Allowance for Loan and Lease Losses Adequacy: Revisiting FASB Statements 5 & 114
By: Ken Torgler, Regional Manager-East
The thought process behind calculating the adequacy of the allowance for loan and lease losses (ALLL) has undergone multiple changes over time. In the past, it was a fairly simple calculation, requiring very little time to prepare and analyze. However, beginning with the Tax Reform Act of 1986, which stripped away real estate investment tax shelters and devalued real estate, legislative and regulatory actions significantly altered the process. Also in 1986, the Securities Exchange Commission (SEC) issued an update for "Procedural Discipline in Determining the Allowance and Provision for Loan Losses". Then, in 1991, Congress passed the FDIC Improvement Act which required regulators to verify Call Report consistency with Generally Accepted Accounting Procedures (GAAP). While Financial Accounting Standards (FAS) 5 was originally issued in 1975, the creation of FAS 114 in 1993 changed GAAP. Once the lingering effects of the Tax Reform Act subsided, banks overall became highly profitable and loan losses decreased, but the ALLL continued to grow. In 1998, SEC analysts questioned whether financial entities were managing earnings through provision expenses (i.e., were current earnings deferred to future periods in anticipation of losses?). If so, the current period earnings were being understated, the true market value of the entity was not reflected, and there was a need to protect shareholder interests. While the SEC was focused on larger national entities, the changes soon trickled down to community banks. The result is the application of today's standards.
FAS 5 and FAS 114 are documentation-based accounting standards and GAAP does not permit the establishment of allowances that are not supported by appropriate analyses. Therefore, the approach to determine the ALLL adequacy should be well-documented and applied consistently from period to period. Since bankers typically assume a conservative view when funding the ALLL, regulatory agencies have adopted an educational approach in discussing the ALLL funding methodology. Some bankers are using FAS 5 and FAS 114 as a justification for a lower ALLL, while others are implementing higher-risk environmental factors into the methodology to justify increased ALLL balances. Either method is acceptable as long as a systematic methodology is employed, the rationale supporting the determination is adequate, relevant matters for loan collectibility are consistently applied, and a disciplined manner and prudent judgment are utilized in all periods. Again, the key is documentation, documentation, documentation.
The majority of bankers have adopted some form of methodology in the spirit of FAS 5 and FAS 114. However, some may need to revisit their adequacy calculation and update their methodology to better reflect the intent of the accounting standards. While the actual accounting standards are not always exciting reading material, other documents can offer insight. As you conduct your review, the following information should prove helpful: SEC Staff Accounting Bulletin 102 (SAB 102) (www.sec.gov/interps/account.shtml); FFEIC Interagency Policy Statement July 2001 (www.fdic.gov/news/news/financial/2001/fil0163a.pdf); Emerging Issues Task Force Topic D-80 (www.osbckansas.org/topicD-80.pdf) and FAS 5 and 114 (Review Statements, Status, and Summary links)( www.fasb.org/).
