Ebook Allowance for Loan and Lease Losses
The allowance for loan and lease losses, which was originally referred to as the “reserve for bad debts,” is a valuation reserve established and maintained by charges against the bank’s operating income. As a valuation reserve, it is an estimate of uncollectible amounts that is used to reduce the book value of loans and leases to the amount that is expected to be collected.
Few banks provided reserves for bad debts until the Internal Revenue Service (IRS) allowed the additions to such reserves to be deducted on a bank’s tax return. Although such deductions have been allowed since the passage of the Revenue Act of 1921, no clear-cut guidelines for the amount to be deducted were established until 1965, when the IRS issued Revenue Ruling 65-92. Under this ruling, a bank could make tax-deductible additions to its loan loss reserve until the reserve totaled 2.4 percent of eligible outstanding loans (as defined).
In 1969, the OCC issued regulations requiring a provision for possible loan losses to be included in operating expenses. The regulations provided that the minimum provision charged to operating expense could not be less than the amount computed under one of three permissible methods to be selected by the bank and followed consistently beginning in 1969. Under the 1969 regulation, a bank’s loan loss reserve balance consisted of three distinct elements: the valuation portion, a contingency portion, and a deferred tax portion.
Beginning with the reports of condition and income for December 31, 1976, the valuation portion of the bank’s reserve was required to be reported as a deduction from total loans. The deferred tax portion was to be included with other liabilities, and the contingency portion was to be included in the equity capital section of the balance sheet. In addition, the provision for possible loan losses could no longer be based on a minimum amount as computed under one of the three methods established in 1969. Instead, all banks with more than $25 million total assets were required to provide, through charges to income, the amount considered necessary by management to bring the valuation portion of the reserve to an adequate level to absorb expected loan losses based on its knowledge of the bank’s loan portfolio.
Since 1976, the OCC’s guidance to banks and examiners on the determination of an adequate level for the allowance for loan and lease losses has been updated several times. Banking Circular 201 on the allowance, which was first issued in May 1985, was substantially expanded and refined in February 1992. This handbook booklet incorporates the substance of Banking Circular 201. The discussion covers the requirements for the allowance, the responsibilities of bank management and examiners in evaluating it, and reporting and accounting considerations that affect the allowance. The “Interagency Policy Statement on the Allowance for Loan and Lease Losses,” dated December 12, 1993, is included in the Appendix, to supplement this discussion.
Contents
Introduction
Background
Exhibit: Chart Illustrating the Relationship Between
Decisions About Loan Classification,
Risks Associated with the Allowance
Establishing an Adequate Allowance
Statement of Financial Accounting Standards 114
A Suggested Analytical Framework
Provisions for Pools of Similar Loans
Methodologies for Analyzing Pools of Loans
Adjusting Historical Loss Experience
Analyzing Coverage for Pools of Loans
International Lending
Ratio Analysis of the Allowance
Estimating the Total Allowance
Management's Responsibility for the Allowance
Examiners’ Review of the Bank's Process
Adjustments to the Allowance
Regulatory Reporting and Accounting Requirements
Exhibit: Sample Worksheet: Allowance Calculation
Nonaccrual Status, and Provisions to the ALLL
Examination Procedures
Appendix
Interagency Policy Statement on the Allowance
for Loan and Lease Losses
Glossary
References
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