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Informational Memorandum
Subject:Accounting for High-Risk/Nonaccrual Loans
Date of Memorandum:03/26/1998
Expiration Date:
Signed By:Smith, Roland
FCA Contact Person:Donnelly, Robert
Contact Phone:703 883-4450
List of Attachments:Examination Bulletin 98-1


March 26, 1998

To: Chairman, Board of Directors
Chief Executive Officer
Each Farm Credit System Institution

From: Roland E. Smith, Chief Examiner Roland E. Smith
Office of Examination

Subject: Accounting for High-Risk/Nonaccrual Loans

Over the past several years, most Farm Credit System (System) institutions have experienced a steady decline in the level of high-risk assets. Undoubtedly, the favorable conditions within the agricultural economy and the commitment of System institutions to work with financially weak borrowers to improve their creditworthiness have contributed to this favorable trend.

However, a review of the performance status of high-risk assets over a period of years indicates there may still be an overstatement of the reported numbers. Recent analysis and review of loan statistics extracted from the System's Annual Report to Investors show that nearly 65 percent of the nonaccrual loans held by institutions are current as to principal and interest payments. This percentage, which has not changed significantly over the past 4 to 5 years, is an indicator that some System institutions may be overly cautious in returning loans to accrual status. The reluctance to return loans to accrual status may be attributed to a narrow interpretation by some System institutions of certain regulatory guidance on the accounting and classification requirements for high-risk/nonaccrual loans.

The System's Accounting Standards Work Group recently revised the System's High-Risk Asset Accounting Guidelines (guidelines) with the objective of providing further direction to the System institutions regarding income recognition, reinstatements, and other accounting for high-risk assets. These guidelines permit, and even encourage, more judgment in determining how best to implement the accounting and classification requirements for nonaccrual loans. The guidelines are consistent with generally accepted accounting principles (GAAP), which are the basis of the Farm Credit Administration's (FCA) regulations dealing with the accounting for high-risk assets. The revisions to these guidelines will enhance the interpretation and application of GAAP among System institutions with respect to high-risk assets.

To further address this issue of accounting for high-risk assets, the attached examination bulletin provides additional guidance to examiners on conducting reviews of high-risk/nonaccrual loans. Similar to the System's efforts, the objectives in issuing this guidance are to promote consistency and emphasize the importance of examiner judgment when evaluating an institution's compliance with certain FCA requirements. The examination bulletin provides further clarification con-cerning existing requirements for the return of nonaccrual loans to accrual status and the recog-nition of income when cash payments are received. The bulletin also stresses the importance of using sound business judgment with respect to the proper accounting for high-risk/nonaccrual loans within the framework of the FCA regulations and GAAP.

You are encouraged to review the attached examination bulletin and share it with appropriate staff in your institution. If you have any questions regarding the information contained in the examination bulletin, please call the director of your respective FCA field office or Thomas J. Holland, Director and Chief Accountant, Special Examination and Supervision Division, Office of Examination at (703) 883-4484, or on the Internet at E-Mail address


Examination Bulletin 98-1 Subject: Review of High-Risk/Nonaccrual Loans Supplemental Guidance

This bulletin provides additional examination guidance concerning the review of high-risk/nonaccrual loans and serves to supplement current requirements and guidance. The objective of the bulletin is to promote consistency in the application of regulatory accounting and classification requirements for high-risk/nonaccrual loans. The bulletin also provides further clarification of existing regulatory requirements covering high-risk/nonaccrual loans.


Current regulatory guidance addressing the accounting and classification requirements for high-risk/nonaccrual loans has evolved over a period of years. With an appropriate emphasis on consistency and conservatism, many of the current requirements are very distinct as to criteria and conditions for the classification of a high-risk loan as nonaccrual, the proper accounting treatment for a nonaccrual loan, and the determination that a nonaccrual loan is eligible for transfer back to accrual status.

While sound business judgment should be exercised in applying these requirements, it appears that the regulations are being interpreted too narrowly. As a result, there may be a reluctance on the part of some Farm Credit System (System) institutions to recognize cash-basis income upon receipt of cash payments, reinstate loans to accrual status, and record recoveries of amounts previously charged off.

Most of this reluctance has been attributed to the (perceived) conservative nature of the Farm Credit Administration's (FCA or Agency) regulations pertaining to accounting requirements for high-risk/nonaccrual loans. As a result, System representatives have expressed the belief that many institutions are not recognizing income in an orderly fashion and, therefore, are concerned about the impact this could have on the financial statements. Our view is that the regulations permit System institutions to use sound business judgment relating to the accounting treatment for nonaccrual loans, especially with respect to recognition of cash-basis income, and reinstatements to accrual status. While the Agency's high-risk/nonaccrual accounting requirements remain appropriate, additional examination guidance is needed to ensure consistency of application of those requirements.

Examination Guidance

There should be reason for concern if an institution does not employ the use of sound business judgment in accounting for high-risk/nonaccrual loans, especially with respect to the recognition of cash-basis income on nonaccrual loans and reinstatement of loans to accrual status. If the amounts involved are material, failure to employ good business judgment could cause the institution's reported financial condition or performance to be misleading. Accordingly, as part of the initial survey performed in planning an examination, a review should be conducted to determine whether the institution has followed a practice of leaving loans in nonaccrual status, even though they are contractually current as to principal and interest payments.

If there is evidence of such a trend, the institution's accounting practices for high-risk/nonaccrual loans should be carefully evaluated to assess whether such practices are appropriate and provide for the timely recognition of interest income and reinstatements to accrual status. The institution's accounting practices for recognition of recoveries of chargeoffs should also be reviewed to determine whether they are material to the institution's financial condition and performance and to determine if they are impeding the timely recognition of interest income and reinstatements to accrual status. The recognition of recoveries of amounts previously charged off are appropriate if circumstances warrant.

In those instances where an institution's accounting practices are causing significant delays in interest income recognition and reinstatements to accrual status, they should be brought to the attention of the institution's management. It is important to remember, however, that when attempting to evaluate whether an institution's accounting is appropriate, judgment must be used in conjunction with a thorough review of all surrounding facts and circumstances. Similar judgment should be used in assessing whether or not the finding should be included in the Report of Examination.

Additional Technical Guidance - Criteria Requiring Clarification

As discussed previously, there are a few accounting regulations relating to high-risk/nonaccrual loans that are being interpreted too narrowly. So far, this bulletin has attempted to address various concerns with respect to the impact this may have on an institution's financial statements. However, additional guidance is also needed in some of the more technical aspects to provide further clarification as to how to address these concerns. Accordingly, additional guidance and clarification are provided with respect to recognizing income on nonaccrual loans, including a discussion on repayment patterns, source of repayment and recognition of recoveries of amounts previously charged off.

Repayment Pattern - Regulation 12 CFR 621.8(b)(3) requires that before cash payments may qualify for interest income recognition "The loan, after considering the payment, is not contractually past due more than 90 days and is not expected to become 90 days past due, or a repayment pattern has been established that reasonably demonstrates future repayment capacity." (Emphasis added.) In many cases, it is difficult to assess whether a loan will again become 90 days past due, especially where recent payments have returned the loan to under 90 days past due. On the other hand, a review of a documented credit evaluation may substantiate whether a repayment pattern has reasonably demonstrated the borrower's future repayment capacity.

Therefore, in evaluating whether a loan payment is eligible for recognition as cash-basis income, added consideration should be given to the support provided by the institution's current credit evaluation. Among the issues that should be considered is whether the credit evaluation adequately addresses the borrower's current repayment performance and provides clear evidence that the borrower has the financial capacity to sustain performance in accordance with the contractual terms of the loan. In addition, the information provided by an institution should demonstrate that the other criteria in 12 CFR 621.8(b) for cash-basis income recognition have been met.

The issue of "sustained performance" is referenced in 12 CFR 621.9(d), which addresses criteria for reinstatement to accrual status. This regulation states that "Sustained performance will generally be demonstrated by 6 consecutive monthly payments, 4 consecutive quarterly payments,..." (Emphasis added). These payment criteria are not intended to be absolute requirements. Examiner judgment must be used when reviewing evidence of sustained performance. There will undoubtedly be instances where the number of consecutive payments by a borrower will not conform to the criteria suggested by this regulation, but other information regarding the borrower's ability to perform will warrant reinstatement of the loan to accrual status. As mentioned previously, consideration needs to be given to all the available information that provides evidence that the borrower has the financial capacity to perform in accordance with the contractual terms of the loan, including the institution's most current credit evaluation of the borrower's financial capacity.

Source of repayment - Included in 12 CFR 621.8(b) is a provision that cash payments on a nonaccrual loan may qualify for interest income recognition when, among other things, the payment has come from a source detailed in the plan of collection.

The requirement that the cash payment has to be from a source in the plan of collection does not prevent an institution from periodically modifying the plan to keep it current. This would include updates/amendments to reflect unexpected cash payments from previously unidentified sources of repayment and changes to the borrower's financial condition. Accordingly, institutions should be encouraged to keep the plan current to allow for the recognition of cash-basis income when appropriate, rather than applying the payment as a reduction of principal. This treatment will result in financial statements that more accurately depict the institution's financial condition and performance.

Recognition of recoveries of chargeoffs - The regulations require the recovery of all amounts previously charged off prior to the recognition of cash-basis income or reinstatements to accrual status. As a result, untimely recognition of recoveries can delay the recognition of cash-basis income and the return of eligible loans to accrual status.

Neither generally accepted accounting principles nor the regulations provide definitive guidance with respect to when it is appropriate to recognize recoveries of amounts previously charged off. These decisions must be made based on the individual facts and circumstances affecting each loan. Therefore, an institution's recognition of a recovery of amounts previously charged off will be considered appropriate in those instances where a cash payment has been received and where there is clear documentation that collection of the recorded investment in the loan, after consideration is given to recovery of the charge-off, is no longer in doubt. In addition, a charge-off should not be required unless there is clear evidence that a known loss currently exists. A specific allowance is required for any estimate of potential loss. Known losses are routinely identified when it is determined that the borrower's planned sources of repayment will not or have not materialized and that the remaining source of collection will result exclusively from the liquidation of collateral which is inadequate to repay the loan. Similarly, known losses may exist where a formal restructuring of the borrower's debt is imminent.

3/26/98 Roland E. Smith
Date Roland E. Smith
Chief Examiner