B-200230, FEB 4, 1981

B-200230, FEB 4, 1981

SUBJECT: GUIDELINES FOR ESTABLISHING RESERVES FOR LOANS:

HEADS OF ALL DEPARTMENTS AND AGENCIES:

ON DECEMBER 17, 1979, I ISSUED A MEMO TO GUIDE AGENCIES IN ESTABLISHING RESERVES FOR OUTSTANDING ACCOUNTS RECEIVABLE. THAT MEMO RECOMMENDED SEVERAL ACCEPTABLE ALTERNATIVES; HOWEVER, THE SUBJECT OF PROVISIONS FOR LOSSES ON LOANS WAS NOT ADDRESSED. FOR THIS REASON, I AM NOW ISSUING A MEMO TO SPECIFY MORE DEFINITE ACCOUNTING AND REPORTING PROCEDURES FOR LOANS RECEIVABLE AND RELATED ALLOWANCES FOR LOAN LOSSES UNDER TITLE II OF THE GENERAL ACCOUNTING OFFICE POLICY AND PROCEDURES MANUAL FOR GUIDANCE OF FEDERAL AGENCIES (2 GAO 12.4). THIS MEMO ESTABLISHES THE CRITERIA WITH WHICH AGENCIES SHOULD COMPLY TO ESTIMATE ALLOWANCES FOR LOAN LOSSES (SOMETIMES REFERRED TO AS "LOAN LOSS RESERVES"); TO ACCOUNT FOR PROPERTY ACQUIRED IN SETTLEMENTS; AND TO ACCOUNT FOR RESTRICTED EQUITY (INVESTMENT IN THE U. S. GOVERNMENT) OR, IN THE CASE OF BUSINESS-TYPE FUNDS OR ENTITIES, RETAINED EARNINGS.

LOAN LOSS RESERVES

WHEN LOAN RECEIVABLES ARE RECORDED, SOME DEGREE OF UNCERTAINTY ABOUT THEIR COLLECTIBILITY USUALLY EXISTS. AT THE END OF EACH REPORTING PERIOD, ESTIMATED LOSSES PERTAINING TO PROBABLE UNCOLLECTIBLE LOANS SHOULD BE ACCRUED, AND THE TOTAL ESTIMATED AMOUNTS SHOULD BE NETTED AGAINST THE TOTAL LOAN RECEIVABLE AMOUNTS FOR FINANCIAL STATEMENT PRESENTATION. THIS IS ACCOMPLISHED BY A PERIODIC CHARGE TO AN OPERATING EXPENSE (LOSSES ON LOANS RECEIVABLE) AND A CREDIT TO THE ALLOWANCE FOR LOSSES ON LOANS RECEIVABLE ACCOUNT WHEN BOTH OF THE FOLLOWING CONDITIONS EXIST.

- INFORMATION AVAILABLE BEFORE THE FINANCIAL STATEMENTS WERE ISSUED INDICATES THAT A LOAN RECEIVABLE PROBABLY HAS BEEN IMPAIRED AT THE DATE OF THE FINANCIAL STATEMENTS. THIS CONDITION IMPLIES THAT ONE OR MORE FUTURE EVENTS ARE LIKELY TO OCCUR, CONFIRMING THE LOSS.

- THE AMOUNT OF THE LOSS CAN BE REASONABLY ESTIMATED.

VARIOUS FACTORS ENTER INTO THE DETERMINATION OF THE AMOUNT OF LOSS, SUCH AS PRIOR EXPERIENCE ON LOAN LOSSES, WRITEOFFS AND RECOVERIES, AND THE CURRENT ECONOMIC ENVIRONMENT. THESE FACTORS CAN BE CONSIDERED IN RELATION TO INDIVIDUAL LOANS OR IN RELATION TO GROUPS OF SIMILAR TYPES OF LOANS. IN THE LATTER CASE, ACCRUAL SHOULD BE MADE EVEN THOUGH THE PARTICULAR LOANS RECEIVABLE, WHICH ULTIMATELY BECOME UNCOLLECTIBLE, ARE NOT IDENTIFIABLE.

AT THE END OF EACH REPORTING PERIOD, THE ALLOWANCE FOR LOSSES ON LOANS RECEIVABLE SHOULD BE ADJUSTED TO PROVIDE A BALANCE EQUAL TO THE AGENCY'S ESTIMATE OF LIKELY LOSSES THAT WILL PROBABLY BE SUSTAINED IN THE LIQUIDATION OF CURRENT LOANS. THE AMOUNT OF THIS ADJUSTMENT SHOULD BE DETERMINED AFTER ALL WRITEOFFS AND RECOVERIES APPLICABLE TO THE PERIOD HAVE BEEN RECORDED.

TO GUIDE AGENCIES IN ESTIMATING LOSSES ON LOANS RECEIVABLE, WE SUGGEST THE USE OF THE SPECIFIC IDENTIFICATION METHOD, THE GENERAL ALLOWANCE METHOD, OR A COMBINATION OF THE TWO, AS DISCUSSED BELOW.

SPECIFIC IDENTIFICATION METHOD

UNDER THIS METHOD, EACH OUTSTANDING LOAN IS REVIEWED TO DETERMINE ITS COLLECTIBILITY AND TO ESTIMATE THE TOTAL LOSSES ON ALL LOANS THAT WILL BE SUSTAINED IN COLLECTION. THIS PROCEDURE IS MOST APPROPRIATE WHEN THE LOAN PORTFOLIO IS CHARACTERIZED BY A LIMITED NUMBER OF LARGE ACCOUNT BALANCES.

THE ESTIMATE SHOULD BE BASED ON THE BEST JUDGMENT, TAKING ALL PERTINENT FACTORS INTO CONSIDERATION, INCLUDING LOAN DELINQUENCY STATUS, COLLECTION EXPERIENCE, COLLATERAL, GUARANTEES OR ENDORSEMENTS, AND ANY GENERAL CREDIT KNOWLEDGE ABOUT THE BORROWERS.

GENERAL ALLOWANCE METHOD

UNDER THIS METHOD, AN ALLOWANCE IS DETERMINED BASED ON LOAN LOSS EXPERIENCE AND CHANGES IN THE OUTSTANDING BALANCE OF ALL LOANS. THIS PROCEDURE IS APPROPRIATE WHEN THE VOLUME OF LOANS IS SUCH THAT REVIEW OF INDIVIDUAL PAST-DUE LOANS GENERALLY IS NOT PRACTICABLE OR NECESSARY.

UNDER THIS METHOD, WE RECOMMEND THAT THE AGENCY CALCULATE THE RATIO OF ITS ACTUAL LOAN LOSSES TO LOANS GRANTED OVER THE PAST 5-YEAR PERIOD. THIS RATIO REPRESENTS THE PERCENTAGE OF TOTAL NET LOAN LOSSES (LOSSES LESS RECOVERIES) FOR THE CURRENT YEAR AND FOR THE 4 PRECEDING YEARS TO THE SUM OF THE LOANS GRANTED DURING THE 5-YEAR PERIOD. THE RESULTING RATIO IS APPLIED TO LOANS GRANTED DURING THE CURRENT YEAR TO DETERMINE THE AMOUNT THAT SHOULD BE CREDITED TO THE ALLOWANCE ACCOUNT AND ALSO CHARGED TO CURRENT EXPENSES.

AGENCIES WITH LESS THAN 5-YEAR'S EXPERIENCE SHOULD USE THE LOSS RATIO TO DATE. FOR AGENCIES THAT HAVE NO EXPERIENCE, LOSS RATIOS OF OTHER AGENCIES WITH SIMILAR LOAN PORTFOLIOS CAN BE SUBSTITUTED.

THIS PROCEDURE MUST BE ACCOMPANIED BY ADEQUATE WRITEOFF POLICIES, OR REALISTIC ESTIMATES OF LOSSES WILL NOT BE REPORTED. ALTHOUGH WE REALIZE THAT DIFFERENT LOAN PORTFOLIO COMPOSITIONS MAY HAVE DIFFERENT PERIODS UPON WHICH PAST-DUE LOANS ARE CONSIDERED BY MANAGEMENT TO BE NO LONGER COLLECTIBLE, AGENCIES MUST DEFINE WHEN DELINQUENT LOANS ARE CONSIDERED DEFAULTS AND SUBSEQUENTLY WRITTEN OFF. THIS CANNOT BE DETERMINED WITHOUT LISTING THE PAST-DUE LOANS.

COMBINATION OF BOTH METHODS

YOUR AGENCY MAY FIND IT MORE APPROPRIATE TO COMBINE BOTH OF THE ABOVE METHODS FOR ESTIMATING LOAN LOSSES. FOR EXAMPLE, AN ANALYTICAL REVIEW OF LARGE LOANS, SUCH AS HOME LOANS, COULD BE INCLUDED WITH AN APPLICATION OF A PAST EXPERIENCE FACTOR FOR LOANS SUCH AS INSTALLMENT LOANS IN ARRIVING AT THE AMOUNT OF LOSS TO BE RECOGNIZED IN THE ALLOWANCE ACCOUNT.

REGARDLESS OF WHICH OF THE ABOVE METHODS IS CHOSEN, YOUR AGENCY SHOULD CONTINUOUSLY REVIEW THE ADEQUACY OF INTERNAL CONTROLS OVER LENDING AND COLLECTION PRACTICES TO PROVIDE FOR AND MAINTAIN A FINANCIALLY SOUND LOAN PORTFOLIO.

RESTRICTED INVESTMENT OF THE U. S. GOVERNMENT

SOME AGENCIES, NOTABLY THOSE POSSESSING CHARACTERISTICS OF BUSINESS TYPE ORGANIZATIONS (SUCH AS BUSINESS-TYPE ENTITIES OR FUNDS), SEGREGATE A PORTION OF THEIR INVESTMENT OF THE U. S. GOVERNMENT AS A RESERVE AGAINST FUTURE LOSSES ON LOANS. THE AMOUNTS OF THE RESTRICTIONS ARE DETERMINED BY MANAGEMENT BASED ON LEGAL MANDATES OR ON ADMINISTRATIVE DECISIONS. THE ACCOUNTING AND FINANCIAL REPORTING FOR THESE RESTRICTIONS SHALL BE CONTAINED WITHIN THE INVESTMENT OF THE U. S. GOVERNMENT SECTION OF THE STATEMENT OF FINANCIAL POSITION. WHEN THE RESTRICTION IS ESTABLISHED, OR INCREASED AS THE CASE MAY BE, UNRESTRICTED AMOUNTS OF INVESTMENT ARE TRANSFERRED TO RESTRICTED INVESTMENT ACCOUNTS. WHEN MANAGEMENT DEEMS THE RESTRICTION IS NO LONGER NECESSARY OR MAY BE REDUCED, THE APPROPRIATE AMOUNT SHALL BE TRANSFERRED TO THE UNRESTRICTED INVESTMENT ACCOUNTS. CURRENT OPERATING COSTS OR LOSSES ASSOCIATED WITH LOANS RECEIVABLE ACCOUNTS SHALL NOT BE CHARGED TO RESTRICTED AMOUNTS OF THE INVESTMENTS, AND NO PART OF THE RESTRICTED INVESTMENT TRANSFERRED BACK TO THE UNRESTRICTED ACCOUNT SHALL BE CREDITED TO INCOME.

PROPERTY ACQUIRED IN SETTLEMENT

IN MANY CASES, PROPERTY OR OTHER ASSETS ARE RECEIVED IN FORECLOSURE OR SETTLEMENT OF A DELINQUENT LOAN RECEIVABLE. IN THIS CASE, LOANS RECEIVABLE AND THE ALLOWANCE FOR LOSSES ON LOANS RECEIVABLE SHALL BE REDUCED BY THE REMAINING LOAN BALANCE. THE PROPERTY ACQUIRED IN SETTLEMENT SHOULD BE VALUED AT THE NET REALIZABLE AMOUNT, WHICH IS THE AMOUNT OF CASH EXPECTED TO BE DERIVED FROM THE SALE OF THE PROPERTY LESS THE COST OF DISPOSAL. SUCH PROPERTY SHOULD BE RECOGNIZED IN THE STATEMENT OF FINANCIAL POSITION WITH A CORRESPONDING CREDIT TO A RECOVERY ACCOUNT. FOR PRESENTATION ON THE STATEMENT OF OPERATIONS, THE RECOVERY ACCOUNT SHOULD BE COMBINED WITH THE LOSS ON LOANS RECEIVABLE EXPENSE TO SHOW THE NET LOSS OF LOANS WRITTEN OFF.

IMMATERIAL GAINS AND LOSSES ON THE SALE OF PROPERTY SHOULD BE CHARGED OR CREDITED TO THE LOAN LOSSES EXPENSE ACCOUNT. SIGNIFICANT GAINS AND LOSSES RESULTING FROM THE ASSET'S SALE SHOULD BE SEPARATELY STATED ON THE INCOME STATEMENT.