The ALL estimate is guided by NCUA Rules and Regulations and Generally Accepted Accounting Principles (GAAP). The following resources were considered in the creation of this article:

  1. FASB ASC Topic 450: Accounting for Contingencies [formerly FAS 5];
  2. FASB ASC Topic 310: Accounting for Receivables [formerly FAS 114];
  3. NCUA Interpretive Ruling and Policy Statement 02-3: ALLL Methodologies and Documentation for Federally Insured Credit Unions;
  4. NCUA Letter to Credit Unions 03-CU-01: Loan Charge-off Guidance; and
  5. NCUA Accounting Bulletin No. 06-01

Because of the newly implemented ASC, it maybe difficult, especially for those, like myself, who are familiar with the original FASB standards, to identify the most current accounting reference materials.

There are two primary topics under the ASC that address the ALL. Key concepts extracted from Topics 450 and 310 of the ASC are summarized below.

  1. Topic 450, Subtopic 20, “Loss Contingencies,” addresses accounting for loss contingencies. Much of this topic is derived from Statement of Financial Accounting Standards (SFAS) Statement 5, “Accounting for Contingencies.  Topic 450 specifically references Topic 310, noting that the ALL is a subset of loss contingencies.
  2. Topic 310, “Receivables,” addresses various issues related to accounting issues subsequent to the origination or acquisition of receivables, such as impairment. Former accounting standards SFAS 5, SFAS 15, and SFAS 114 provide much of the content for this section.

Subjective and Imprecise

The appropriate degree of allowance involves a high degree of “management judgment” within a “range of estimated losses.”  Moreover, determining the allowance for loan and lease loss, hereafter referred to ALL is “subjective and imprecise.”  ALL estimates are based on a comprehensive, well documented and consistently applied analysis of the credit union’s loan portfolio.

ALL takes into consideration available information as of the financial statement date including environmental factors. The ALL provides an estimate of probable but unconfirmed losses in the loan portfolio as of the financial statement date; it is not a reserve for future anticipated losses.    The use of environmental factors may likely cause estimated credit losses associated with the credit union’s existing loan portfolio to differ from the historical loss experience.  Your analysis should consider significant factors affecting the collectibility of the portfolio and attempts to support the credit losses estimated by the ALL process. A credit union should adopt methodologies and documentation practices that are appropriate for their size and complexity.  Credit unions with fewer and less complex loan products, the amount of supporting documentation for the ALL may be less exhaustive than for credit unions with more complex loan products or portfolios. Your methodology and documentation needed to support the ALL estimates should be prepared in accordance with generally accepted accounting principles (GAAP).  The Statement of Financial Accounting Standard (FAS) 5 will be most relevant to the majority of credit unions. Finally, understanding the theory, building strong policies and analytics, and increasing director governance are key to a successful ALL outcomes.

Allowance for Loan Loss Components:

  • FAS 5-historical loss rates applied to loan pools;
  • FAS 114-impaired loans, TRD’s and large loans individually reviewed for impairment; and
  • Q&E-loss ratios past experience may not be reflective of current trends.

More Information on FAS 5 and FAS 114

Under GAAP, Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (FAS 5), provides the basic guidance for recognition of a loss contingency, such as the collectability of loans (receivables), when it is probable that a loss has been incurred and the amount can be reasonably estimated.  Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (FAS 114) provides more specific guidance about the measurement and disclosure of impairment for certain types of loans.  Specifically, FAS 114 applies to loans that are identified for evaluation on an individual basis.  Loans are considered impaired when, based on current information and events, it is probable that the creditor will be unable to collect all interest and principal payments due according to the contractual terms of the loan agreement.

For individually impaired loans, FAS 114 provides guidance on the acceptable methods to measure impairment.  Specifically, FAS 114 states that when a loan is impaired, a creditor should measure impairment based on the present value of expected future principal and interest 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 collateral, if the loan is collateral dependent.  When developing the estimate of expected future cash flows for a loan, a credit union should consider all available information reflecting past events and current conditions, including the effect of existing environmental factors.  FAS 114 deals with individual classification of large-balance, non-homogeneous loans, which for credit unions will predominantly consist of business and agricultural loans.

Large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment are not included in the scope of FAS 114.   Such groups of loans may include, but are not limited to, credit card, residential mortgage, and consumer installment loans.  FAS 5 addresses the accounting for impairment of these loans.  Also, FAS 5 provides the accounting guidance for impairment of loans that are not identified for evaluation on an individual basis.

Directional Consistency

The concept of directional consistency is an important ALL concept.  During periods of strong economic trends and strong loan quality, there is an expectation of relatively smaller ALL balances and lower provision for loan loss expense. During periods of worsening economic conditions, there is the opposite expectation. This concept is in strong opposition to a practice followed by many financial institutions in past years of building reserves during the good times to avoid the impact of negative earnings during the challenging times.

Troubled Debt Restructuring-Allowance for Loan Loss Implications

Calculating accurate TDR provisions for Allowance for Loan Losses (ALL) is a critical component for regulatory and financial statement disclosures and requires comparative present value of cash flows calculations in accordance with Codification 310 (FAS 114), Accounting by Creditors for Impairment of a Loan.

The Credit Union calculates the present value of future cash flows in a restructured loan at the effective interest rate. This is a key step in completing the calculations for TDRs. The difference between the present value calculation of the restructured loan and the current loan balance is the allowance for loan loss subject to ASC 310 (FAS 114).  The present value of this TDR versus the loan balance would be the amount charged to the ALL and accreted accordingly.  Present Value calculations and accretion adjustments to the ALL are done in totality on a monthly basis.

Under GAAP’s definition, the TDR classification can be removed if (1) when the loan returns to its market rate, and (2) there is a sustained period of performance on the loan.

Questions regulators and auditors will want answered:

  1. Does the credit union have an effective loan review system and controls in place to identify, monitor and address asset quality problems accurately and timely?
  2. Does the credit union have an adequate data capture and reporting system in place to supply the necessary information needed to support and document the ALL balance?
  3. Is the credit union prepared to document and support any adjustment made to the new model or to the output of the model in estimating its credit losses?
  4. Is the credit union promptly charging off loans determined to be uncollectible in accordance with policy and best practices?
  5. Does the credit union have the ALL validated annually?

Inappropriate ALL Practices:

  • Using preset provisioning balances like the individual classification, i.e. 25% at 90-days past due, 50% at 120-days past due, etc.
  • A lack of documented high-level management oversight and testing.
  • Frequent computational errors (right approach, bad calculations).  No double checking of calculations in the model.
  • Failing to charge-off timely, i.e. provisioning long-term for confirmed losses.
  • Not recognizing loan losses in a timely manner due to:
    • Not having or applying a consistent board approved charge-off policy;
    • Not recognizing losses on repossessed collateral at the time of repossession or other known losses; and
    • Inadequate collection functions or reporting that does not identify a loan as a loss
  • Loan portfolio categories are too broad and more segmentation should be done.
  • Seriously delinquent loans given the same historical loss factor applied to current loans when the risk of loss is much greater.
  • Seeing pool segmentation and net historical charge-offs developed by segment with no economic or environmental factors considered.
  • Not adjusting loss experience rates for changing factors such as:
    • A significant decline or improvement in loan quality not yet reflected in loss ratios;
    • Changes in the economic environment or other environmental factors; and
    • New riskier loan products.
  • When current year net charge-offs exceed the prior years ALLL balance is a “red flag” for underfunding.
Recommendations:
  • Work with your CPA firm or independent practitioner prior to your audit or exam;
  • Communication is critical between the finance. lending and collections department; and 
  • Documentation in the form of policies, procedures and meeting minutes is important, i.e. have it all in writing. 

This blog entry you have just read was written by Edward Lis, Vice President of Finance and a former senior executive. If you enjoyed this article I encourage you to learn more about Edward by visiting www.edwardlis.com.

Edward B. Lis is a well respected  credit union executive  known by his peers as being decisive; a visionary; communicative; and energetic.  He has led during difficult economic times driving change, achieving objectives, and effectively managing projects moving from a vision and strategy phase to implementation and final execution.

Other Resources:

Current ALLL Exam Issues and Practical Ways to Factor Q&E Adjustments into the Methodology

NCUA Presentation: Calculating the ALLL and What is a TDR?

06-01 Interagency Policy Statement on the ALLL

06-01 Question and Answer (Q&A) on the ALLL

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