Problem Loans:
Accounting & Reporting
Joint World Bank/Federal Reserve
System Seminar for Senior Bank
Supervisors
Arthur Lindo
Federal Reserve Board
Presentation Topics
•The “Big Picture”
•Reporting Treatment
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Nonaccrual loans
Restructured loans
Foreclosed assets
Loan loss reserves
•Current Trends
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The “Big Picture”
•Nonaccrual rules have important role:
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Avoid overstatement of income & capital
Reflect deterioration of asset quality
Encourage management’s corrective actions
•Rules’ application should be balanced
• Improvements and declines are reflected
• Should not discourage prudent work outs of
problem loans or continued lending
3
The “Big Picture”
•Loans, or portions thereof, considered
uncollectible are classified “loss”
•Does not mean there is no recovery or
salvage value
•Banks should promptly charge off such
identified losses on loans against the
loan loss reserve
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Nonaccrual Loans
•Loans for which accrual of interest has
been suspended
•Warrant special management attention
•Nonaccrual status does not necessarily
indicate that principal is uncollectible
• But must assess loan loss reserves
•Can be restored to accrual status
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Nonaccrual Loans:
General Criteria
•Maintained on cash basis by bank
•Collectibility of principal or interest
doubtful
•90 days or more past due should be on
nonaccrual, unless both:
• Well secured
• In process of collection
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Nonaccrual Loans:
Treatment of Payments Received
•Income recognition or principal
reduction?
•General principle:
• When collectibility is in doubt, apply
payments as reduction of loan principal
• Continue this treatment until collectibility of
remaining balance is reasonable assured
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Nonaccural Loan - Maranello
Computer Example
Profile:
Loan:
Computer drive manufacturer
Term:
Rate:
5 years
Collateral:
Equipment
$20 million loan for business
expansion and equipment upgrade
Prime +5% with quarterly interest
and annual principal payments
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Nonaccural Loan - Maranello
Computer Example
Status: Year 3 in the 4th quarter
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30% drop in demand for computer drives
No interest or principal paid in 3rd or 4th quarter
Remaining principal $12 million
Credit Analysis: Nonaccrual/Workout
• Estimated collateral value $9 million
• Demand expected to increase by the 2nd quarter
of year 4
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Nonaccrual Loans:
Multiple Loans to One Borrower
•Determine nonaccrual status based
on individual loan’s attributes
• All loans with the same borrower do not
have to go on nonaccrual status
• Must evaluate other loans to the borrower
when one loan becomes nonaccrual
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Nonaccrual Loans:
Restoration to Accrual Status
•Loan is contractually current and bank
expects full contractual repayment over a
reasonable time frame, and
•Borrower demonstrates sustained
repayment performance (e.g., six months)
•Or, loan becomes well secured and in
process of collection.
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Nonaccural Loan - Maranello
Computer Example
•Status: Year 4 - End of 3rd quarter
• All year 3 principal and interest payments
were received
• Year 4 - 1st and 2nd quarter interest paid
•Credit Analysis: Restore to Accrual
• Estimated collateral value $7 million
• Need to secure major contract in order to
continue to repay loan
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Nonaccrual Loans:
Cash Basis Income Recognition
•Permitted when the loan’s remaining
balance is fully collectible
•May allocate payment among:
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interest income
principal reduction
recovery of charge-offs
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Nonaccrual Loans:
Acquisition of Nonaccrual Loans
•Banks may follow AICPA Practice Bulletin
No. 6
• If nonaccrual on seller’s books, then
nonaccrual to buyer
– Presumption is overcome if remaining book
balance is collectible
• Accrete discount as interest income
• If collectibility uncertain, use cost recovery
method
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Troubled Debt Restructuring
(TDR)
•TDR Definition
• Creditor grants concession to borrower
related to its financial difficulties
•Examples:
• Receipt of assets or equity interest in
borrower’s business as repayment
• Modification of principal or interest terms
•Not all loan restructurings are TDRs
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TDR
Accounting Treatment
•TDR as a receipt of assets
• Record assets at their fair value (FV) at the
time of the restructuring
• Record loss on loan
•TDR as a modification of terms
• Record loss if book value exceeds present
value of expected future cash flows
discounted at the loan's effective interest rate
(or FV of underlying collateral, if loan is
collateral dependent)
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TDR
Accrual Status and Disclosure
•Return to accrual status is permitted:
• When reasonably assured of repayment
and of performance according to its
modified terms
• Borrower has sustained repayment
performance under the modified terms for a
reasonable period
•Disclosure of TDRs is required
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Foreclosed Loans
Accounting
•Charge-off balance in excess of Fair Value
less estimated selling costs (net FV)
•Transfer net FV from Loans to other
account (e.g., Other Real Estate Owned,
securities, or other assets)
•Subsequent valuation:
• Other Real Estate Owned — lower-of-cost
or market using valuation allowance
• Other assets — fair value or amortized cost
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Sales of Foreclosed Assets
Accounting
•No sale or gain recognized if seller
continues to control asset
•Recognize loss on sale immediately
•Gain recognition, for assets other
than real estate:
• Full gain recognition on sale
• Reduced gain if seller ‘s collection of all
sales proceeds is in doubt
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Sales of Foreclosed Assets
Accounting, Continued
•Gain recognition, for real estate:
• Full accrual method
• Percentage of completion method
• Installment method
• Reduced profit method
• Cost recovery method
• Deposit method
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Loan & Lease Loss Reserves
•Reserves should be sufficient to
cover estimated credit losses in the
loan portfolio -- including any losses
on:
• Classified loans
• Nonaccrual loans
• Restructured loans
• Non-classified or troubled loans
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Loan & Lease Loss Reserves
Considerations
•Historical loss rates
•Trends in volume or severity of problem loans
•Changes in policies, procedures, or standards
•Changes in concentrations of credits
•Economic factors
•External factors (e.g., legal or competition)
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•Changes in the overall risk profile
Basel Committee Activities
Recent Papers on Lending
•Principles for the
Management of Credit Risk
•Best Practices for Credit
Risk Disclosure
•Industry Views on Credit
Risk Mitigation
•Quality Loan Accounting
and Disclosure Paper
•Credit Risk Modeling Paper
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Basel Committee Activities
Principles for the Management of Credit Risk paper
•Issued September 2000, http://www.bis.org,
Publication No. 75
•5 considerations when assessing credit risk
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Credit risk environment
Sound credit granting processes
Sound credit administration, measurement, and
monitoring processes
• Adequate control over credit risk
• Supervisors hold management accountable, conduct
independent evaluations, and set lending limits
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Basel Committee Activities
Best Practices for Credit Risk Disclosure
•Issued September 2000,
http://www.bis.org, Publication No. 74
•Recommended disclosures
• Accounting policies
• Credit risk management
• Credit exposures
– Segment disclosures
– Concentration information
– Credit risk mitigation techniques
• Credit quality
• Earnings
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Basel Committee Activities
Industry Views on Credit Risk Mitigation
•Issued January 2000,
http://www.bis.org Publication No. 67
•Bank surveys
• Views on the use of credit risk mitigation
techniques
• Views on specific topics
– Residual risks
– Extent of risk reduction
– Issues relating to individual credit risk mitigation
techniques
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Basel Committee Activities
Loan Accounting and Disclosure paper
•Issued July 1999, http://www.bis.org
Publication No. 55
•26 sound practices to implement
• Foundations
• Loan accounting (recognition, derecognition,
measurement, impairment, and loan loss
reserves)
• Public disclosure (accounting policies, credit
risk management, credit exposures, and
credit quality)
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• Role of supervisors
Basel Committee Activities
Credit Risk Modeling paper
•Issued April 1999, http://www.bis.org,
Publication No. 49
•Summarizes key risks and issues to
consider when evaluating credit risk
modeling systems
• Overview of Conceptual Approaches
• Parameter Specification and Estimation
• Validation
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Summary
•The “Big Picture”
•Reporting Treatment
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•
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Nonaccrual loans
Restructured loans
Foreclosed assets
Loan loss reserves
•Current Trends
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