TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK
Financial Accounting Standards Board Statement No. 114, "Accounting by Creditors for
Impairment of a Loan" (FAS 114), as amended by Statement No. 118, "Accounting by Creditors for
Impairment of a Loan -- Income Recognition and Disclosures" (FAS 118), sets forth standards for
estimating the impairment of a loan for general financial reporting purposes. This letter provides guidance
for use by examiners in assessing the portion of the allowance for loan and lease losses (ALLL)
established for impaired loans under FAS 114 in conjunction with the evaluation of the overall adequacy
of a bank's loan loss allowance. Guidance is also provided herein on other supervisory issues affected
by FAS 114.1 In summary, while allowances established under FAS 114 should be considered by
examiners in performing an evaluation of the adequacy of a bank's allowance, examiners should continue
to focus primarily on the assessment of the adequacy of the overall ALLL.
Summary of FAS 114
FAS 114, as amended by FAS 118 with regard to income recognition, establishes
generally accepted accounting principles (GAAP) for use by banking organizations and other creditors
when accounting for the impairment of certain loans. According to FAS 114, a loan is "impaired" when,
based on current information and events, it is probable that a creditor will be unable to collect all amounts
due (principal and interest) according to the contractual terms of the loan agreement.2
When a creditor has determined that a loan is impaired, FAS 114 requires that an
allowance be established based on the present value of expected future cash flows of the loan
discounted at the loan's effective interest rate (i.e., contract rate, as adjusted for any net deferred loan
fees or costs, premium, or discount) or, as a practical expedient, at the loan's observable market price, or
the fair value of the collateral if the loan is collateral dependent. Since allowances under FAS 114 apply
only to a subset of loans (i.e., those that are subject to the standard and that are deemed to be impaired),
FAS 114 does not address the adequacy of a creditor's overall ALLL or how the creditor should assess
the adequacy of its ALLL.
FAS 114 is effective for fiscal years beginning after December 15, 1994, and earlier
application was permitted. FAS 118 is effective concurrently with FAS 114.
Supervisory Guidance
FAS 114, as amended by FAS 118, has been adopted by the Federal Financial
Institutions Examination Council (FFIEC) for purposes of reporting by banks in Call Reports, subject to the
additional regulatory reporting guidelines discussed below.3 Furthermore, the FFIEC concluded that FAS
114 sets forth methods for establishing only a portion of an institution's ALLL. Accordingly, while the
methods set forth in FAS 114 must be used by banks in determining the portion of the ALLL attributable
to impaired loans as defined by FAS 114 for purposes of reporting in Call Reports, no separate reporting
of the portion established under FAS 114 has been required in such reports. The overall ALLL should
continue to be reported on existing Call Report line items.
Examiners should continue to focus primarily on the assessment of the adequacy of the
overall ALLL.4 While the allowances determined under FAS 114 should be considered by examiners in
performing an evaluation of the adequacy of a bank's allowance, examiners should not focus unduly on
the adequacy of this or any other portion of the ALLL established for a subset of loans.
Several other supervisory issues related to the implementation of FAS 114 and FAS 118
by banks are discussed below:
As a GAAP standard, FAS 114 is generally intended to be applied on a consolidated basis.
Some banks may be subsidiaries of holding companies that have chosen to identify loans for
evaluation under FAS 114 on a consolidated holding company basis. In that event, the size
threshold used for determining whether FAS 114 is applied to a loan may be so large that smaller
subsidiary banks will have few or no loans identified for evaluation under FAS 114. Examiners
should not take exception to this method of applying FAS 114 for Call Report purposes, provided
that the same approach is used for financial reporting purposes and the bank continues to review
credits that are large or significant to it (whether or not subject to FAS 114) on an individual basis
when analyzing the adequacy of its ALLL.
Collateral dependent loans. A loan is considered "collateral dependent" when the repayment of
the debt will be provided solely by the underlying collateral, and there are no other available and
reliable sources of repayment. When determining the amount of impairment on a collateral
dependent loan for purposes of reporting on Call Reports, the FFIEC decided that, consistent with
the Interagency Policy Statement on the Review and Classification of Commercial Real Estate
Loans (November 1991, SR 91-24), institutions must base their determination on the fair value of
the collateral. In addition, the FFIEC reiterated that any portion of the loan balance on a
collateral dependent loan that exceeds the fair value of the collateral and that can be identified as
uncollectible should generally be classified Loss and promptly charged off against the ALLL.
A collateralized loan that becomes impaired is not considered "collateral dependent" if repayment
is available from reliable sources other than the collateral. Any impairment on such a loan may,
at the bank's option, be determined based on the present value of the expected future cash flows
discounted at the loan's effective interest rate or, as a practical expedient, on the loan's
observable market price.
Additional allowance on impaired loans. Consistent with guidance issued by the FFIEC, the
Federal Reserve will not automatically require an additional allowance for credit losses for
impaired loans over and above what is required on these loans under FAS 114. However, an
additional allowance on impaired loans may be necessary based on consideration of institution-specific factors, such as historical loss experience compared with estimates of such losses and
concerns about the reliability of cash flow estimates, the quality of an institution's loan review
function, and controls over its process for estimating its FAS 114 allowance. Of course, when an
institution's reported ALLL does not meet the objectives for an adequate ALLL set forth in the
Interagency Policy Statement on the Allowance for Loan and Lease Losses, the institution should
be required to restore the level of the ALLL to an adequate level as of the evaluation date.
Charge-offs. The FFIEC has recently reaffirmed existing supervisory policies that require banks
to promptly charge off identified losses. Thus, when available information confirms that specific
loans and leases (including any recorded accrued interest, net deferred loan fees or costs, and
unamortized premium or discount), or portions thereof, are uncollectible, these amounts should
be promptly charged off against the ALLL, regardless of whether an allowance was established to
recognize impairment under FAS 114. Any recoveries on loans or leases previously charged off
should be credited to the ALLL.
Income recognition. FAS 118 amended FAS 114 to eliminate its income recognition provisions,
and, thus, no FASB standard exists for income recognition on impaired loans. For supervisory
purposes, and to ensure consistency in the recognition of interest income, the FFIEC decided to
retain existing nonaccrual policies. As with all other loans, impaired loans should be reported as
past due or nonaccrual loans in Call Report Schedule RC-N when meeting the definitions to these
Call Report items. Since full collection of principal and interest is generally not expected for
impaired loans, income accrual should normally be discontinued on such loans at the time that
they first become impaired. Any cash payments received on impaired loans should be reported
in accordance with the criteria for the cash basis recognition of income in the Glossary entry for
"nonaccrual status" contained in the instructions to the Call Report.
Classification. An institution's adoption of FAS 114 for regulatory reporting purposes generally
should not affect the examiner's classification of troubled loans. Examiners should continue to
classify troubled loans, including any troubled collateral dependent loans, based on the definitions
of Loss, Doubtful, and Substandard contained in the Federal Reserve's Commercial Bank
Examination Manual and other supervisory guidance. If any loan is determined to be wholly or
partially Loss, the amount of such Loss should be promptly charged off without regard to whether
the loan is subject to FAS 114 or whether an allowance for estimated credit losses has been
established in accordance with the standard.
Regulatory reporting and disclosure. Consistent with the decisions that FAS 114 sets forth
methods for determining a portion of the overall ALLL and that examiners should primarily focus
their attention on the adequacy of the overall ALLL, the FFIEC decided not to collect any new
supervisory information in Call Reports with respect to FAS 114. Nonetheless, if a banking
organization prepares GAAP financial statements, disclosures will be provided in the financial
statements or accompanying notes about impaired loans and the allowance related to such loans.
The examiner should consider reviewing these disclosures as part of the assessment of the
adequacy of an institution's ALLL. Regulatory capital. Consistent with determinations made by the FFIEC, the ALLL, including the part established in accordance with FAS 114, should continue to be reported net of any identified losses and be includible in Tier 2 capital, subject to current limits.5
As noted above, for additional examination guidance on the evaluation of the adequacy
of the overall ALLL, please refer to the Interagency Policy Statement on the Allowance for Loan and
Lease Losses (see SR 93-70) and to Section 2070.1 of the Commercial Bank Examination Manual,
"Allowance for Loan and Lease Losses." Additional guidance with respect to commercial real estate
loans is contained in the Interagency Policy Statement on the Review and Classification of Commercial
Real Estate Loans (SR 91-24). For further information on FAS 114 and its application for Call Report
purposes, refer directly to FAS 114 and the Call Report glossary "Loan Impairment."
If you have any questions on FAS 114 or the guidance contained herein, please call
Charles Holm, Project Manager, Regulatory Reporting and Accounting Issues Section, at (202) 452-3502,
Arthur Lindo, Supervisory Financial Analyst, Regulatory Reporting and Accounting Issues Section, at
(202) 452-2695, or Kevin Bertsch, Supervisory Financial Analyst, Policy Development Section, at (202)
452-5265.
Director
Footnotes 1. This guidance applies to examinations of state member banks which file Reports of Condition and Income (Call Reports) with the Federal Reserve. Except for the guidance on the regulatory capital treatment of the portion of the ALLL established under FAS 114, this guidance does not directly apply to bank holding companies; however, bank holding companies are required to follow FAS 114 in FR Y-9C Reports. The guidance included herein is generally not applicable to U.S. branches and agencies of foreign banks for purposes of preparing FFIEC 002 reports. U. S. branches and agencies of foreign banks should refer to SR 95-4 for further guidance on the ALLL. Return to text 2. FAS 114's guidance on impairment does not apply to "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, and debt securities as defined in FAS 115, "Accounting for Certain Investments in Debt and Equity Securities." FAS 114 also generally applies to loans that are restructured in a troubled debt restructuring involving a modification of terms. Return to text 3. Guidance from the FFIEC that has been reiterated in this letter was previously announced in the February 10, 1995 Federal Register. Return to text 4. Consistent with existing policy as set forth in the Interagency Policy Statement on the Allowance for Loan and Lease Losses, the ALLL should be adequate to absorb estimated credit losses associated with the loan and lease portfolio, including all binding commitments to lend. To the extent not provided for in a separate liability account, the ALLL should also be sufficient to absorb estimated credit losses associated with off-balance sheet credit instruments such as standby letters of credit. Return to text 5. Under current risk-based capital guidelines, the amount of the ALLL qualifying in Tier 2 capital may not exceed 1.25 percent of risk-weighted assets. Return to text |
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