|Subject:||Accounting for Allowance for Loan Losses|
|Date of Memorandum:||11/08/1999|
|Expiration Date:|| |
|Signed By:||Smith, Roland|
|FCA Contact Person:||Holland, Tom|
|List of Attachments:||none|
November 8, 1999
To: Chairman, Board of Directors
Chief Executive Officer
Each Farm Credit System Institution
From: Roland E. Smith, Chief Examiner /s/
Office of Examination
Subject: Accounting for Allowance for Loan Losses
During the past several months, you may have heard or read about various discussions among authoritative sources regarding the processes and procedures for determining the allowance for loan losses (ALL) in accordance with generally accepted accounting principles (GAAP). The purpose of this memorandum is to reaffirm the expectations of the Office of Examination (OE) of the Farm Credit Administration (FCA) regarding Farm Credit System (FCS) institutions’ practices for evaluating the adequacy of the ALL.
FASB Guidance on Accounting for the ALL
For recognition of loan losses, GAAP requires that an impairment of a receivable be recognized when it is probable that a loss has been incurred based on past events and conditions existing at the date of the financial statements. Losses should not be recognized before it is probable that they have been incurred. In a Financial Accounting Standards Board (FASB) Viewpoint article, dated April 12, 1999, FASB staff provided guidance on the recognition of loan losses under GAAP. As a result, some have concluded that the FASB guidance would require institutions to change their practices and potentially reduce the ALL in order to comply with GAAP.
Expectations of the Office of Examination
The OE does not believe the FASB article nor the recent discussions among the authoritative sources will have a significant impact on FCS institutions. In our opinion, the FASB article did not substantially change the criteria for evaluating the adequacy of the ALL or mandate reductions to the ALL for any FCS institution. In an environment of increasing risk, it would not be prudent for an institution to reduce the ALL. As a result, any significant reduction to the ALL will be evaluated by FCA examiners to ensure the institution had a sound basis for the reduction.
While there is general consensus among financial regulators regarding the underlying foundation of GAAP for evaluating the adequacy of the ALL, we would like to reiterate the points OE has recently made at a number of meetings with senior financial and accounting staff of FCS institutions and the Systemwide external auditors.
- The ALL accounting employed by FCS institutions should be in compliance with GAAP.
- The process of establishing an adequate ALL involves a significant degree of judgment; sound management judgment must be used in the process.
- In a risk-increasing environment, a conservative approach should be used that results in an adequate, but not excessive, level of the ALL.
- The ALL evaluation process usually results in a range of estimeated losses that can be considered acceptable, yet the amount selected must be based on management's best estimate within the range.
- The ALL evaluation and pertinent analysis must be well documented and applied consistently from year-to-year.
- Given the current agricultural environment, any significant increase or reduction in the ALL by an FCS institution could prompt examination concern.
Further, establishing and maintaining the ALL at a predetermined range or based on a fixed percentage of loan volume is not in accordance with GAAP. In addition, recognition of losses should not be deferred and should be recorded during the period that management determines the losses have been incurred.
If you have any questions regarding this Informational Memorandum, please contact Thomas J. Holland, Director, Special Examination and Supervision Division, Office of Examination, at (703) 883-4484, or correspond on the Internet at e-mail address email@example.com.