Depository Institutions:

Divergent Loan Loss Methods Undermine Usefulness of Financial Reports

AIMD-95-8: Published: Oct 31, 1994. Publicly Released: Oct 31, 1994.

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GAO reviewed the methods that federally insured depository institutions used to establish loan loss reserves, focusing on whether: (1) the reserve amounts were justified by supporting analysis and comparable among institutions; and (2) accounting standards and regulatory guidance were sufficient to promote fair and consistent financial reporting of loan loss reserves among depository institutions.

GAO found that: (1) case studies showed that the depository institutions maintained significant amounts of unsupported loan loss reserves, particularly large supplemental reserves that were not linked to loss exposure; (2) most of the institutions' loan loss reserves were not justified by supporting analysis and were not comparable among institutions; (3) the institutions' reserving methods varied greatly regarding the use of individual loan assessment results, determination and use of historical loss experience, and the inclusion of supplemental reserves; (4) financial report users could not compare the adequacy of the institutions' reserves or judge the quality of their loan portfolios; (5) unjustified supplemental reserves could cushion changes in the condition of the loan portfolio and mask the institutions' true financial status, which in turn could impede regulators' oversight; and (6) there was no regulatory guidance for establishing loan loss reserves, which gave the institutions excessive flexibility in how they calculated their loss reserves.

Recommendations for Executive Action

  1. Status: Closed - Not Implemented

    Comments: FASB believes that loan loss accounting is inherently subjective and that the flexibility provided in current accounting rules is appropriate. FASB believes that providing more specific accounting rules may limit financial statement preparers in providing meaningful information about actual loan losses incurred. FASB believes that its most recent guidance, Statement No. 114, sufficiently addressed the subject and that its annual survey to prioritize projects showed little interest for FASB to continue to study loan loss accounting. FASB implied that the findings may be more appropriately auditing considerations.

    Recommendation: The Financial Accounting Standards Board (FASB), in close consultation with the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS), should develop a comprehensive standard for establishment of loan loss reserves, which includes a requirement that reserves for all large impaired loans be based on detailed individual assessments, and no specific reserve amounts in excess of those determined from such assessments should be allowed for those loans. For collateral dependent commercial loans, a reserve should be established to cover the difference between the outstanding loan balance and the estimated recoverable amount from the collateral based on an assessment of the collateral's fair value.

    Agency Affected: Financial Accounting Standards Board

  2. Status: Closed - Not Implemented

    Comments: FASB believes that loan loss accounting is inherently subjective and that the flexibility provided in current accounting rules is appropriate. FASB believes that providing more specific accounting rules may limit financial statement preparers in providing meaningful information about actual loan losses incurred. FASB believes that its most recent guidance, Statement No. 114, sufficiently addressed the subject and that its annual survey to prioritize projects showed little interest for the FASB to continue to study loan loss accounting. FASB implied that the findings may be more appropriately auditing considerations.

    Recommendation: FASB, in close consultation with OCC, FRB, FDIC, and OTS, should develop a comprehensive standard for establishment of loan loss reserves, which includes guidance regarding the use of historical analyses to estimate inherent losses existing in the portion of the portfolio which has not been specifically analyzed for impairment. Such guidance should address methods of analyses as well as the appropriate time periods of historical data to be included.

    Agency Affected: Financial Accounting Standards Board

  3. Status: Closed - Not Implemented

    Comments: FASB believes that loan loss accounting is inherently subjective and that the flexibility provided in current accounting rules is appropriate. FASB believes that providing more specific accounting rules may limit financial statement preparers in providing meaningful information about actual loan losses incurred. FASB believes that its most recent guidance, Statement No. 114, sufficiently addressed the subject and that its annual survey to prioritize projects showed little interest for the FASB to continue to study loan loss accounting. FASB implied that the findings may be more appropriately auditing considerations.

    Recommendation: FASB, in close consultation with OCC, FRB, FDIC, and OTS, should develop a comprehensive standard for establishment of loan loss reserves, which includes a requirement that all portions of the reserve, including any supplemental amounts, should be directly linked to and justified by a comprehensive documented analysis of current loss exposure in the loan portfolio and that the periodic provision for loan losses adjust the reserve balance to the level determined necessary by such an analysis.

    Agency Affected: Financial Accounting Standards Board

 

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