement guidance in FASB Statement No. 114. If the creditor determines that a loan is not individually impaired, the next step is to consider whether or not the loan needs to be evaluated as part of another allowance component calculated in accordance with FASB Statement No. 5. A.14 This SOP further clarifies that the allowance for credit losses provided for a specific individual loan under FASB Statement No. 114 may not be supplemented by an additional allowance for credit losses under FASB Statement No. 5. If the loan is determined to be impaired, the FASB Statement No. 114 allowance should be the sole measure of impairment for that loan even if the measurement of impairment under FASB Statement No. 114 results in no allowance for credit losses. In the April 1999 Viewpoints article, the FASB staff clarified that “double counting” is not permitted. AcSEC believes that point is self-evident, but has nevertheless incorporated that guidance in this SOP. Collective Impairment A.15 FASB Statement No. 114 states in paragraph 7 that “In addition to the allowance calculated in accordance with this Statement, a creditor should continue to recognize an allowance for credit losses necessary to comply with Statement 5." AcSEC believes that the principles of FASB Statement No. 5 are unclear regarding their precise application. - 25 -
  • 26. DRAFT 6-7-01 A.16 This SOP reaffirms the position expressed in the FASB Viewpoints article (April 1999) that (a) loans that are considered impaired after a specific FASB Statement No. 114 review should not be considered within an FASB Statement No. 5 assessment and (b) loans that are not considered impaired after a specific FASB Statement No. 114 review should be considered for inclusion within an FASB Statement No. 5 assessment. A.17 AcSEC considered establishing specific loss-recognition "triggers" for portfolios (or specific categories) of loans. Those loss-recognition triggers would have been required as evidence that a loan within a pool of loans had been impaired at the date of the financial statements. Those loss-recognition triggers were: (a) the downgrading by a creditor of a loan that is credit-risk graded to a below-investment-grade classification, and (b) the movement of a retail loan that is not credit-risk graded into a past-due payment status. A.18 AcSEC was concerned, however, that the downgrading of a commercial loan's credit-risk grade is a management decision whereas the actual cause of impairment (credit loss) are events and circumstances that occur independent of management's decisions. AcSEC was even more concerned that the movement of a consumer loan that is not credit risk graded into a past due status is an event that may occur well after asset impairment has occurred. Thus, using it as the sole recognition trigger for pools of loans would result in delaying recognition of asset impairment that has occurred. AcSEC could identify no specific loss-recognition triggering events earlier than past-due status for consumer loans - 26 -
  • 27. DRAFT 6-7-01 that are not credit-risk graded. Additionally, AcSEC could make no conceptual distinction in the need for a specific loss-recognition trigger for consumer loans that are not credit-risk graded and loans that are credit-risk graded. A.19 AcSEC also considered a measurement approach for pools of loans that sought to predict the period from the occurrence of the loss-triggering event to the loss confirmation. That period would represent the time it takes an otherwise unidentified loss to migrate to loss confirmation (or charge-off). The “loss confirmation period” would then be used to calculate the amount of the embedded losses in the portfolio. For example, if a pool of loans had a loss confirmation period of two years, an annual loss rate of 27 basis points, and an outstanding balance of $10 million, the allowance component would be $540,000. However, the ability to identify the loss-triggering event is fundamental to this measurement approach and many believe that a loss triggering event is not identifiable for every loan even with hindsight. Further, loss confirmation periods are not used to any significant degree in existing credit risk estimation processes and a requirement to use them would be a significant change in business practice. A.20 AcSEC dismissed the triggering event recognition approach and the loss confirmation period measurement approach. Instead, AcSEC took an approach that requires a strengthened relationship between information available regarding credit risk characteristics and changes in the allowance for credit losses. - 27 -
  • 28. DRAFT 6-7-01 A.21 Generally, AcSEC concluded that an allowance for credit losses recognized pursuant to FASB Statement No. 5 should consist of components that (a) are predicated on sets of observable data that are relevant to the measurement of the asset impairment associated with similar credit risk characteristics and (b) change in a manner that is directionally consistent with changes in the related observable data from period to period. A.22 AcSEC believes that basing recognition and measurement of the allowance for credit losses on observable data will introduce more objectivity into the collective loan impairment estimation process, resulting in a significant improvement in that process. For that reason, this SOP requires that observable data be the basis for loss recognition and measurement. A.23 AcSEC believes that most creditors will rely principally on the historical loss experience of pools of loans as the predominant component of collective loan impairment. However, creditors should identify additional components of collective loan impairment in the loan portfolio and identify the observable data to analyze those components of collective loan impairment elements to arrive at a more precise impairment estimation than that afforded by an approach based solely on historical loss experience. A.24 AcSEC acknowledges, however, that the estimation of the allowance for credit losses is a dynamic process and, as such, observable data may become more or less relevant to the impairment recognition and measurement over time. Thus AcSEC concluded that creditors should change observable data they consider if changes in the environment - 28 -
  • 29. DRAFT 6-7-01 indicate that other observable data have become more relevant or if new observable data that are more relevant and directly representative of the component of collective loan impairment become available. A.25 This SOP provides that creditors should follow the measurement guidance in FASB Statement No. 114 in measuring collective impairment components. AcSEC acknowledges that FASB Statement No. 114 provides guidance on the measurement of impairment of individual loans and pools of individually impaired loans, not on the measurement of impairment of pools of loans generally. AcSEC can see no reason, however, why the measurement of collective impairment components of the allowance for credit losses should be fundamentally different from the measurement of impairment of individual loans. A.26 FASB Statement No. 114, paragraph 13 states, in part: When a loan is impaired..., a creditor shall measure impairment based on the present value of expected future 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 the collateral if the loan is collateral dependent. Regardless of the measurement method, a creditor shall measure impairment based on the fair value of the collateral when the creditor determines that foreclosure is probable. This SOP acknowledges that the practical expedients in paragraph 13 of FASB Statement No. 114 may provide appropriate measures of collective loan impairment. Readers should note, however, that FASB Statement No. 114 states in paragraph 54 that “the Board concluded that - 29 -
  • 30. DRAFT 6-7-01 loan impairment should be recognized based solely on deterioration of credit quality evidenced by a decrease in expected future cash flows rather than on changes in both expected future cash flows and other current economic events, such as changes in interest rates.” Thus, a decline in the market value of a pool of loans should not be viewed as a loss-triggering event. A .27 AcSEC believes that FASB Statement No. 114 is unclear regarding the guidance on data to be considered in estimating expected future cash flows for valuation purposes. Paragraph 8 of FASB Statement No. 114 indicates that impairment is triggered “based on current information” suggesting to some current information proponents that both recognition and measurement should be based solely on current information. As such, only the observable data that exist at the balance sheet date would be used to estimate expected future cash flows. Others look to paragraph 15 of FASB Statement No. 114, which states, in part, “measure of impaired loans… shall be the creditor’s best estimate based on reasonable and supportable assumptions and projections.” Projection proponents suggest that paragraph 15 of FASB Statement No. 114 clearly requires projecting the future events to determine expected future cash flows. For example, the current information proponents would use current occupancy, rental, and absorption rates as the observable data for estimating cash flows for a pool of troubled real estate loans, while the projection proponents would use both current and projected rates as their observable data for estimating cash flows. A.28 AcSEC believes that only existing observable data should be used to measure expected future cash flows and that projecting future changes in observable data is prohibited. The basic - 30 -
  • 31. DRAFT 6-7-01 concept of observable data as a recognition and measurement principle is that changes in the observable data from period to period are reflected in each period’s income statement. Including projections regarding possible changes in the observable data that may occur in the future would result in accelerating such losses into an earlier period, which is inconsistent with this SOP and FASB Statement No. 5. A.29 Practically, AcSEC believes that the FASB Statement No. 114 measurement principles apply easily to pools of loans. Generally, cash flows are estimated to obtain a value of a loan for comparison to the current outstanding balance. Inversely, a creditor can estimate lost cash flows as a component of loss without comparison to the outstanding balance. For example, using historical loss rates and current pool grading as observable data, cash flows can be estimated simply. For example. if the outstanding balance of a pool is $10 million, the annual loss rate is 17 basis points, the average life is 3.5 years, and the average loan rate is 10%, the allowance component would be $43,000. A.30 AcSEC notes that the nature of judgments required may necessitate using a range to properly estimate loan impairment. GAAP requires that creditors use their best estimate and if, after an analysis of all observable data, a single, best estimate does not exist then the low end of the range should be recorded. This SOP requires that the point selection be based on observable data. Movement within the range that is not directionally-consistent with changes in observable data is prohibited. - 31 -
  • 32. DRAFT 6-7-01 A.31 Observers have noted that an allowance component called “margin for imprecision” is permitted under GAAP. This SOP does not preclude any specific component of collective loan impairment by name or short hand description. However, AcSEC reiterates its view that all components of collective loan impairment must be supported by observable data that is relevant to the specific credit risk characteristics of the pool of loans. AcSEC accepts that judgment is necessary in estimating losses, but believes that all components must be supported by observable data and collective loan impairment components should not result in the double-counting of loan impairment. A.32 Paragraph 26 of this SOP provides that a creditor that has no experience of its own should use peer group experience as the basis for estimating its allowance for credit losses if, and only if, a specific, documented analysis indicates the comparability of the creditor’s portfolio and the industry or peer group portfolio. AcSEC believes its guidance is consistent with FASB Statement No. 5, which states in paragraph 23 that “In the case of an enterprise that has no experience of its own, reference to the experience of other enterprises in the same business may be appropriate.” [emphasis added]. AcSEC notes that amounts reported in an entity’s financial statements purport to be information about the entity, not about the entity’s industry. AcSEC believes that, without a specific, documented analysis indicating the comparability of the creditor’s portfolio and the peer group portfolio, a creditor is unable to know if the peer group experience is representative of the creditor’s own experience or what adjustments, if any, would need to be made to estimates based on the peer group experience. AcSEC therefore believes that without that analysis, peer group experience does not constitute a basis for a reasonable estimate - 32 -
  • 33. DRAFT 6-7-01 of a creditor’s credit losses. Disclosures A.33 FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises, states in paragraph 54 that— Financial reporting often provides information that depends on, or is affected by, management’s estimates and judgment. Investors, creditors, and others are aided in evaluating estimates and judgmental information by explanations of underlying assumptions or methods used, including disclosure of significant uncertainties about principal underlying assumptions or estimates. Although AcSEC believes this SOP will result in the necessary correlation between available information and the level of the allowance for credit losses and that it will narrow the range of judgment in the determination of a creditor’s allowance for credit losses, estimates and judgment will remain significant factors in the determination of the allowance for credit losses. Further, AcSEC seeks more transparency in the factors that cause the estimation judgments and the results of those judgments. Thus, AcSEC believes that robust disclosures regarding the composition of the allowance for credit losses are needed by users of financial statements. Further, AcSEC believes more transparency is needed regarding the data that influences the estimation judgments and the resulting allowance amounts. - 33 -
  • 34. DRAFT 6-7-01 A.34 AcSEC’s deliberations regarding disclosures related to the allowance for credit losses identified several opportunities for improved disclosures. Generally, AcSEC assessed the need for improved narrative and quantitative disclosures regarding (i) the composition of the allowance for credit losses, (ii) available information used by creditors to assess credit losses and manage credit risk, (iii) a creditor’s process and methodology for determining and assessing the appropriateness of the allowance for credit losses, and (iv) changes in the components of the allowance for credit losses from period to period. A.35 At the core of AcSEC’s deliberation was a desire to balance the need for comparability among entities with the need to disclose information that would allow users of financial statements to understand the specific creditor’s allowance-development process. In addition, certain disclosure requirements were enhanced to facilitate comparability among creditors. A.36 Also critical in AcSEC’s deliberations was a belief that the ability to understand a creditor’s credit-risk position and the related period-to-period provision for credit losses has a significant effect on the overall usefulness of the financial statements. A.37 As part of the decision the enhance the disclosures related to the allowance for credit losses, AcSEC reviewed the following documents: (a) a March 2000 Board of Governors of the Federal Reserve System Staff Study, “Improving Public Disclosure in Banking,” (b) a September 2000 Basel Committee on Banking Supervision report titled “Best Practices for Credit Risk Disclosure,” and (c) a January 11, 2001 letter from the Working Group on Public Disclosure to - 34 -
  • 35. DRAFT 6-7-01 Federal Reserve Chairman Laurence H. Meyer. Those documents provided similar recommendations and best practices for improving the disclosures for the allowance for credit losses and credit risk. A.38 Existing GAAP disclosures regarding a creditor’s accounting policies related to the provision and allowance for credit losses are both limited and too broad to facilitate a sufficient understanding of their effect on the overall financial statements or any meaningful comparability among entities or of a creditor from period to period. A.39 A basic concept of this SOP is that each component of the allowance for credit losses recognized pursuant to FASB Statement No. 5 may utilize different recognition and measurement techniques for pools of loans (collective impairment components). The new disclosure focus parallels this concept and attempts to provide users of the financial statements with additional information sufficient for them to understand period-to-period changes in the provision and resulting allowance for credit losses, and the information relied upon by the creditor to make such estimates. A.40 This SOP requires disclosure of the accounting recognition and measurement principles and policies utilized for each significant component of the allowance for credit losses. A significance threshold of 5 percent of the recorded allowance was selected because, given the high degree of judgment required to apply the recognition and measurement principles of FASB - 35 -
  • 36. DRAFT 6-7-01 Statement No. 5, information that helps users understand an entity’s practices and judgment parameters was considered very important by AcSEC. A.41 AcSEC considered a requirement to use standard loan groupings for credit risk disclosures. AcSEC believes that the importance of understanding management’s assessment of their credit risk as captured by their credit-risk-management process outweighs the benefits of standardization for comparability purposes. - 36 -
  • 37. DRAFT 6-7-01 Appendix B -EXAMPLES ILLUSTRATING THE APPLICATION OF THE CONCEPTS IN THIS SOP B.1 This appendix illustrates how the concepts in this SOP would be considered in practice. These examples are not intended to address how a creditor would support recognition and measurement of these individual components or any other aspect of this SOP. The examples herein are not intended to be comprehensive. Components of the Allowance for Credit Losses B.2 The following example illustrates the concept of components within the allowance for credit losses as described in paragraph 9 of this SOP. Creditors exercise considerable judgment in estimating the allowance for credit losses. As such, many credit risk characteristics are reflected in the actual allowance balance at any given balance sheet date. The allowance related to these are referred to in this SOP as “allowance components.” In the most simple example, an allowance may have just three components; 1) a FASB Statement No. 114 component, 2) a historical loss rate component that represents bank regulatory classification grouping using estimated annual loan loss rates and 3) a general component estimated to reflect current conditions not appropriately reflected in the historical loss rate component. B.3 Bank ABC has a loan portfolio consisting of both commercial and consumer loans. Bank ABC's allowance for credit losses consists of four components as follows: - 37 -
  • 38. DRAFT 6-7-01 • An individual loan impairment component for credit losses on commercial loans that are credit risk graded as substandard or doubtful in accordance with the Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans, dated November 6,1991, and the Interagency Statement for the Allowance for Loan and Lease Losses, dated December 21, 1993. These loans are reviewed individually as part of the bank's normal credit risk-evaluation process and are considered to be individually impaired. Impairment of these loans is measured in accordance with FASB Statement No. 114. • Three collective impairment components for loans that are not considered in the FASB Statement No. 114 component, as follows: —Historical loss experience by credit-risk grade for commercial loans —Historical loss experience based on migration analysis for consumer loans —Current economic environment risk not reflected in the historical period for developing loss factors for commercial and consumer loans B.4 Bank KGM has the same components as Bank ABC with the following additional components: • Commercial Real Estate loans are excluded from the broad-base grading process and assessed independently based on current market leasing data. • A new, revolving mortgage line of credit product is excluded from the consumer component and relevant, peer group data is used to estimate this component. - 38 -
  • 39. DRAFT 6-7-01 • Certain LDC loans are excluded from the commercial loan pools and assessed independently based on economic development information of the respective regions. Collective Loan Impairment and Observable Data B.5 The following example illustrates the components of a creditor's collective impairment assessment that, along with the individual loan impairment component, make up a creditor's total recognized allowance for credit losses. Components of an allowance for credit losses are grouped as either 1) FASB Statement No. 114 impaired and measured (including both commercial and specific non-homogeneous consumer) and 2) all other components referred to as “collective loan impairment” components. These examples exhibit how certain collective loan impairment components are assessed relative to their observable data. As set forth in the SOP, a collective loan impairment component can only be recognized if there is observable data that is relevant, as defined, to the similar credit risk characteristic represented in the pool of loans. B.6 Bank EJS has a loan portfolio consisting of commercial and consumer loans. Bank EJS has removed individually impaired loans from its population of loans subject to assessment for collective impairment. Bank EJS has identified five collective impairment components relative to its portfolio of loans that were not deemed to be individually impaired: historical loss experience related to commercial loans, adjustments related to Federal Reserve Statistics, historical loss experience related to consumer loans, adjustments related to delinquencies and - 39 -
  • 40. DRAFT 6-7-01 losses from a prolonged agricultural slow down that did not exist in the historical period utilized for commercial loan loss rate development. B.7 Bank EJS assesses impairment of its portfolio of commercial loans that are not deemed to be individually impaired based on credit-risk grades assigned as part of its normal credit-risk evaluation procedures. Impairment is measured for these loans based on outstanding loan balance and average annual historical loss rates. Such average annual loss rates are derived using a five year historic loss period that measures loss migration for the subsequent twelve month period. Bank EJS assesses the need to adjust its historic loan grading component to reflect current conditions by reference to changes in Federal Reserve Board domestic economic information (observable data). Reviewing this observable data for the last five years reflects that data within the historical loss period is similar to current data, thus supporting no adjustment. B.8 Bank EJS assesses impairment of its consumer loan portfolio based on the payment status of the loans by type of loan within the portfolio. Impairment of loans in the consumer portfolio is measured based on an assessment performed annually by Bank EJS of the migration of loans from the respective payment status categories to ultimate charge-off. The loss rates utilized represent the average of the last three years. This historic loss migration component is reviewed for adjustment to reflect current conditions by reference to Bank EJS’s delinquency information (observable data). Bank EJS analyzed its delinquencies at the balance sheet date and over the past three-year period used in the migration analysis, noting that the delinquency information over the past three-year period was worse than the delinquency information at the balance sheet - 40 -
  • 41. DRAFT 6-7-01 date. An additional component for collective loan impairment would be recorded based on changing delinquency rates (observable data) for this similar credit risk characteristic. B.9 Bank EJS had identified in the prior year evidence of a possible agricultural slow down affecting the communities within which it lends. The prolonged agricultural slow down is causing extended plant shut-downs and employee lay-offs. No agricultural slow down existed during the historical period on which Bank EJS's initial impairment assessment for commercial and consumer loans was based. Bank EJS segregated groups of loans to commercial and consumer borrowers that it believes may be adversely affected by the agricultural slow down. A component of Bank EJS's allowance for credit losses reflects its estimate of the effect of this current condition on those borrowers. The adjustment to Bank EJS’s commercial historic loss rate component is based on trends in the wheat and soy bean futures as provided by the Chicago Commodities Exchange (observable data). The adjustment for the consumer migration loss components is based on trends in reported unemployment rates for the counties affected by the agricultural slow down as reported by the State Employment Agency (observable data). B.10 Bank GEM has a portfolio of international loans, with particular exposure to borrowers in Taiwan. Bank GEM establishes a separate collective loan impairment component to adjust for the different risk profile of loans to private borrowers in Taiwan from the one captured through Bank GEM's commercial credit-risk grading component. Bank GEM uses expected default frequencies (EDFs) by country calculated by an outside third-party as the observable data supporting this component of collective loan impairment. During the current period the EDFs - 41 -
  • 42. DRAFT 6-7-01 for Taiwan improved. Accordingly, Bank GEM reduced its Taiwan collective loan impairment component. Directionally-Consistent Measurement B.11 Fundamental to the measurement of allowance for credit losses set forth in this SOP is the concept that period to period changes in the provision for credit losses moves in a directionally consistent fashion with the changes in the observable data evidencing the similar credit risk characteristics of the various components that make up the overall allowance for credit losses. The SOP requires that the observable data be relevant, as defined, to the loss indicated by the similar credit risk characteristics the SOP does not require that this relationship be mathematical. However, in some cases a creditor may conclude that there is a reasonable and appropriate mathematical relationship to the loss estimate. The following example illustrates the "directionally consistent" concept set forth in paragraph 23 of this SOP. B.12 Bank SDS has a residential 1-4 family loan portfolio. The Bank uses a loss migration model to estimate its historical loss rate component for this collective loan impairment. To adjust the historically based loss rate component for current conditions, Bank SDS utilizes unemployment statistics as its observable data. Through an analysis of historic loss trends to changes in employment levels, Bank SDS utilizes a proportionate relationship based on the historical correlation. For example, for each one basis point deterioration in unemployment, loss - 42 -
  • 43. DRAFT 6-7-01 estimates increase by 3 basis points. If unemployment improves, by 3 basis points, the component of collective loan impairment decreases by 9 basis points. Best Estimate Selection Within a Range B.13 This example illustrates the principles set forth in paragraph 26 of this SOP regarding a creditor's selection of a “best estimate” from a range of possible loss estimates. B.14 Bank TTT grades its portfolio of commercial loans using a nine-grade credit-risk grading methodology, with each grade in the credit-risk grading methodology representing borrower attributes that are indicative of the borrowers’ ability to make contractual principal and interest payments. Loans that are placed in grade nine are deemed to be impaired on an individual loan basis. Thus, Bank TTT measures impairment on those loans under FASB Statement No. 114 and does not include them in its collective loan impairment assessment. B.15 For estimating its allowance for credit losses on grades one through eight, Bank TTT constructs a range of estimated impairment for each credit-risk grade by analyzing the migration of loans from each credit-risk grade to charge-off during three economic periods: strong, moderate, and poor. The historic loss rates are estimated by reference to historic economic periods with strong, moderate or poor economic characteristics, and calculating a two-year average annual loss rate for each of the three periods. Further, Bank TTT used key economic indicators (observable data) that are relevant to assessing economic conditions in determining the - 43 -
  • 44. DRAFT 6-7-01 three economic periods. Bank TTT will utilize those key economic indicators each period to determine the point within the range to select. B.16 Bank TTT selects the point within the historic range of observable data that is the most representative of the current observable data and selects the corresponding annual loss rate. In subsequent quarters, the current observable data is compared to the same historical observable data and a new corresponding loss rate is utilized. Use of Peer Data B.17 The following example illustrates the possible use of peer data in estimating collective impairment for a pool of loans. B.18 Bank CDE began originating subprime home equity loans during the current year. Bank CDE has not engaged in subprime lending in the past and therefore has no experience of its own regarding the loss attributes of subprime home-equity loans. In order to estimate collective loan impairment for this portfolio of loans, Bank CDE reviewed public securitization documents to obtain relevant credit loss data for the same loan types. Bank CDE assessed the credit score distribution of loans within the securitizations and the credit score distribution of loans in its own portfolio and considered them to be materially the same. Bank CDE assessed impairment of the subprime portfolio of loans using the securitization credit-loss data during the first two years. In - 44 -
  • 45. DRAFT 6-7-01 the third year of subprime origination, Bank CDE began using its own subprime portfolio historical loss data to assess collective loan impairment. - 45 -
  • 46. DRAFT 6-7-01 APPENDIX C — Illustrative Application Guidance The following examples illustrate the application of the principles set forth in paragraphs 17-23 of this SOP related to collective impairment components and the related observable data used to support those components. Pool of International Working Capital Loans Facts Bank LWS is a super-regional bank with assets of $30.0 billion. Bank LWS has a $10.0 million portfolio of international working capital loans with exposure to corporate borrowers in Taiwan. The loans were originated by Bank LWS within the last three years, have an average maturity of five years and are denominated in US dollars. Bank LWS has been extending loans to corporate borrowers in Taiwan for nearly ten years. At December 31, the portfolio of loans to corporate borrowers in Taiwan consisted of 25 loans with an loan principal average balance of $400,000. The weighted average coupon rate of the pool is 11%. Bank LWS assesses the impairment of the pool of loans to corporate borrowers in Taiwan separately as those loans are deemed to have a risk profile different from other loans within the commercial and industrial portfolio. Accordingly, historical charge-off data is maintained separately for Taiwan working capital loans. Bank LWS’s historical annual charge-off rates for Taiwan working capital loans over the last three years have been 100 basis points. (The - 46 -
  • 47. DRAFT 6-7-01 historical charge-off rate is an annual rate calculated using actual annual charge-offs divided by the beginning of the year pool principal balance). This historical charge-off rate was experienced during stable economic times within Taiwan. In order to adjust the historical loss data for current information and events, Bank LWS uses expected default frequency data (EDFs) by country calculated by an outside third party. This data provides current information that aids Bank LWS in adjusting historical charge-off data for current events and conditions existing at the balance sheet date. This data is released on a quarterly basis in the second month of the succeeding quarter (that is, September quarterly information is released in November). This information has been available for several years and Bank LWS anticipates it will continue to be available in the future. Based upon past analysis, changes in historical charge-off rates lag movements in the EDF data by nine months (that is, higher EDF rates result in increased charge-offs approximately nine months later). Bank LWS’s analysis of current EDF data indicates that the level of defaulting companies in Taiwan has risen 10% from the average levels of the past three years. In the prior year, Bank LWS did not record a separate collective loan impairment component for increasing defaults by Taiwan companies as Bank LWS’s analysis of the EDF data did not indicate significant changes in current conditions when compared to the prior three year base period. As such, no adjustment was required to reconcile the historical loss component to events or conditions existing at those balance sheet dates. Bank LWS therefore concluded an additional allowance component in addition to the historical loss component was not necessary. - 47 -
  • 48. DRAFT 6-7-01 Bank LWS has also learned that long-range economic forecasts indicate that the Taiwan unemployment rate will increase by nearly 20% in the next four years, before beginning to recover, which may negatively impact Bank LWS’s Taiwan loan portfolio. Also, recent polls indicate that Taiwan voters may prefer a change in government leadership. The party leading in these polls appears to favor an policy of quick economic expansion. Conclusion Based upon available information, Bank LWS concludes that the pool is impaired at the balance sheet date. In estimating the collective loan impairment component, Bank LWS projected the cash flows (both principal and interest) of the pool for the pool’s remaining life assuming that $100,000 in principal cash flows will not be received annually. The expected future cash flows are discounted at 11% and compared to the pool carrying amount to arrive at a collective loan impairment estimate for Taiwan working capital loans of $244,400. Bank LWS concludes that another $10,000 in annual losses have been incurred due to the increase in the EDF data. As such, Bank LWS calculates another component of its allowance to adjust the historical loss rate component to current conditions. The revised expected future cash flows are discounted at 11% and compared to the previous discounted value to arrive at a collective loan impairment component estimate of $24,400. - 48 -
  • 49. DRAFT 6-7-01 Based upon Bank LWS’s analysis, the total allowance for credit losses for this pool of working capital loans to corporate borrowers in Taiwan is $268,800 ($244,400 + $24,400). Basis for Conclusion Bank LWS used its historical loss experience, adjusted for current conditions, as evidenced by observable data that has is relevant to the pool of working capital loans to corporate borrowers in Taiwan, to determine this collective loan impairment component. The historical evidence and third-party data was determined to be more objectively verifiable than other available information. Other available information that was not specifically used in determining the allowance included the long-range economic forecasts and the potential outcome of the upcoming government elections. While this information is beneficial to Bank LWS as it manages the overall portfolio risk, the information is not observable data, as defined by the SOP, in part because it will not be available in future periods. Accordingly, this information cannot be included in the analysis to result in the allowance for credit losses. - 49 -
  • 50. DRAFT 6-7-01 Pool of Agricultural Loans Facts Bank MES is a regional bank located in Wichita, Kansas with total assets of $5.0 billion. The bank’s lending focus is based upon the economy of Kansas and consists of medium to small commercial and industrial lending, one-to-four family real estate, and agricultural (wheat) lending. All of Bank MES’s commercial loans are credit risk graded; however, due to a concentration of loan portfolio exposure to wheat farmers, Bank MES has removed such loans from the credit risk graded pools and considered the loans as a pool of loans with similar credit risk characteristics for allowance estimation. Bank MES’s loan portfolio contains working capital loans to wheat farmers totaling $500 million at December 31, 2000. Loans with a principal balance of $1 million or greater in this portfolio are evaluated individually for impairment. As a result of this impairment evaluation, Bank MES concludes that loans totaling $60 million are individually impaired. Impairment for these loans is calculated to be $5.2 million based on management’s estimate of discounted expected future cash flows for those loans. The loans with principal balances of $1 million or greater that are not deemed to be individually impaired ($140 million) are combined with wheat loans with principal balances of less than $1 million ($300 million) in a single pool of loans for collective loan impairment evaluation. The weighted average coupon rate of the pool is 8.5%. The pool of loans has an average maturity of - 50 -
  • 51. DRAFT 6-7-01 nine months. Average historical charge-off experience for the last three years for working capital loans to wheat farmers has been 175 basis points annually. Wheat futures prices were stable during the three year period over which the average historical charge-off rate was developed. Stable is defined by Bank MES to mean wheat prices within a range of plus/minus 10%. However, within the last quarter, wheat futures prices as quoted on the Kansas City Board of Trade have risen nearly 25% from the prior quarter. Conclusion Based upon available information, Bank MES concludes that the pool of wheat farming loans is impaired at the balance sheet date. In estimating the collective loan impairment component, Bank MES determines the expected future cash flows of the pool (both principal and interest) over the remaining life of the pool. This estimate is made by assuming the pool performs according to its contractual terms with expected lost cash flows of $7,700,000 ($440 million x 175 basis) annually. The expected future cash flows are discounted at the rate of the pool of loans to arrive at a collective loan impairment estimate of $5.6 million (the result of $7,700,000 x 9/12 discounted at 8.5%) Based on the wheat futures prices, Bank MES calculates a collective impairment component for the impact of increasing wheat prices to adjust the historical charge-off rate for current conditions. This adjustment for current events is estimated to reduce the expected lost cash flow by 20% or $1.1 million ($5.6 million x 20%). - 51 -
  • 52. DRAFT 6-7-01 Based upon Bank MES’s analysis, the total allowance for credit losses for its pool of working capital loans to wheat farmers consists of the following components (dollars in millions): Individually-impaired loans $ 5.2 Wheat farmer-historically-based migration 5.6 Current wheat price component ( 1.1 ) Total allowance for credit losses for wheat farmers $ 9.7 Basis for Conclusion Bank MES used historical loss experience, adjusted for current conditions in determining the allowance for credit losses for this pool of wheat farming loans. This historical evidence and current economic information (wheat futures prices) was determined to be more objectively verifiable than extended weather forecasts. - 52 -
  • 53. DRAFT 6-7-01 Pool of 1-to-4 family residential mortgage loans Facts Bank RAP, a national bank with assets of $400 billion and total loans of $150 billion, has a portfolio of 1-to-4 family residential mortgage loans consisting of 200,000 loans that totals $30 billion at December 31. The loans were originated by Bank RAP to customers in the U.S. and have an average maturity of 9 years. Bank RAP segments its $30 billion pool of residential mortgage loans by geographic region (i.e., where each borrower lives). Bank RAP’s regions are defined in the same way as the U.S. Bureau of Labor Statistics’ regions. Bank RAP’s segmentation of the pool as of December 31, 2002 is as follows (dollars in billions): Geographic Region Balance West $2.9 Midwest 13.3 South 8.6 Northeast 5.2 Total $30.0 - 53 -
  • 54. DRAFT 6-7-01 Bank RAP has noted the following average charge-off rates based on a migration analysis performing analyzing the respective pools. The migration results used in estimating the historical loss rate component of collective loan impairment for these pools are as follows: Average annual charge-off rate per Geographic Region migration analysis West 0.055% Midwest 0.039 South 0.045 Northeast 0.050 In order to assess whether the historical loss rate component of collective loan impairment is sufficient to result in an appropriate measure of collective loan impairment for these pools of loans, Bank RAP continually monitors U.S. economic reports issued by the U.S. Department of Commerce and the U.S. Department of Labor Statistics. Bank RAP also subscribes to economic data report services that provide more breakdown for different regions of the U.S., including those for its primary lending areas. Based on these economic reports (observable data), Bank RAP has noted that average unemployment rates in its lending regions have increased recently compared to unemployment rates during the migration analysis period, as follows: Average during Geographic November migration analysis Region 2002 period West 5.3% 5.0% Midwest 4.1 3.7 South 4.6 4.3 Northeast 5.2 4.8 In addition, consumer debt burdens and bankruptcy rates for borrowers in the 1-to-4 family mortgage portfolio have increased by 15%. Further, Bank RAP has noted that late payments on - 54 -
  • 55. DRAFT 6-7-01 its residential mortgage loans have risen in the last quarter by about 1% over levels experienced in the past three years. Bank RAP makes a determination, based on its past experience and the observable data it has compiled, that it will not collect all contractual principal and interest payments on the residential mortgage loans in the pool. Therefore, the pool is considered impaired. Furthermore, Bank RAP notes that its historical average charge-off rates by region on residential mortgage loans are slightly less than the charge-off rates it is experiencing in the current quarter. Bank RAP estimates, based on increases in unemployment rates, that actual losses in the portfolio will be higher than those estimated using historical charge-off data. Bank RAP estimates charge-offs will increase as follows: 6% in the West; 11% in the Midwest; 7% in the South; and 8% in the Northeast. As such, the additional collective loan impairment components, by region, are as follows: Geographic Region Adjustments to estimate West 0.003% Midwest 0.004 South 0.003 Northeast 0.004 These increases in regional loss rates are consistent with Bank RAP’s past loan loss experience in similar economic circumstances. More specifically, when the U.S. economy experienced a downturn in 1990-1991 and showed similar increases in unemployment, Bank RAP’s residential mortgage loan charge-offs increased by rates similar to the increases in unemployment rates, by - 55 -
  • 56. DRAFT 6-7-01 region. Bank RAP measures impairment on its pool of residential mortgage loans using two of the measurement methods available under FAS 114: loans’ observable market price and present value of expected future cash flows of the loans. For approximately $12 billion of the $30 billion outstanding balance, Bank RAP has obtained quoted market prices for the loans. The loans included in the $12 billion are loans to borrowers in the Midwest region for which there is a ready and liquid market and were underwritten to be in accordance with agency guidelines. The observable market prices (quoted market prices) for Bank RAP’s pool of $12 billion loans is $12.2 billion, resulting in no allowance for this pool. For the remaining $18 billion balance of residential mortgage loans, Bank RAP measures impairment by calculating the present value of expected future cash flows of the pool, discounted at the pool’s weighted average effective interest rate, and comparing that value to the carrying value of the loans on Bank RAP’s books. Bank RAP determines the expected monthly cash flows of the pool (both principal and interest), by region, over the remaining pool life by starting with contractual cash flows. The weighted average effective interest rate for the $18 billion pool of loans is 7.8%. Conclusion Based upon Bank RAP’s analysis, the total allowance for credit losses for its pool of $30 billion in residential mortgage loans is as follows: - 56 -
  • 57. DRAFT 6-7-01 Unemploymen Total Historical loss t increase Allowance for component component Credit Losses Midwest – observable market $ - $ - $ - Present value of expected future cash flows: West 10.0 0.5 10.5 Midwest 3.2 0.3 3.5 South 24.4 1.6 26.0 Northeast 16.4 1.3 17.7 $ 54.0 $ 3.7 $ 57.7 Basis for Conclusion The SOP states that the weight of each set of observable data on the assumptions and projections utilized to estimate expected future cash flows should be commensurate with the extent to which the relevance of the observable data to the collective loan impairment can be verified objectively. In measuring collective impairment on its pool of $30 billion in residential mortgage loans, Bank RAP placed the greatest weight on the increase in unemployment rates, by region, during the past six months. The increase in late payments is based on Bank RAP’s internal data and is therefore both observable and verifiable, however Bank RAP does not establish another collective loan impairment component as the increased late payments have already been captured by the other collective loan impairment components. Bank RAP obtains objective data on changes in regional unemployment rates from both the U.S. Bureau of Labor Statistics and from individual state governments within its lending areas. Bank RAP’s internal analysis shows that changes in regional unemployment rates have an economic relationship with its loss experience - 57 -
  • 58. DRAFT 6-7-01 on residential mortgage loans. - 58 -
  • 59. DRAFT 6-7-01 Pool of Automobile Loans Facts Bank ECP is a state chartered bank with total assets of $2.5 billion. During 19X1 the bank originated $5 million in automobile loans in the state of Maryland. The loans have an average loan to value of 90% and were originated through several dealer networks. The average balance of each of the loans was $20,000. Bank ECP’s policy is to group small balance loans with similar credit characteristics into a pools for impairment evaluation. The weighted average maturity of the pool of automobile loans is 3 years. The weighted average coupon for the pool is 9%. The bank’s historical charge-off rate for these types of loans is 100 basis points. The bank’s annual historical charge-off rate was developed during the economic prosperity of the previous 5 years. During 19X2, the unemployment rate and personal bankruptcies in the Mid-Atlantic increased by 20% from 19X1 and are currently at 6.5% and 6.8%, respectively. The prime interest rate has decreased to 5.5%. As a result of the decrease in the prime rate, economists are reporting that the economic downturn the region is currently experiencing will be short lived and that economic growth is expected in the first or second quarter of 19X3. Additionally, a bill is being debated in the state legislature that would establish a personal property tax on all automobiles. At the current time, there is no personal property tax assessed on automobiles. Bank ECP believes a personal property tax would have a significant impact on the market for used cars and the banks would incur losses on resale of repossessed autos. - 59 -
  • 60. DRAFT 6-7-01 Conclusion Bank ECP has concluded the pool of car loans is impaired (all contractual principal and interest will not be collected). As such, Bank ECP will utilize historical loss data adjusted for current economic information to measure this impairment. Based on the annual historical loss rate of 100 basis points, Bank ECP calculates the expected future cash flows of the pool over the remaining average pool life. Bank ECP assumes the losses incurred to date will result in uncollectible cash flows of $150,000. The pool’s expected uncollectible cash flows are then discounted at the weighted average coupon of the pool (9%) to arrive at an allowance of $126,565. Bank ECP further concludes that based on the 20% increases in both unemployment and personal bankruptcies that the allowance should be adjusted upward. Bank ECP historical data for similar economic times (that is, a fast slowing economy after long expansion period), indicated that a 150 basis point loss rate should be utilized. However, that historic loss rate existed during a period in which the unemployment and personal bankruptcy rates were only 5.5% and 6.2% respectively. The bank believes that given the severity of the current downturn, that an expected loss rate of 225 basis points would better reflect the current economic environment. This 125 basis point increase in the estimated loss rate was used to revise the expected future cash flow of the pool in the same manner as above. The increase resulted in an additional allowance of $158,206, resulting in a total allowance for the pool of loans of $284,771. The bank did not give any weighting to current economic forecasts that the downturn - 60 -
  • 61. DRAFT 6-7-01 would be short lived because that would incorporate future events that had not yet occurred - 61 -
  • 62. DRAFT 6-7-01 Loss Event Company XYZ is a consumer finance company with a $Z billion home equity loan portfolio. In estimating its allowance for credit losses, Company XYZ pools loans based on borrower payment status: current, 30 days past due, 60 days past due, and 90+ days past due. Company XYZ performs a migration analysis by which it analyzes losses that migrate from each pool over a one year period. The results of the migration analysis are used as Company XYZ’s estimate of expected lost cash flows in its estimation of the allowance for credit losses. The current unemployment rate in the community within which Company XYZ lends are consistent with the unemployment rates during the migration analysis period, thus Company XYZ does not believe that any additional allowance components are necessary to reconcile the historical loss component to current conditions. Just prior to year end, Company XYZ learns that the largest employer in the community within which it lends is moving its operations out of the country and laying off its U.S. workforce. While Company XYZ believes that unemployment rates, which have an economic relationship to a borrower’s ability to repay contractual principal and interest, will rise as a result of the projected increase in unemployment, it does not record an additional component for collective impairment as its projection of observable data is not sufficient to support measurement of such component. Accordingly, Company XYZ discloses the event that occurred at the end of the period pursuant to the guidance in paragraph 10 of FASB Statement No. 5. - 62 -
  • 63. DRAFT 6-7-01 APPENDIX D — Illustrative Disclosure Guidance Disclosure D.1 The following examples illustrate the disclosures required by this SOP. This SOP does not require the formats used in the illustrations. AcSEC encourages creditors to use a format that displays the information in the most understandable manner in the specific circumstances. D.2 Disclosures required by this SOP that are incremental to existing GAAP requirements are presented in italics. Other disclosures required by existing GAAP are presented in order to illus- trate this SOP’s disclosure requirements in context. Readers should note that the total allowance for credit losses, and its underlying components, are for illustrative purposes only—the amounts and percentages presented are not intended to influence a creditor’s determination of its overall allowance for credit losses. Example 1 – A Bank Holding Company NOTE X – Summary of Significant Accounting Policies Loans and Leases. Loans are stated at their principal amount outstanding and interest income is recognized on an accrual basis. Accrued interest is presented separately in the balance sheet, ex- cept for accrued interest on credit cards, which is included in the outstanding loan balance. Loan origination fees and costs incurred to extend credit are deferred and amortized over the term of the loan and the loan commitment period as a yield adjustment. Loan fees representing adjust- ment of interest rate yield are generally deferred and amortized into interest income over the term of the loan using the interest method. Loan commitment fees are generally deferred and - 63 -
  • 64. DRAFT 6-7-01 amortized into noninterest income on a straight-line basis over the commitment period. Un- earned discounts on consumer loans are recognized by the interest method. Lease financing assets include aggregate lease rentals, net of related unearned income, which includes deferred investment tax credits, and related nonrecourse debt. Leasing income is recognized as a constant percentage of outstanding lease financing balances over the lease terms. Nonperforming Loans. With the exception of certain consumer and residential real estate loans, loans and leases on which payments are past due for 90 days are placed on nonaccrual status, unless those loans and leases are is in the process of collection and, in management’s opinion, are fully secured. Residential real estate loans over 120 days past due are placed on nonaccrual status, while other consumer loans are generally written off when deemed uncollectible or when they reach a predetermined number of days past due depending upon loan product, country, terms, and other factors. When a loan is placed on nonaccrual status, uncollected interest accrued in prior years is charged against the allowance for credit losses and current year accrual interest is revised to interest income. A loan is returned to accrual status when principal and interest are no longer past due and collectibility is probable. Restructured loans are those on which concessions in terms have been made as a result of deterioration in a borrower’s financial condition. Under the Company’s credit policies and practices, individually impaired loans include all nonaccrual and restructured commercial, agricultural, construction, and commercial real estate loans, but exclude certain consumer loans, residential real estate loans, and lease financing - 64 -
  • 65. DRAFT 6-7-01 classified as nonaccrual. Loan impairment for all loans is measured based on the present value of expected future cash flows discounted at the loan’s or loan pool’s effective interest rate or, as a practical expedient, at the observable market price of the loan or the loan pool or the fair value of the collateral if the loan or loan pool is collateral dependent. Allowance for Credit Losses. The allowance for credit losses is management’s estimate of the amount of probable credit losses in the loan portfolio. The Company determines the allowance for credit losses based on an on-going evaluation. This evaluation is inherently subjective as it requires material estimates, including the amounts and timing of cash flows expected to be received on impaired loans, that may be susceptible to significant change. Increases to the allowance for credit losses are made by charges to the provision for credit losses. Loans deemed to be uncollectible are charged against the allowance for credit losses. Recoveries of previously charged-off amounts are credited to the allowance for credit losses. The Company’s allowance for credit losses is the accumulation of various components that are calculated based on independent methodologies. All components of the allowance for credit losses represent an estimation performed pursuant to either FASB Statement No. 5 or FASB Statement No. 114. Management’s estimate of each allowance for credit losses component is based on certain observable data that management believes is the most reflective of the underlying credit losses being estimated. Changes in the amount of each component of the allowance for credit losses are directionally consistent with changes in the observable data and - 65 -
  • 66. DRAFT 6-7-01 accompanying analyses. Refer to Note X for further discussion and descriptions of the individual components of the allowance for credit losses. A key element of the methodology for determining the allowance for credit losses is the Company’s credit risk-evaluation process, which includes credit-risk grading individual commercial loans. Loans are assigned credit-risk grades based on the Company’s assessment of conditions that affect the borrower’s ability to meet its contractual obligations under the loan agreement. That process includes reviewing borrowers’ current financial information, historical payment experience, credit documentation, public information, and other information specific to each individual borrower. Certain commercial loans are reviewed on an annual or rotational basis or as management becomes aware of information affecting the borrower’s ability to fulfill its obligations. Note X – Loans and the Allowance for Credit Losses The following is a summary of loans outstanding as of December 31, 2001 and 2000: (in millions) 2001 2000 Commercial, financial, and industrial $ 11,956 $ 11,311 Real estate –construction and land development 1,005 943 Foreign 1,510 1,459 Real estate –residential mortgage 9,236 8,917 Installment 13,930 11,997 Total loans and leases 37,637 34,627 Unearned discount (2,112) (1,773) Total loans and leases, net of unearned discount $ 35,525 $ 32,854 - 66 -
  • 67. DRAFT 6-7-01 A summary of changes in the allowance for credit losses is as follows: (in millions) 2001 2000 1999 Balance at beginning of year $649 $644 $628 Provision for credit losses 261 212 212 Charge-offs (229) (240) (213) Recoveries 12 33 17 Net charge-offs (217) (207) (196) Balance at end of year $693 $649 $644 The components of the allowance for credit losses at December 31, 2001 and 2000 are as follows: December 31, 2001 Loan type Commercial Financial & Real estate Residential Allowance for Credit Losses Components agricultural Construction Foreign Mortgage Installment Total Individually Impaired Loan Component: Individually impaired loans Loan balance $ 71 $ 8 $ 10 N/A N/A $ 89 Allowance 20 2 3 N/A N/A 25 Collective Loan Impairment Components: Historical Loss Experience: Credit risk-graded loans (1) - Grade 1 Loan balance 1,497 245 316 - - 2,058 Allowance 18 2 3 - - 24 - Grade 2 Loan balance 4,990 531 901 - - 6,422 Allowance 75 8 14 - - 96 - Grade 3 Loan balance 4,122 132 228 - - 4,482 Allowance 103 3 6 - - 112 -Grade 4 (Special Mention) Loan balance 1,156 68 43 - - 1,267 Allowance 58 3 2 - - 63 - 67 -
  • 68. DRAFT 6-7-01 -Grade 5 (Substandard) Loan balance 120 21 12 - - 153 Allowance 18 3 2 - - 23 Consumer loans based on payment status -Current Loan balance - - - 7,959 10,448 18,407 Allowance - - - 16 52 68 -30 days past due Loan balance - - - 988 2,786 3,774 Allowance - - - 3 42 45 - 60 days past due Loan balance - - - 188 696 884 Allowance - - - 7 139 146 - 90+ days past due Loan balance - - - 101 - 101 Allowance - - - 2 - 2 Loan balance $ 11,956 $ 1,005 $ 1,510 $ 9,236 $ 13,930 $ 37,637 Allowance 292 22 29 28 233 605 Other Components: (2) Consumer bankruptcy Loan balance - - - 9,236 13,930 23,166 Allowance - - - 14 21 35 Industry exposure – agricultural Loan balance 1,820 - - - - 1,820 Allowance 36 - - - - 36 Foreign exposure Loan balance - - 1,510 - - 495 Allowance - - 17 - - 17 TOTAL ALLOWANCE FOR CREDIT LOSSES $ 328 $ 22 $ 46 $ 42 $ 254 $ 693 December 31, 2000 Loan type Commercial Allowance for Credit Losses Components: Financial & Real estate Residential agricultural Construction Foreign Mortgage Installment Total Individually Impaired Loan Component: Individually impaired loans Loan balance $ 68 $ 12 $ 15 N/A N/A $ 95 Allowance 24 7 13 N/A N/A 44 Collective Loan Impairment Components: Historical Loss Experience: Credit risk-graded loans (1) - Grade 1 Loan balance 1,309 202 358 - - 1,869 Allowance 16 2 4 - - 21 - Grade 2 Loan balance 4,921 475 804 - - 6,200 Allowance 74 7 12 - - 93 - Grade 3 Loan balance 3,788 121 236 - - 4,145 Allowance 95 3 6 - - 104 -Grade 4 (Special Mention) Loan balance 1,101 121 33 - - 1,255 Allowance 55 6 2 - - 63 -Grade 5 (Substandard) Loan balance 124 12 13 - - 149 Allowance 19 2 2 - - 22 Consumer loans based on payment status - 68 -
  • 69. DRAFT 6-7-01 -Current Loan balance - - - 7,269 8,632 15,901 Allowance - - - 15 43 58 -30 days past due Loan balance - - - 1,354 2,855 4,209 Allowance - - - 5 43 48 - 60 days past due Loan balance - - - 195 510 705 Allowance - - - 7 102 109 - 90+ days past due Loan balance - - - 99 - 99 Allowance - - - 2 - 2 Loan balance $ 11,311 $ 943 $ 1,459 $ 8,917 $ 11,997 $ 34,627 Allowance 282 27 38 28 188 563 Other Components: (2) Consumer bankruptcy Loan balance - - - 8,917 11,997 20,914 Allowance - - - (9) (12) (21) Industry exposure – agricultural Loan balance 1,820 - - - - 1,820 Allowance 60 - - - - 60 Foreign exposure Loan balance - - 1,459 - - 495 Allowance - - 46 - - 46 TOTAL ALLOWANCE FOR CREDIT LOSSES $ 342 $ 27 $ 84 $ 20 $ 176 $ 649 (1) Loans that are classified as “loss” in the Company’s credit risk-grading process are immediately charged off. All loans classified as “doubtful” are individually reviewed for impairment. Any allowance deemed necessary is included in the Individually Impaired Component above. (2) The loan balances in the Other Components, above, are, in some cases, subsets of the historical loss experience components and represent adjustments to the historical loss experience. - 69 -
  • 70. DRAFT 6-7-01 Allowance for Credit Losses Components. The Company’s allowance for credit losses is the sum of various components recognized and measured pursuant to FASB Statement Nos. 5 and AICPA SOP “Allowance for Credit Losses” (for pools of loans) and 114 (for individually impaired loans). The Company’s allowance for credit losses components include the following: (a) a component estimated based on historical loss experience by credit risk-grade (for commercial loan pools) and payment status (for consumer loan pools), (b) a component based on a consumer bankruptcy loss attribute, (c) a component for industry risk exposure, and d) a component for foreign exposure. The Company’s historical loss component is the most significant of the allowance for credit losses components, and all other allowance for credit losses components are based on loss attributes that management believes exist within the total portfolio that are not captured in the historical loss experience component. The FASB Statement No. 114 component of the allowance for credit losses is determined as part of the Company’s credit risk-grading process. Once it is determined that it is probable that an individual loan is impaired, the Company measures the amount of the impairment for that loan using the expected future cash flows of the loan discounted at the loan’s effective interest rate. The FASB Statement No. 5, as amended, components are determined based on similar credit risk characteristics that are supported by observable data. There were no significant changes to the observable data utilized by the Company to measure these components during 2001 and 2000. - 70 -
  • 71. DRAFT 6-7-01 The historical loss experience components of the allowance for credit losses represent the results of migration analyses of historical charge-offs for portfolios of loans (including groups of commercial loans within each credit risk grade and groups of consumer loans by payment status). For measuring impairment in a pool of loans, the historical charge-off or migration experience is utilized to estimate expected losses to be realized from the pool of loans over the average life of the pool discounted at the average pool interest rate. The consumer bankruptcy component reflects management’s assertion that it is probable there are additional incurred credit losses that are not adequately captured in the historical loss experience components and represents management’s estimate of the losses resulting from the increase in individual consumer bankruptcies in recent years. This component adjusts the historical loss experience to reflect management’s estimate of the effect of current conditions. The primary observable data utilized as the driver of the impairment recognition and measurement for this component is the month-to-month bankruptcy rate in excess of a three-year rolling average bankruptcy rate for each consumer product type. The industry exposure component of the allowance for credit losses reflects management’s assertion that it is probable there are additional incurred credit losses related to the agriculture portfolio that are not adequately captured in the historical loss experience component. The principal observable data utilized by management as the driver of the impairment recognition and measurement for the agriculture portfolio is published wheat futures. - 71 -
  • 72. DRAFT 6-7-01 Credit Risk-Grades The following summarizes the Company’s credit-risk grades utilized as part of its credit risk- valuation process for commercial loans as presented in the table above: “Pass” Loans (Grades 1, 2, and 3) are not considered a greater than normal credit risk. Generally, the borrowers have the apparent ability to satisfy obligations to the bank, and therefore the Company anticipates insignificant uncollectible amounts based on its individual loan review. Special-Mention Loans are commercial loans that have identified potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in noticeable deterioration of the repayment prospects for the asset or in the institution’s credit position. Substandard Loans are inadequately protected by the current financial condition and paying capacity of the obligor or by any collateral pledged. Loans so classified have a well-defined weakness or weaknesses that may jeopardize the liquidation of the debt pursuant to the contractual principal and interest terms. Such loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not corrected. Doubtful Loans have all the weaknesses inherent in those classified as substandard, with the added characteristic that existing facts, conditions, and values make collection or liquidation in full highly improbable. Such loans are currently managed separately to determine the highest recovery alternatives. All doubtful loans are included in the “Individually impaired loans” - 72 -
  • 73. DRAFT 6-7-01 category and are measured in accordance with FASB Statement No. 114. Nonperforming Assets Total nonperforming assets and 90-day past due loans and leases at December 31 were: (in millions) Individually impaired loans: 2001 2000 - Nonaccrual $ 89 $ 94 - Restructured - 1 Total individually impaired loans 89 95 Other nonaccrual loans and leases 13 17 Total nonaccrual and restructured loans 102 112 Other real estate owned 50 43 Total nonperforming assets 152 155 Loans and leases past due 90 days and still accruing 153 110 Total nonperforming assets and 90 days past due $ 305 $ 265 The average balances of individually impaired loans for the years ended December 31, 2001 and 2000 were $89 million and $95 million, respectively. The allowance for credit losses related to individually impaired loans at December 31, 2001 and 2000 was $25 million and $30 million, respectively. No allowance for credit losses was provided for individually impaired loans of $1.8 million and $0.9 million at December 31, 2001 and 2000, respectively, because of the net realizable value of loan collateral, guarantees, and other factors. During December, 2001, the Company learned that a borrower has announced its intention to relocate its manufacturing operations. Management believes that commercial and consumer losses will increase over the short-term as the consequences of this action result in borrower default and subsequent loses. However, there has been no change in relevant observable data and thus no additional component was recorded at December 31, 2001. - 73 -
  • 74. DRAFT 6-7-01 There were no material commitments to lend additional funds to customers whose loans were classified as nonaccrual or restructured at December 31, 2001 - 74 -
  • 75. Example 2 – A Consumer Finance Company Nature of Operations In our consumer finance operations, we make home equity loans, originate secured and unsecured consumer loans, extend lines of credit, purchase retail sales contracts and provide revolving retail services arising from the retail sale of consumer goods and services by retail merchants, and offer private label services for retail merchants. Significant Accounting Policies Finance Receivables. Finance receivables are carried at amortized cost, which includes accrued finance charges on interest-bearing finance receivables, unamortized deferred origination costs, and unamortized net premiums and discounts on purchased finance receivables. Precomputed receivables are net of unamortized finance charges and unamortized points and fees. The Company determines delinquency on finance receivables based on contractual terms. 75
  • 76. Revenue Recognition. Finance charges are recognized as revenue on the accrual basis using the interest method. The Company amortizes premiums and discounts on purchased finance receivables as a revenue adjustment. Accrual of revenue is suspended when the fourth contractual payment becomes past due for loans and retail sales contracts and when the sixth contractual payment becomes past due for revolving retail contracts. Upon suspension, the Company does not reverse amounts previously accrued. The accrual of revenue for loans and retail sales contracts is resumed if the Company receives additional payments and the finance receivable is less than four contractual payments past due. Late charges, prepayment penalties, and extension fees are recognized as revenue when received. The Company defers the costs to originate certain finance receivables and the revenue from nonrefundable points and fees on loans and amortizes them to revenue on the accrual basis using the interest method over the lesser of the contractual term or the estimated life based upon prepayment experience. If a finance receivable liquidates before amortization is completed, any unamortized costs or points and fees are charged or credited to revenue at the date of liquidation. Allowance for Finance Receivable Losses. The allowance for finance receivable losses is management’s best estimate of the amount of probable credit losses in our existing portfolio. Increases to the allowance are made by charges to the provision for finance receivable losses. Recoveries of previously charged off amounts are credited to the allowance. 76
  • 77. The Company’s policy is to charge off each month non-real estate loans on which little or no collections were made in the prior six months, retail sales contracts that are six installments past due, and revolving retail accounts that are 180 days past due. Foreclosure proceedings are started on real estate loans when four monthly installments are past due. When foreclosure is completed and the Company has obtained title to the property, the real estate is recorded as an asset at fair value, with a charge off of any loan amount in excess of that value. Note X – Finance Receivables and the Allowance for Credit Losses The components of net finance receivables by type were as follows: December 31, 2001 Non-Real Real Estate Retail (in millions) Estate Loans Sales Total Loans Finance Gross receivables $7,297 $3,366 $1,667 $12,330 Unearned finance charges and points (854) (77) (237) (1,168) and fees Accrued finance charges 102 31 22 155 Deferred origination costs 82 4 -- 86 Premiums, net of discounts 37 34 1 72 $6,664 $3,358 $1,453 $11,475 77
  • 78. December 31, 2000 Non-Real Real Retail (in millions) Estate Estate Sales Total Loans Loans Finance Gross receivables $7,087 $2,910 $1,546 $11,543 Unearned finance charges and (911) (64) (220) (1,195) points and fees Accrued finance charges 105 25 23 153 Deferred origination costs 90 4 -- 94 Premiums, net of discounts 2 42 -- 44 $6,373 $2,917 $1,349 $10,639 Changes in the allowance for finance receivable losses were: Years Ended December 31, (in millions) 2001 2000 1999 Balance at beginning of year $400 $383 $373 Provision for finance receivable losses 204 224 230 Charge-offs (220) (225) (231) Recoveries 14 18 11 Net charge-offs (206) (207) (220) Balance at end of year $394 $400 $383 78
  • 79. Allowance for Credit Losses Components: December 31, 2001 Non-Real Real Retail (in millions) Estate Estate Sales Total Loans Loans Finance Historical Loss Component: - Current Loan balance $5,198 $2,838 $1,279 $9,315 Allowance 34 7 5 46 - 30 days past due Loan balance 800 252 73 1,125 Allowance 16 2 3 21 - 60 days past due Loan balance 399 167 58 624 Allowance 100 8 6 114 - 90 days past due Loan balance 167 84 29 280 Allowance 66 4 7 77 - 120+ days past due Loan balance 100 17 14 131 Allowance 53 6 5 64 Total Loan balance 6,664 3,358 1,453 11,475 Allowance 269 27 26 322 Other Components: Consumer bankruptcy Loan balance 6,664 3,358 1,453 11,475 Allowance 52 9 11 72 Total Allowance for Credit Losses $ 321 $ 36 $ 37 $ 394 79
  • 80. Allowance for Credit Losses Components. The Company’s allowance for credit losses is the sum of various components determined in accordance with FASB Statement No. 5, as amended. The Company’s allowance for credit losses components include the following: (a) a component estimated based on historical loss experience by payment status (for loan pools) and (b) a component based on a consumer bankruptcy loss attribute. The Company’s historical loss component is the most significant of the allowance for credit losses components, and all other allowance for credit losses components are based on loss attributes that management believes exist within the total portfolio that are not captured in the historical loss experience component. The FASB Statement No. 5 components are supported by observable data. There were no significant changes to the observable data utilized by the Company to measure these components during 2001 and 2000. The historical loss experience component of the allowance for credit losses represent the results of analyses of historical charge-offs for the Company’s portfolios of loans. For measuring impairment in a pool of loans, the historical charge-off experience is utilized to project expected losses over the expected life of the portfolio for each separately identified pool of loans discounted at the respective pools’ effective interest rate. The consumer bankruptcy component reflects management’s assertion that it is probable there are additional incurred credit losses that are not adequately captured in the historical loss experience components and represents management’s estimate of the losses resulting from the increase in individual consumer bankruptcies in recent years. This component adjusts the historical loss experience to reflect management’s estimate of the effect of current events and conditions. The primary observable data utilized by management as the driver of the 80
  • 81. impairment recognition and measurement for this component is the month-to-month bankruptcy ratio in excess of a three-year rolling average bankruptcy rate for each consumer product type. 81
  • 82. APPENDIX E — Amendments to Existing AICPA Pronouncements This SOP amends and makes uniform the guidance concerning the allowance for credit losses in certain AICPA publications, as follows: [PLACEHOLDER FOR PUBLICATIONS AFFECTED] 82
  • 83. APPENDIX F — Glossary Credit risk evaluation or grading process is the process by which creditors categorize certain loans within their portfolio based on characteristics of the loan that are indicative of the underlying borrowers’ ability to comply with contractual terms of the loan agreement. For financial institutions subject to the FFIEC loan classification criteria, this credit risk evaluation process typically results in the classification of loans as pass, special mention, substandard, doubtful, and loss. Observable data is internal or external information that provides a reasonable basis for concluding that it is probable an asset has been impaired because certain loans in a group will fail to perform pursuant to their contractual terms and for estimating the asset impairment. Observable data does not include opinions or conjecture. Observable data can be either data developed by a creditor or data available from external sources. Similar credit risk characteristic is an attribute of a loan or condition affecting a borrower that evidences a kind or degree of loss probability. For example, a loan risk grading process would result in pools of loans with a similar credit risk characteristic, as would a pool of loans in a distressed industry or economically depressed geographic location. 83