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l l5K

Federal Reserve Bank
of Dallas

DALLAS, TEXAS
75265-5906

July 24, 2001

Notice 01-56

TO: The Chief Executive Officer of each
financial institution and others concerned
in the Eleventh Federal Reserve District
SUBJECT
Interagency Policy Statement on
Allowance for Loan and Lease Losses Methodologies and Documentation for
Banks and Savings Institutions
DETAILS
The Federal Financial Institutions Examination Council (FFIEC), on behalf of the
Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation,
the Office of the Comptroller of the Currency, and the Office of Thrift Supervision, has adopted
an interagency policy statement on Allowance for Loan and Lease Losses (ALLL) Methodologies and Documentation for Banks and Savings Institutions. The National Credit Union Administration, also a member of the FFIEC, is currently reviewing this policy and may issue similar
guidance specifically directed toward credit unions.
The policy statement, which is effective immediately, provides guidance on the
design and implementation of ALLL methodologies and supporting documentation practices.
ATTACHMENT
A copy of the FFIEC’s notice as it appears on pages 35629–39, Vol. 66, No. 130 of
the Federal Register dated July 6, 2001, is attached.
MORE INFORMATION
For more information, please contact Dorsey Davis, Banking Supervision,
(214) 922-6051. For additional copies of this Bank’s notice, contact the Public Affairs
Department at (214) 922-5254 or access District Notices on our web site at
http://www.dallasfed.org/banking/notices/index.html.

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices

35629

FEDERAL FINANCIAL INSTITUTIONS
EXAMINATION COUNCIL
Policy Statement on Allowance for
Loan and Lease Losses Methodologies
and Documentation for Banks and
Savings Institutions
July 2, 2001.
AGENCY: Federal Financial Institutions
Examination Council.
ACTION: Notice of final interagency
policy statement.
SUMMARY: The Federal Financial
Institutions Examination Council
(FFIEC), on behalf of the Board of
Governors of the Federal Reserve
System (FRB), the Federal Deposit
Insurance Corporation (FDIC), the Office
of the Comptroller of the Currency
(OCC), and the Office of Thrift
Supervision (OTS) (collectively referred
to as the ‘‘banking agencies’’), is
adopting an interagency Policy
Statement on Allowance for Loan and
Lease Losses (ALLL) Methodologies and
Documentation for Banks and Savings
Institutions (Policy Statement). The
National Credit Union Administration
(NCUA), also a member of the FFIEC, is
currently reviewing this policy and may
issue similar guidance specifically
directed toward credit unions. This
Policy Statement is intended to provide
guidance on the design and
implementation of ALLL methodologies
and supporting documentation
practices.
EFFECTIVE DATE: The Policy Statement is
effective immediately.
FOR FURTHER INFORMATION CONTACT:
FRB: Linda V. Griffith, Supervisory
Financial Analyst, (202) 452–3506,
Division of Banking Supervision and
Regulation, Board of Governors of the
Federal Reserve System, 20th Street and
Constitution Avenue, NW., Washington,
DC 20551.
FDIC: Doris L. Marsh, Examination
Specialist, Division of Supervision,
(202) 898–8905, FDIC, 550 17th Street,
NW., Washington, DC 20429.
OCC: Richard Shack, Senior
Accountant, Chief Accountant’s Office,
Core Policy Division, (202) 874–5411, or
Louise A. Francis, National Bank
Examiner, Chief Accountant’s Office,
Core Policy Division, (202) 874–1306,
Office of the Comptroller of the
Currency, 250 E Street, SW.,
Washington, DC 20219.
OTS: William Magrini, Senior Project
Manager, Policy Division, (202) 906–
5744, or Harrison E. Greene, Jr.,
Securities Accountant, Accounting
Policy Division, (202) 906–7933, Office
of Thrift Supervision, 1700 G Street,
NW., Washington, DC 20552.

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35630

Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices

SUPPLEMENTARY INFORMATION:

I. Background
On March 10, 1999, the Federal
Deposit Insurance Corporation, the
Federal Reserve Board, the Office of the
Comptroller of the Currency, the Office
of Thrift Supervision, and the Securities
and Exchange Commission (together,
the Agencies) issued a joint letter to
financial institutions on the allowance
for loan and lease losses (the Joint
Letter). In the Joint Letter, the Agencies
agreed to establish a Joint Working
Group to study ALLL issues and to
assist financial institutions by providing
them with improved guidance on this
topic. The Agencies agreed that the Joint
Working Group would develop and
issue parallel guidance for two key areas
regarding the ALLL:
• Appropriate methodologies and
supporting documentation, and
• Enhanced disclosures.
This Policy Statement represents the
banking agencies’ guidance to banks and
savings institutions relating to
methodologies and supporting
documentation for the ALLL. The
Securities and Exchange Commission
staff has issued parallel guidance on this
topic for public companies in Staff
Accounting Bulletin No. 102.1
This Policy Statement clarifies the
banking agencies’ expectations
regarding methodologies and
documentation support for the ALLL.
For financial reporting purposes,
including regulatory reporting, the
provision for loan and lease losses and
the ALLL must be determined in
accordance with generally accepted
accounting principles (GAAP). GAAP
requires that an institution maintain
written documentation to support the
amounts of the ALLL and the provision
for loan and lease losses reported in the
financial statements.
The Policy Statement does not change
existing accounting guidance in, or
modify the documentation requirements
of, GAAP or guidance provided in the
relevant joint interagency statements
issued by the Agencies. It is intended to
supplement, not replace, the guidance
the banking agencies provided in their
Interagency Policy Statement on the
Allowance for Loan and Lease Losses,
which was issued in December 1993. It
is also intended to supplement guidance
the banking agencies provided in their
interagency guidelines establishing
standards for safety and soundness that
were issued in 1995 and 1996 pursuant
1 In addition, the American Institute of Certified
Public Accountants (AICPA) is developing guidance
on the accounting for loan losses and the
techniques for measuring probable incurred losses
in a loan portfolio.

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to section 39 of the Federal Deposit
Insurance Act (FDI Act).2 Under the
guidelines for asset quality, each
institution should estimate and
establish a sufficient ALLL supported by
adequate documentation. This Policy
Statement does not address or change
current guidance regarding loan chargeoffs; therefore, institutions should
continue to follow existing regulatory
guidance that addresses the timing of
charge-offs.
The guidance in this Policy Statement
recognizes that institutions should
adopt methodologies and
documentation practices that are
appropriate for their size and
complexity. For institutions with fewer
and less complex loan products, the
amount of supporting documentation
for the ALLL may be less exhaustive
than for institutions with more complex
loan products or portfolios.
Recognizing that a primary mission of
the banking agencies is to support a safe
and sound banking system, examiners
will continue to evaluate the overall
adequacy of the ALLL, including the
adequacy of supporting documentation,
to ensure that it is appropriate. While
the Policy Statement generally does not
provide guidance to examiners in
conducting safety and soundness
examinations, examiners may criticize
institutions that fail to document and
maintain an adequate ALLL in
accordance with this Policy Statement
and other banking agency guidance. In
such cases, institution management may
be cited for engaging in unsafe and
unsound banking practices and may be
subject to further supervisory action.
II. The Proposed Policy Statement
The FFIEC sought public comment on
a proposed policy statement on ALLL
methodologies and documentation
practices for banks and savings
institutions on September 7, 2000 (65
FR 54268). The proposal indicated that
the purpose of the policy statement was
to provide financial institutions with
enhanced guidance on appropriate
ALLL methodologies and
documentation practices.
The proposed Policy Statement
explained that the board of directors of
each institution is responsible for
ensuring that controls are in place to
determine the appropriate level of the
ALLL. It also emphasized the banking
agencies’ long-standing position that
2 Institutions should refer to the guidelines
adopted by their primary federal regulator as
follows: For national banks, Appendix A to Part 30;
for state member banks, Appendix D to Part 208;
for state nonmember banks, Appendix A to Part
364; for savings associations, Appendix A to Part
570.

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institutions should maintain and
support the ALLL with documentation
that is consistent with their stated
policies and procedures, GAAP, and
applicable supervisory guidance.
The proposal described significant
aspects of ALLL methodologies and
documentation practices. Specifically,
the proposal provided guidance on
maintaining and documenting policies
and procedures that are appropriately
tailored to the size and complexity of
the institution and its loan portfolio.
The proposal stated that an institution’s
ALLL methodology must be a thorough,
disciplined, and consistently applied
process that incorporates management’s
current judgments about the credit
quality of the loan portfolio.
The proposal also discussed the
methodology and documentation
needed to support ALLL estimates
prepared in accordance with GAAP,
which requires loss estimates based
upon reviews of individual loans and
groups of loans. The proposal stated that
after determining the allowance on
individually reviewed loans and groups
of loans, management should
consolidate those loss estimates and
summarize the amount to be reported in
the financial statements for the ALLL.
To verify that the ALLL methodology is
appropriate and conforms to GAAP and
supervisory guidance, a party who is
independent from the ALLL estimation
process should review the methodology
and its application in a manner
appropriate to the size and complexity
of the institution.
The proposal included illustrations of
implementation practices that
institutions may find useful for
enhancing their own ALLL practices; an
appendix that provided examples of
certain key aspects of ALLL guidance; a
summary of applicable GAAP guidance;
and a bibliographical list of relevant
GAAP guidance, joint interagency
statements, and other literature on ALLL
issues.
III. Discussion of Public Comments
A. General Comments
The FFIEC received 31 letters
commenting on the proposed policy
statement. Twenty financial
organizations submitted comments,
whose size (based upon total assets)
ranged from $18 million to $450 billion.
The other letters were primarily
submitted by industry trade groups and
the accounting profession.
Two of the commenters fully
supported the guidance in the proposed
policy statement. Thirteen commenters
opposed issuance of the policy
statement. The commenters who oppose

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Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices
the guidance expressed two primary
concerns. First, they believe
institutions, particularly smaller
institutions, will need to unnecessarily
increase resources dedicated to ensure
compliance with the guidance. Second,
they thought that issuance of the policy
statement may be premature given the
ALLL guidance expected to be
developed by the AICPA. The other
commenters generally supported the
guidance with certain modifications.
The two commenters who supported
the proposed policy statement in the
form it was issued believe that they are
already in compliance with the
proposal’s requirements. They
understood that the guidance did not
attempt to expand current GAAP
requirements and allowed institutions
to continue to use judgment in
implementing loan loss estimation
methodologies that are appropriate to
individual institutions.
The banking agencies believe that
institutions currently complying with
GAAP should not need to dedicate
additional resources to create or support
the ALLL included in their regulatory
reports. The banking agencies have
expected institutions to follow GAAP,
as it applies to the ALLL, for regulatory
reporting purposes for a number of
years. The proposal is consistent with
existing GAAP, which requires that
allowances be well documented, with
clear explanations of the supporting
analysis and rationale. The banking
agencies encourage institutions to
carefully evaluate their current ALLL
methodologies and supporting
documentation practices as well as
other credit risk management practices
and reports before making significant
changes to their current practices or
creating new processes, reports, or other
supporting documents in order to follow
this guidance.
Some commenters suggested the
Policy Statement should include the
banking agencies’ views on the ALLL
guidance being developed by the
AICPA. While the attached Policy
Statement mentions that the AICPA is
developing guidance on the ALLL, a
description of that project’s scope or a
summary of its anticipated guidance is
outside the scope of this Policy
Statement. Furthermore, the AICPA
continues to develop its guidance, and
the Agencies are closely monitoring and
actively contributing to that process.
Several commenting financial
institutions indicated that following the
guidance may prompt a reduction in the
ALLL level at their institutions.
However, as noted above, institutions
are already required to follow GAAP
when determining the ALLL and the

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guidance does not change existing
GAAP; therefore, following this Policy
Statement should not result in
adjustments to the ALLL by institutions
following GAAP.
Several commenters suggested that
documentation requirements for small
or noncomplex institutions should be
substantially different than the guidance
for larger or more complex institutions.
The guidance in the policy statement
includes a broad description of the steps
taken during the ALLL estimation
process that must be documented. The
types of documentation described in the
examples illustrate that management
has considerable flexibility in
determining the appropriate level and
type of supporting documentation given
the type of loans and associated credit
risks being evaluated. Additionally, the
guidance specifically states that
institutions with less complex products
or portfolios may consider combining
some of the procedures outlined in the
proposed guidance. Furthermore, when
appropriate, these institutions may
utilize documentation that is already
being generated for other purposes to
support their ALLLs. The banking
agencies believe these suggestions will
assist these institutions in supporting
their ALLLs without any unnecessary
burden.
A number of the commenters
suggested that the guidance in the
policy statement should clarify the
banking agencies’ position on the term
‘‘unallocated’’ ALLLs. The guidance
recognizes that, regardless of the
terminology that an institution uses to
label portions of its ALLL, the entire
ALLL should be determined in
accordance with GAAP and supported
with adequate documentation.
B. Changes to the Proposal in Response
to Comments
One issue that was raised by some
commenters was concern that the Policy
Statement would confuse the distinction
between current GAAP requirements
and what would be considered best
practices in corporate governance. They
believe that some of the documentation
requirements contained in the proposed
policy statement are not requirements of
GAAP. In response to these comments,
a footnote was added to the Policy
Statement to clarify how the Policy
Statement describes, but does not
increase, the documentation
requirements already existing within
GAAP. The footnote states that the
documentation guidance in the Policy
Statement is predominantly based upon
certain specifically identified
pronouncements that have been issued
by the Financial Accounting Standards

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35631

Board, the Emerging Issues Task Force,
the American Institute of Certified
Public Accountants, and the SEC. Such
pronouncements represent established
accounting principles or are widely
recognized as being generally accepted.
A few commenters were concerned
that the discussion in the proposed
policy statement regarding the
estimation of loan losses for groups of
loans based upon historical loss data
meant that institutions were prohibited
from using loss estimation methods
other than those based upon historical
loss data. The application of historical
loss rates to segmented portions of the
loan portfolio, adjusted for
environmental factors, is one way to
estimate ALLLs for pools of loans.
However, other methods are acceptable
if they estimate losses in accordance
with GAAP. The Policy Statement has
been revised to refer to other types of
loss estimation techniques.
A few commenters questioned the
banking agencies’ intent in including
examples of documentation in the Q&A
portion of the proposed policy
statement. They interpreted the
examples to be a list of requirements or
a ‘‘safe harbor’’ of supporting
documentation. The banking agencies
included these examples to assist
institutions in generating ideas on how
to implement the guidance and did not
intend to create a list of required
documents. So that the purpose of the
examples is better understood, the
banking agencies have clarified the
language in the examples and have
added an introductory paragraph to the
Q&A section in Appendix A.
Lastly, some commenters suggested
the guidance in the proposed policy
statement placed undue burden upon
financial institutions’ boards of
directors. The banking agencies did not
intend to expand directors’
responsibilities beyond those that
currently exist. At present, directors are
responsible for approving ALLL policies
and attesting to the validity of the
regulatory reports, which includes the
ALLL. While the board of directors has
ultimate responsibility for these
functions, daily administration of
policies and recordkeeping may be
delegated to operating management. The
banking agencies have clarified the
guidance to state that the scope of board
of directors’ responsibilities is not
changed or expanded with the issuance
of this Policy Statement.
IV. Paperwork Reduction Act
In accordance with the Paperwork
Reduction Act of 1995 (44 U.S.C.
chapter 35), the banking agencies have
reviewed the Policy Statement and

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Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices

determined that it does not add any
collections of information pursuant to
the Act.
V. Policy Statement
The text of the Policy Statement
follows:
Policy Statement on Allowance for
Loan and Lease Losses Methodologies
and Documentation for Banks and
Savings Institutions
July 2, 2001.

Boards of directors of banks and
savings institutions are responsible for
ensuring that their institutions have
controls in place to consistently
determine the allowance for loan and
lease losses (ALLL) in accordance with
the institutions’ stated policies and
procedures, generally accepted
accounting principles (GAAP), and
ALLL supervisory guidance.1 To fulfill
this responsibility, boards of directors
instruct management to develop and
maintain an appropriate, systematic,
and consistently applied process to
determine the amounts of the ALLL and
provisions for loan losses. Management
should create and implement suitable
policies and procedures to communicate
the ALLL process internally to all
applicable personnel. Regardless of who
develops and implements these policies,
procedures, and underlying controls,
the board of directors should assure
themselves that the policies specifically
address the institution’s unique goals,
systems, risk profile, personnel, and
other resources before approving them.
Additionally, by creating an
environment that encourages personnel
to follow these policies and procedures,
management improves procedural
discipline and compliance.
The determination of the amounts of
the ALLL and provisions for loan and
lease losses should be based on
management’s current judgments about
the credit quality of the loan portfolio,
and should consider all known relevant
internal and external factors that affect
loan collectibility as of the reporting
date. The amounts reported each period
for the provision for loan and lease
losses and the ALLL should be reviewed
and approved by the board of directors.
To ensure the methodology remains
appropriate for the institution, the board
of directors should have the
methodology periodically validated and,
if appropriate, revised. Further, the
1 A bibliography is attached that lists applicable
ALLL GAAP guidance, interagency statements, and
other reference materials that may assist in
understanding and implementing an ALLL in
accordance with GAAP. See Appendix B for
additional information on applying GAAP to
determine the ALLL.

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audit committee2 should oversee and
monitor the internal controls over the
ALLL determination process.3
The banking agencies’4 have longstanding examination policies that call
for examiners to review an institution’s
lending and loan review functions and
recommend improvements, if needed.
Additionally, in 1995 and 1996, the
banking agencies adopted interagency
guidelines establishing standards for
safety and soundness, pursuant to
Section 39 of the Federal Deposit
Insurance Act (FDI Act).5 The
interagency asset quality guidelines and
the guidance in this paper assist an
institution in estimating and
establishing a sufficient ALLL
supported by adequate documentation,
as required under the FDI Act.
Additionally, the guidelines require
operational and managerial standards
that are appropriate for an institution’s
size and the nature and scope of its
activities.
For financial reporting purposes,
including regulatory reporting, the
provision for loan and lease losses and
the ALLL must be determined in
accordance with GAAP. GAAP requires
that allowances be well documented,
with clear explanations of the
supporting analyses and rationale.6 This
2 All institutions are encouraged to establish audit
committees; however, at small institutions without
audit committees, the board of directors retains this
responsibility.
3 Institutions and their auditors should refer to
Statement on Auditing Standards No. 61,
Communication With Audit Committees (as
amended by Statement on Auditing Standards No.
90, Audit Committee Communications), which
requires certain discussions between the auditor
and the audit committee. These discussions should
include items, such as accounting policies and
estimates, judgments, and uncertainties that have a
significant impact on the accounting information
included in the financial statements.
4 The banking agencies are the Federal Deposit
Insurance Corporation, the Federal Reserve Board,
the Office of the Comptroller of the Currency, and
the Office of Thrift Supervision.
5 Institutions should refer to the guidelines
adopted by their primary federal regulator as
follows: For national banks, Appendix A to Part 30;
for state member banks, Appendix D to Part 208;
for state nonmember banks, Appendix A to Part
364; for savings associations, Appendix A to Part
570.
6 The documentation guidance within this Policy
Statement is predominantly based upon the GAAP
guidance from Financial Accounting Standards
Board (FASB) Statement Numbers 5 and 114 (FAS
5 and FAS 114, respectively); Emerging Issues Task
Force Topic No. D–80 (EITF Topic D–80 and
attachments), Application of FASB Statements No.
5 and No. 114 to a Loan Portfolio (which includes
the Viewpoints Article—an article issued in 1999
by FASB staff providing guidance on certain issues
regarding the ALLL, particularly on the application
of FAS 5 and FAS 114 and how these statements
interrelate), Chapter 7—Credit Losses, the American
Institute of Certified Public Accountants’ (AICPA)
Audit and Accounting Guide, Banks and Savings
Institutions—2000 edition (AICPA Audit Guide);

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Policy Statement describes but does not
increase the documentation
requirements already existing within
GAAP. Failure to maintain, analyze, or
support an adequate ALLL in
accordance with GAAP and supervisory
guidance is generally an unsafe and
unsound banking practice.7
This guidance applies equally to all
institutions, regardless of the size.
However, institutions with less complex
lending activities and products may find
it more efficient to combine a number of
procedures (e.g., information gathering,
documentation, and internal approval
processes) while continuing to ensure
the institution has a consistent and
appropriate methodology. Thus, much
of the supporting documentation
required for an institution with more
complex products or portfolios may be
combined into fewer supporting
documents in an institution with less
complex products or portfolios. For
example, simplified documentation can
include spreadsheets, check lists, and
other summary documents that many
institutions currently use. Illustrations
A and C provide specific examples of
how less complex institutions may
determine and document portions of
their loan loss allowance.
Documentation Standards
Appropriate written supporting
documentation for the loan loss
provision and allowance facilitates
review of the ALLL process and
reported amounts, builds discipline and
consistency into the ALLL
determination process, and improves
the process for estimating loan and lease
losses by helping to ensure that all
relevant factors are appropriately
considered in the ALLL analysis. An
institution should document the
relationship between the findings of its
detailed review of the loan portfolio and
the amount of the ALLL and the
provision for loan and lease losses
reported in each period.8
At a minimum, institutions should
maintain written supporting
documentation for the following
decisions, strategies, and processes:
(1) Policies and procedures:
(a) Over the systems and controls that
maintain an appropriate ALLL and
and the Securities and Exchange Commission’s
(SEC) Financial Reporting Release No. 28 (FRR 28).
7 Failure to maintain adequate supporting
documentation does not relieve an institution of its
obligation to record an appropriate ALLL.
8 This position is fully described in the SEC’s FRR
28, in which the SEC indicates that the books and
records of public companies engaged in lending
activities should include documentation of the
rationale supporting each period’s determination
that the ALLL and provision amounts reported were
adequate.

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(b) Over the ALLL methodology,
(2) Loan grading system or process,
(3) Summary or consolidation of the
ALLL balance,
(4) Validation of the ALLL
methodology, and
(5) Periodic adjustments to the ALLL
process.
The following sections of this Policy
Statement provide guidance on
significant aspects of ALLL
methodologies and documentation
practices. Specifically, the paper
provides documentation guidance on:
(1) Policies and Procedures,
(2) Methodology,
(3) ALLL Under FASB Statement of
Financial Accounting Standards No.
114, Accounting by Creditors for
Impairment of a Loan (FAS 114),
(4) ALLL Under FASB Statement of
Financial Accounting Standards No. 5,
Accounting for Contingencies (FAS 5),
(5) Consolidating the Loss Estimates,
and
(6) Validating the ALLL Methodology.
Policies and Procedures
Financial institutions utilize a wide
range of policies, procedures, and
control systems in their ALLL process.
Sound policies should be appropriately
tailored to the size and complexity of
the institution and its loan portfolio.
In order for an institution’s ALLL
methodology to be effective, the
institution’s written policies and
procedures for the systems and controls
that maintain an appropriate ALLL
should address but not be limited to:
(1) The roles and responsibilities of
the institution’s departments and
personnel (including the lending
function, credit review, financial
reporting, internal audit, senior
management, audit committee, board of
directors, and others, as applicable) who
determine, or review, as applicable, the
ALLL to be reported in the financial
statements;
(2) The institution’s accounting
policies for loans and loan losses,
including the policies for charge-offs
and recoveries and for estimating the
fair value of collateral, where
applicable;
(3) The description of the institution’s
systematic methodology, which should
be consistent with the institution’s
accounting policies for determining its
ALLL;9 and
(4) The system of internal controls
used to ensure that the ALLL process is
maintained in accordance with GAAP
and supervisory guidance.
An internal control system for the
ALLL estimation process should:
9 Further explanation is presented in the
Methodology section that appears below.

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(1) Include measures to provide
assurance regarding the reliability and
integrity of information and compliance
with laws, regulations, and internal
policies and procedures;
(2) Reasonably assure that the
institution’s financial statements
(including regulatory reports) are
prepared in accordance with GAAP and
ALLL supervisory guidance;10 and
(3) Include a well-defined loan review
process containing:
(a) An effective loan grading system
that is consistently applied, identifies
differing risk characteristics and loan
quality problems accurately and in a
timely manner, and prompts
appropriate administrative actions;
(b) Sufficient internal controls to
ensure that all relevant loan review
information is appropriately considered
in estimating losses. This includes
maintaining appropriate reports, details
of reviews performed, and identification
of personnel involved; and
(c) Clear formal communication and
coordination between an institution’s
credit administration function, financial
reporting group, management, board of
directors, and others who are involved
in the ALLL determination or review
process, as applicable (e.g., written
policies and procedures, management
reports, audit programs, and committee
minutes).
Methodology
An ALLL methodology is a system
that an institution designs and
implements to reasonably estimate loan
and lease losses as of the financial
statement date. It is critical that ALLL
methodologies incorporate
management’s current judgments about
the credit quality of the loan portfolio
through a disciplined and consistently
applied process.
An institution’s ALLL methodology is
influenced by institution-specific
factors, such as an institution’s size,
organizational structure, business
environment and strategy, management
style, loan portfolio characteristics, loan
administration procedures, and
10 In addition to the supporting documentation
requirements for financial institutions, as described
in interagency asset quality guidelines, public
companies are required to comply with the books
and records provisions of the Securities Exchange
Act of 1934 (Exchange Act). Under Sections
13(b)(2)-(7) of the Exchange Act, registrants must
make and keep books, records, and accounts,
which, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of assets of
the registrant. Registrants also must maintain
internal accounting controls that are sufficient to
provide reasonable assurances that, among other
things, transactions are recorded as necessary to
permit the preparation of financial statements in
conformity with GAAP. See also SEC Staff
Accounting Bulletin No. 99, Materiality.

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management information systems.
However, there are certain common
elements an institution should
incorporate in its ALLL methodology. A
summary of common elements is
provided in Appendix B.11
Documentation of ALLL Methodology in
Written Policies and Procedures
An institution’s written policies and
procedures should describe the primary
elements of the institution’s ALLL
methodology, including portfolio
segmentation and impairment
measurement. In order for an
institution’s ALLL methodology to be
effective, the institution’s written
policies and procedures should describe
the methodology:
(1) For segmenting the portfolio:
(a) How the segmentation process is
performed (i.e., by loan type, industry,
risk rates, etc.),
(b) When a loan grading system is
used to segment the portfolio:
(i) The definitions of each loan grade,
(ii) A reconciliation of the internal
loan grades to supervisory loan grades,
and
(iii) The delineation of
responsibilities for the loan grading
system.
(2) For determining and measuring
impairment under FAS 114:
(a) The methods used to identify loans
to be analyzed individually;
(b) For individually reviewed loans
that are impaired, how the amount of
any impairment is determined and
measured, including:
(i) Procedures describing the
impairment measurement techniques
available and
(ii) Steps performed to determine
which technique is most appropriate in
a given situation.
(c) The methods used to determine
whether and how loans individually
evaluated under FAS 114, but not
considered to be individually impaired,
should be grouped with other loans that
share common characteristics for
impairment evaluation under FAS 5.
(3) For determining and measuring
impairment under FAS 5:
(a) How loans with similar
characteristics are grouped to be
evaluated for loan collectibility (such as
loan type, past-due status, and risk);
(b) How loss rates are determined
(e.g., historical loss rates adjusted for
environmental factors or migration
analysis) and what factors are
considered when establishing
appropriate time frames over which to
evaluate loss experience; and
11 Also, refer to paragraph 7.05 of the AICPA
Audit Guide.

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(c) Descriptions of qualitative factors
(e.g., industry, geographical, economic,
and political factors) that may affect loss
rates or other loss measurements.
The supporting documents for the
ALLL may be integrated in an
institution’s credit files, loan review
reports or worksheets, board of
directors’ and committee meeting
minutes, computer reports, or other
appropriate documents and files.
ALLL Under FAS 114
An institution’s ALLL methodology
related to FAS 114 loans begins with the
use of its normal loan review
procedures to identify whether a loan is
impaired as defined by the accounting
standard. Institutions should document:
(1) The method and process for
identifying loans to be evaluated under
FAS 114 and
(2) The analysis that resulted in an
impairment decision for each loan and
the determination of the impairment
measurement method to be used (i.e.,
present value of expected future cash
flows, fair value of collateral less costs
to sell, or the loan’s observable market
price).
Once an institution has determined
which of the three available
measurement methods to use for an
impaired loan under FAS 114, it should
maintain supporting documentation as
follows:
(1) When using the present value of
expected future cash flows method:
(a) The amount and timing of cash
flows,
(b) The effective interest rate used to
discount the cash flows, and
(c) The basis for the determination of
cash flows, including consideration of
current environmental factors and other
information reflecting past events and
current conditions.
(2) When using the fair value of
collateral method:
(a) How fair value was determined,
including the use of appraisals,
valuation assumptions, and
calculations,
(b) The supporting rationale for
adjustments to appraised values, if any,
(c) The determination of costs to sell,
if applicable, and
(d) Appraisal quality, and the
expertise and independence of the
appraiser.
(3) When using the observable market
price of a loan method:
(a) The amount, source, and date of
the observable market price.
Illustration A describes a practice
used by a small financial institution to
document its FAS 114 measurement of
impairment using a comprehensive

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worksheet.12 Q&A #1 and #2 in
Appendix A provide examples of
applying and documenting impairment
measurement methods under FAS 114.
Begin Text Box—Illustration A
(Documenting an ALLL Under FAS 114,
Comprehensive worksheet for the
impairment measurement process): A small
institution utilizes a comprehensive
worksheet for each loan being reviewed
individually under FAS 114. Each worksheet
includes a description of why the loan was
selected for individual review, the
impairment measurement technique used,
the measurement calculation, a comparison
to the current loan balance, and the amount
of the ALLL for that loan. The rationale for
the impairment measurement technique used
(e.g., present value of expected future cash
flows, observable market price of the loan,
fair value of the collateral) is also described
on the worksheet. End Text Box

Some loans that are evaluated
individually for impairment under FAS
114 may be fully collateralized and
therefore require no ALLL. Q&A #3 in
Appendix A presents an example of an
institution whose loan portfolio
includes fully collateralized loans and
describes the documentation
maintained by that institution to
support its conclusion that no ALLL
was needed for those loans.
ALLL Under FAS 5
Segmenting the Portfolio
For loans evaluated on a group basis
under FAS 5, management should
segment the loan portfolio by
identifying risk characteristics that are
common to groups of loans. Institutions
typically decide how to segment their
loan portfolios based on many factors,
which vary with their business
strategies as well as their information
system capabilities. Smaller institutions
that are involved in less complex
activities often segment the portfolio
into broad loan categories. This method
of segmenting the portfolio is likely to
be appropriate in only small institutions
offering a narrow range of loan
products. Larger institutions typically
offer a more diverse and complex mix
of loan products. Such institutions may
start by segmenting the portfolio into
major loan types but typically have
more detailed information available that
allows them to further segregate the
portfolio into product line segments
based on the risk characteristics of each
12 The referenced ‘‘gray box’’ illustrations are
presented to assist institutions in evaluating how to
implement the guidance provided in this document.
The methods described in the illustrations may not
be suitable for all institutions and are not
considered required processes or actions. For
additional descriptions of key aspects of ALLL
guidance, a series of ALLL Questions and Answers
(Q&As) are included in Appendix A of this paper.

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portfolio segment. Regardless of the
segmentation method used, an
institution should maintain
documentation to support its conclusion
that the loans in each segment have
similar attributes or characteristics.
As economic and other business
conditions change, institutions often
modify their business strategies, which
may result in adjustments to the way in
which they segment their loan portfolio
for purposes of estimating loan losses.
Illustration B presents an example in
which an institution refined its
segmentation method to more
effectively consider risk factors and
maintains documentation to support
this change.
Begin Text Box—Illustration B
(Documenting Segmenting Practices,
Documenting a refinement in a segmentation
method): An institution with a significant
portfolio of consumer loans performed a
review of its ALLL methodology. The
institution had determined its ALLL based
upon historical loss rates in the overall
consumer portfolio. The ALLL methodology
was validated by comparing actual loss rates
(charge-offs) for the past two years to the
estimated loss rates. During this process, the
institution decided to evaluate loss rates on
an individual product basis (e.g., auto loans,
unsecured loans, or home equity loans). This
analysis disclosed significant differences in
the loss rates on different products. With this
additional information, the methodology was
amended in the current period to segment the
portfolio by product, resulting in a better
estimation of the loan losses associated with
the portfolio. To support this change in
segmentation practice, the credit review
committee records contain the analysis that
was used as a basis for the change and the
written report describing the need for the
change End Text Box.

Institutions use a variety of
documents to support the segmentation
of their portfolios. Some of these
documents include:
(1) Loan trial balances by categories
and types of loans,
(2) Management reports about the mix
of loans in the portfolio,
(3) Delinquency and nonaccrual
reports, and
(4) A summary presentation of the
results of an internal or external loan
grading review.
Reports generated to assess the
profitability of a loan product line may
be useful in identifying areas in which
to further segment the portfolio.
Estimating Loss on Groups of Loans
Based on the segmentation of the loan
portfolio, an institution should estimate
the FAS 5 portion of its ALLL. For those
segments that require an ALLL,13 the
13 An example of a loan segment that does not
generally require an ALLL is loans that are fully

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institution should estimate the loan and
lease losses, on at least a quarterly basis,
based upon its ongoing loan review
process and analysis of loan
performance. The institution should
follow a systematic and consistently
applied approach to select the most
appropriate loss measurement methods
and support its conclusions and
rationale with written documentation.
Regardless of the methods used to
measure losses, an institution should
demonstrate and document that the loss
measurement methods used to estimate
the ALLL for each segment are
determined in accordance with GAAP
as of the financial statement date.14
One method of estimating loan losses
for groups of loans is through the
application of loss rates to the groups’
aggregate loan balances. Such loss rates
typically reflect the institution’s
historical loan loss experience for each
group of loans, adjusted for relevant
environmental factors (e.g., industry,
geographical, economic, and political
factors) over a defined period of time. If
an institution does not have loss
experience of its own, it may be
appropriate to reference the loss
experience of other institutions,
provided that the institution
demonstrates that the attributes of the
loans in its portfolio segment are similar
to those of the loans included in the
portfolio of the institution providing the
loss experience.15 Institutions should
maintain supporting documentation for
the technique used to develop their loss
rates, including the period of time over
which the losses were incurred. If a
range of loss is determined, institutions
should maintain documentation to
support the identified range and the
rationale used for determining which
estimate is the best estimate within the
range of loan losses. An example of how
a small institution performs a
comprehensive historical loss analysis
is provided as the first item in
Illustration C.
Before employing a loss estimation
model, an institution should evaluate
and modify, as needed, the model’s
assumptions to ensure that the resulting
loss estimate is consistent with GAAP.
In order to demonstrate consistency
with GAAP, institutions that use loss
estimation models typically document
the evaluation, the conclusions
regarding the appropriateness of
estimating loan losses with a model or
secured by deposits maintained at the lending
institution.
14 Refer to paragraph 8(b) of FAS 5. Also, the
AICPA is currently developing a Statement of
Position that will provide more specific guidance
on accounting for loan losses.
15 Refer to paragraph 23 of FAS 5.

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other loss estimation tool, and the
support for adjustments to the model or
its results.
Begin Text Box—Illustration C
(Documenting the Setting of Loss Rates, First
Illustration, Comprehensive loss analysis in a
small institution): A small institution
determines its loss rates based on loss rates
over a three-year historical period. The
analysis is conducted by type of loan and is
further segmented by originating branch
office. The analysis considers charge-offs and
recoveries in determining the loss rate. The
institution also considers the loss rates for
each loan grade and compares them to
historical losses on similarly rated loans in
arriving at the historical loss factor. The
institution maintains supporting
documentation for its loss factor analysis,
including historical losses by type of loan,
originating branch office, and loan grade for
the three-year period.
(Second Illustration, Adjustment of loss
rates for changes in local economic
conditions): An institution develops a factor
to adjust loss rates for its assessment of the
impact of changes in the local economy. For
example, when analyzing the loss rate on
commercial real estate loans, the assessment
identifies changes in recent commercial
building occupancy rates. The institution
generally finds the occupancy statistics to be
a good indicator of probable losses on these
types of loans. The institution maintains
documentation that summarizes the
relationship between current occupancy rates
and its loss experience. End Text Box

In developing loss measurements,
institutions should consider the impact
of current environmental factors and
then document which factors were used
in the analysis and how those factors
affected the loss measurements. Factors
that should be considered in developing
loss measurements include the
following:16
(1) Levels of and trends in
delinquencies and impaired loans;
(2) Levels of and trends in charge-offs
and recoveries;
(3) Trends in volume and terms of
loans;
(4) Effects of any changes in risk
selection and underwriting standards,
and other changes in lending policies,
procedures, and practices;
(5) Experience, ability, and depth of
lending management and other relevant
staff;
(6) National and local economic
trends and conditions;
(7) Industry conditions; and
(8) Effects of changes in credit
concentrations.
For any adjustment of loss
measurements for environmental
factors, the institution should maintain
sufficient, objective evidence to support
the amount of the adjustment and to
16 Refer to paragraph 7.13 in the AICPA Audit
Guide.

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explain why the adjustment is necessary
to reflect current information, events,
circumstances, and conditions in the
loss measurements.
The second item in Illustration C
provides an example of how an
institution adjusts its commercial real
estate historical loss rates for changes in
local economic conditions. Q&A #4 in
Appendix A provides an example of
maintaining supporting documentation
for adjustments to portfolio segment loss
rates for an environmental factor related
to an economic downturn in the
borrower’s primary industry. Q&A #5 in
Appendix A describes one institution’s
process for determining and
documenting an ALLL for loans that are
not individually impaired but have
characteristics indicating there are loan
losses on a group basis.
Consolidating the Loss Estimates
To verify that ALLL balances are
presented fairly in accordance with
GAAP and are auditable, management
should prepare a document that
summarizes the amount to be reported
in the financial statements for the ALLL.
The board of directors should review
and approve this summary.
Common elements in such summaries
include:
(1) The estimate of the probable loss
or range of loss incurred for each
category evaluated (e.g., individually
evaluated impaired loans, homogeneous
pools, and other groups of loans that are
collectively evaluated for impairment);
(2) The aggregate probable loss
estimated using the institution’s
methodology;
(3) A summary of the current ALLL
balance;
(4) The amount, if any, by which the
ALLL is to be adjusted;17 and
(5) Depending on the level of detail
that supports the ALLL analysis,
detailed subschedules of loss estimates
that reconcile to the summary schedule.
Illustration D describes how an
institution documents its estimated
ALLL by adding comprehensive
explanations to its summary schedule.
Begin Text Box—Illustration D
(Summarizing Loss Estimates, Descriptive
comments added to the consolidated ALLL
summary schedule): To simplify the
supporting documentation process and to
eliminate redundancy, an institution adds
detailed supporting information to its
summary schedule. For example, this
institution’s board of directors receives,
within the body of the ALLL summary
17 Subsequent to adjustments, there should be no
material differences between the consolidated loss
estimate, as determined by the methodology, and
the final ALLL balance reported in the financial
statements.

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schedule, a brief description of the
institution’s policy for selecting loans for
evaluation under FAS 114. Additionally, the
institution identifies which FAS 114
impairment measurement method was used
for each individually reviewed impaired
loan. Other items on the schedule include a
brief description of the loss factors for each
segment of the loan portfolio, the basis for
adjustments to loss rates, and explanations of
changes in ALLL amounts from period to
period, including cross-references to more
detailed supporting documents. End Text
Box

Generally, an institution’s review and
approval process for the ALLL relies
upon the data provided in these
consolidated summaries. There may be
instances in which individuals or
committees that review the ALLL
methodology and resulting allowance
balance identify adjustments that need
to be made to the loss estimates to
provide a better estimate of loan losses.
These changes may be due to
information not known at the time of
the initial loss estimate (e.g.,
information that surfaces after
determining and adjusting, as necessary,
historical loss rates, or a recent decline
in the marketability of property after
conducting a FAS 114 valuation based
upon the fair value of collateral). It is
important that these adjustments are
consistent with GAAP and are reviewed
and approved by appropriate personnel.
Additionally, the summary should
provide each subsequent reviewer with
an understanding of the support behind
these adjustments. Therefore,
management should document the
nature of any adjustments and the
underlying rationale for making the
changes. This documentation should be
provided to those making the final
determination of the ALLL amount.
Q&A #6 in Appendix A addresses the
documentation of the final amount of
the ALLL.
Validating the ALLL Methodology
An institution’s ALLL methodology is
considered valid when it accurately
estimates the amount of loss contained
in the portfolio. Thus, the institution’s
methodology should include procedures
that adjust loss estimation methods to
reduce differences between estimated
losses and actual subsequent chargeoffs, as necessary.
To verify that the ALLL methodology
is valid and conforms to GAAP and
supervisory guidance, an institution’s
directors should establish internal
control policies, appropriate for the size
of the institution and the type and
complexity of its loan products. These
policies should include procedures for a
review, by a party who is independent
of the ALLL estimation process, of the

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ALLL methodology and its application
in order to confirm its effectiveness.
In practice, financial institutions
employ numerous procedures when
validating the reasonableness of their
ALLL methodology and determining
whether there may be deficiencies in
their overall methodology or loan
grading process. Examples are:
(1) A review of trends in loan volume,
delinquencies, restructurings, and
concentrations.
(2) A review of previous charge-off
and recovery history, including an
evaluation of the timeliness of the
entries to record both the charge-offs
and the recoveries.
(3) A review by a party that is
independent of the ALLL estimation
process. This often involves the
independent party reviewing, on a test
basis, source documents and underlying
assumptions to determine that the
established methodology develops
reasonable loss estimates.
(4) An evaluation of the appraisal
process of the underlying collateral.
This may be accomplished by
periodically comparing the appraised
value to the actual sales price on
selected properties sold.
Supporting Documentation for the
Validation Process
Management usually supports the
validation process with the workpapers
from the ALLL review function.
Additional documentation often
includes the summary findings of the
independent reviewer. The institution’s
board of directors, or its designee,
reviews the findings and acknowledges
its review in its meeting minutes. If the
methodology is changed based upon the
findings of the validation process,
documentation that describes and
supports the changes should be
maintained.
Appendix A—ALLL Questions and
Answers
Introduction
The Questions and Answers (Q&As)
presented in this appendix serve several
purposes, including (1) To illustrate the
banking agencies’ views, as set forth in this
Policy Statement, about the types of
decisions, determinations, and processes an
institution should document with respect to
its ALLL methodology and amounts; and (2)
to illustrate the types of ALLL documentation
and processes an institution might prepare,
retain, or use in a particular set of
circumstances. The level and types of
documentation described in the Q&As should
be considered neither the minimum
acceptable level of documentation nor an allinclusive list. Institutions are expected to
apply the guidance in this Policy Statement
to their individual facts, circumstances, and

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situations. If an institution’s fact pattern
differs from the fact patterns incorporated in
the following Q&As, the institution may
decide to prepare and maintain different
types of documentation than did the
institutions depicted in these Q&As.
Q&A #1—ALLL Under FAS 114—Measuring
and Documenting Impairment
Facts: Approximately one-third of
Institution A’s commercial loan portfolio
consists of large balance, non-homogeneous
loans. Due to their large individual balances,
these loans meet the criteria under Institution
A’s policies and procedures for individual
review for impairment under FAS 114. Upon
review of the large balance loans, Institution
A determines that certain of the loans are
impaired as defined by FAS 114.
Question: For the commercial loans
reviewed under FAS 114 that are
individually impaired, how should
Institution A measure and document the
impairment on those loans? Can it use an
impairment measurement method other than
the methods allowed by FAS 114?
Interpretive Response: For those loans that
are reviewed individually under FAS 114
and considered individually impaired,
Institution A must use one of the methods for
measuring impairment that is specified by
FAS 114 (that is, the present value of
expected future cash flows, the loan’s
observable market price, or the fair value of
collateral). Accordingly, in the circumstances
described above, for the loans considered
individually impaired under FAS 114, it
would not be appropriate for Institution A to
choose a measurement method not
prescribed by FAS 114. For example, it
would not be appropriate to measure loan
impairment by applying a loss rate to each
loan based on the average historical loss
percentage for all of its commercial loans for
the past five years.
Institution A should maintain, as
sufficient, objective evidence, written
documentation to support its measurement of
loan impairment under FAS 114. If
Institution A uses the present value of
expected future cash flows to measure
impairment of a loan, it should document the
amount and timing of cash flows, the
effective interest rate used to discount the
cash flows, and the basis for the
determination of cash flows, including
consideration of current environmental
factor 1 and other information reflecting past
events and current conditions. If Institution
A uses the fair value of collateral to measure
impairment, it should document how it
determined the fair value, including the use
of appraisals, valuation assumptions and
calculations, the supporting rationale for
adjustments to appraised values, if any, and
the determination of costs to sell, if
applicable, appraisal quality, and the
expertise and independence of the appraiser.
Similarly, Institution A should document the
amount, source, and date of the observable
1 Question #16 in Exhibit D–80A of EITF Topic
D–80 and attachments indicates that environmental
factors include existing industry, geographical,
economic, and political factors.

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market price of a loan, if that method of
measuring loan impairment is used.

Q&A #3—ALLL Under FAS 114—Fully
Collateralized Loans

Q&A #2—ALLL Under FAS 114—Measuring
Impairment for a Collateral Dependent Loan
Facts: Institution B has a $10 million loan
outstanding to Company X that is secured by
real estate, which Institution B individually
evaluates under FAS 114 due to the loan’s
size. Company X is delinquent in its loan
payments under the terms of the loan
agreement. Accordingly, Institution B
determines that its loan to Company X is
impaired, as defined by FAS 114. Because
the loan is collateral dependent, Institution B
measures impairment of the loan based on
the fair value of the collateral. Institution B
determines that the most recent valuation of
the collateral was performed by an appraiser
eighteen months ago and, at that time, the
estimated value of the collateral (fair value
less costs to sell) was $12 million.
Institution B believes that certain of the
assumptions that were used to value the
collateral eighteen months ago do not reflect
current market conditions and, therefore, the
appraiser’s valuation does not approximate
current fair value of the collateral. Several
buildings, which are comparable to the real
estate collateral, were recently completed in
the area, increasing vacancy rates, decreasing
lease rates, and attracting several tenants
away from the borrower. Accordingly, credit
review personnel at Institution B adjust
certain of the valuation assumptions to better
reflect the current market conditions as they
relate to the loan’s collateral.2 After adjusting
the collateral valuation assumptions, the
credit review department determines that the
current estimated fair value of the collateral,
less costs to sell, is $8 million. Given that the
recorded investment in the loan is $10
million, Institution B concludes that the loan
is impaired by $2 million and records an
allowance for loan losses of $2 million.
Question: What type of documentation
should Institution B maintain to support its
determination of the allowance for loan
losses of $2 million for the loan to Company
X?
Interpretive Response: Institution B should
document that it measured impairment of the
loan to Company X by using the fair value
of the loan’s collateral, less costs to sell,
which it estimated to be $8 million. This
documentation should include the
institution’s rationale and basis for the $8
million valuation, including the revised
valuation assumptions it used, the valuation
calculation, and the determination of costs to
sell, if applicable. Because Institution B
arrived at the valuation of $8 million by
modifying an earlier appraisal, it should
document its rationale and basis for the
changes it made to the valuation assumptions
that resulted in the collateral value declining
from $12 million eighteen months ago to $8
million in the current period.3

Facts: Institution C has $10 million in
loans that are fully collateralized by highly
rated debt securities with readily
determinable market values. The loan
agreement for each of these loans requires the
borrower to provide qualifying collateral
sufficient to maintain a loan-to-value ratio
with sufficient margin to absorb volatility in
the securities’ market prices. Institution C’s
collateral department has physical control of
the debt securities through safekeeping
arrangements. In addition, Institution C
perfected its security interest in the collateral
when the funds were originally distributed.
On a quarterly basis, Institution C’s credit
administration function determines the
market value of the collateral for each loan
using two independent market quotes and
compares the collateral value to the loan
carrying value. If there are any collateral
deficiencies, Institution C notifies the
borrower and requests that the borrower
immediately remedy the deficiency. Due in
part to its efficient operation, Institution C
has historically not incurred any material
losses on these loans. Institution C believes
these loans are fully-collateralized and
therefore does not maintain any ALLL
balance for these loans.
Question: What documentation does
Institution C maintain to adequately support
its determination that no allowance is needed
for this group of loans?
Interpretive Response: Institution C’s
management summary of the ALLL includes
documentation indicating that, in accordance
with the institution’s ALLL policy, the
collateral protection on these loans has been
verified by the institution, no probable loss
has been incurred, and no ALLL is necessary.
Documentation in Institution C’s loan files
includes the two independent market quotes
obtained each quarter for each loan’s
collateral amount, the documents evidencing
the perfection of the security interest in the
collateral, and other relevant supporting
documents. Additionally, Institution C’s
ALLL policy includes a discussion of how to
determine when a loan is considered ‘‘fully
collateralized’’ and does not require an
ALLL. Institution C’s policy requires the
following factors to be considered and the
institution’s findings concerning these factors
to be fully documented:
(1) Volatility of the market value of the
collateral;
(2) Recency and reliability of the appraisal
or other valuation
(3) Recency of the institution’s or third
party’s inspection of the collateral
(4) Historical losses on similar loans;
(5) Confidence in the institution’s lien or
security position including appropriate:
(a) Type of security perfection (e.g.,
physical possession of collateral or secured
filing);

2 When reviewing collateral dependent loans,
Institution B may often find it more appropriate to
obtain an updated appraisal to estimate the effect
of current market conditions on the appraised value
instead of internally estimating an adjustment.
3 In accordance with the FFIEC’s Federal Register
Notice, Implementation Issues Arising from FASB
No. 114, ‘‘Accounting by Creditors for Impairment

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of a Loan,’’ published February 10, 1995 (60 FR
7966, February 10, 1995), impaired, collateraldependent loans must be reported at the fair value
of collateral, less costs to sell, in regulatory reports.
This treatment is to be applied to all collateraldependent loans, regardless of type of collateral.

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(b) Filing of security perfection (i.e., correct
documents and with the appropriate
officials); and
(c) Relationship to other liens; and
(6) Other factors as appropriate for the loan
type.
Q&A #4—ALLL Under FAS 5—Adjusting
Loss Rates
Facts: Institution D’s lending area includes
a metropolitan area that is financially
dependent upon the profitability of a number
of manufacturing businesses. These
businesses use highly specialized equipment
and significant quantities of rare metals in
the manufacturing process. Due to increased
low-cost foreign competition, several of the
parts suppliers servicing these manufacturing
firms declared bankruptcy. The foreign
suppliers have subsequently increased prices
and the manufacturing firms have suffered
from increased equipment maintenance costs
and smaller profit margins. Additionally, the
cost of the rare metals used in the
manufacturing process increased and has
now stabilized at double last year’s price.
Due to these events, the manufacturing
businesses are experiencing financial
difficulties and have recently announced
downsizing plans.
Although Institution D has yet to confirm
an increase in its loss experience as a result
of these events, management knows that it
lends to a significant number of businesses
and individuals whose repayment ability
depends upon the long-term viability of the
manufacturing businesses. Institution D’s
management has identified particular
segments of its commercial and consumer
customer bases that include borrowers highly
dependent upon sales or salary from the
manufacturing businesses. Institution D’s
management performs an analysis of the
affected portfolio segments to adjust its
historical loss rates used to determine the
ALLL. In this particular case, Institution D
has experienced similar business and lending
conditions in the past that it can compare to
current conditions.
Question: How should Institution D
document its support for the loss rate
adjustments that result from considering
these manufacturing firms’ financial
downturns?
Interpretive Response: Institution D should
document its identification of the particular
segments of its commercial and consumer
loan portfolio for which it is probable that
the manufacturing business’ financial
downturn has resulted in loan losses. In
addition, Institution D should document its
analysis that resulted in the adjustments to
the loss rates for the affected portfolio
segments. As part of its documentation,
Institution D maintains copies of the
documents supporting the analysis,
including relevant newspaper articles,
economic reports, economic data, and notes
from discussions with individual borrowers.
Because in this case Institution D has had
similar situations in the past, its supporting
documentation also includes an analysis of
how the current conditions compare to its
previous loss experiences in similar
circumstances. As part of its effective ALLL
methodology, Institution D creates a

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Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices

summary of the amount and rationale for the
adjustment factor, which management
presents to the audit committee and board for
their review and approval prior to the
issuance of the financial statements.

loan type and by internal risk rating, and
support for any adjustments to its historical
loss rates. The institution also maintains
copies of the economic and other reports that
provided source data.

Q&A #5—ALLL Under FAS 5—Estimating
Losses on Loans Individually Reviewed for
Impairment But Not Considered Individually
Impaired
Facts: Institution E has outstanding loans
of $2 million to Company Y and $1 million
to Company Z, both of which are paying as
agreed upon in the loan documents. The
institution’s ALLL policy specifies that all
loans greater than $750,000 must be
individually reviewed for impairment under
FAS 114. Company Y’s financial statements
reflect a strong net worth, good profits, and
ongoing ability to meet debt service
requirements. In contrast, recent information
indicates Company Z’s profitability is
declining and its cash flow is tight.
Accordingly, this loan is rated substandard
under the institution’s loan grading system.
Despite its concern, management believes
Company Z will resolve its problems and
determines that neither loan is individually
impaired as defined by FAS 114.
Institution E segments its loan portfolio to
estimate loan losses under FAS 5. Two of its
loan portfolio segments are Segment 1 and
Segment 2. The loan to Company Y has risk
characteristics similar to the loans included
in Segment 1 and the loan to Company Z has
risk characteristics similar to the loans
included in Segment 2.4
In its determination of the ALLL under
FAS 5, Institution E includes its loans to
Company Y and Company Z in the groups of
loans with similar characteristics (i.e.,
Segment 1 for Company Y’s loan and
Segment 2 for Company Z’s loan).
Management’s analyses of Segment 1 and
Segment 2 indicate that it is probable that
each segment includes some losses, even
though the losses cannot be identified to one
or more specific loans. Management
estimates that the use of its historical loss
rates for these two segments, with
adjustments for changes in environmental
factors provides a reasonable estimate of the
institution’s probable loan losses in these
segments.
Question: How does Institution E
adequately document an ALLL under FAS 5
for these loans that were individually
reviewed for impairment but are not
considered individually impaired?
Interpretive Response: As part of
Institution E’s effective ALLL methodology, it
documents the decision to include its loans
to Company Y and Company Z in its
determination of its ALLL under FAS 5. It
also documents the specific characteristics of
the loans that were the basis for grouping
these loans with other loans in Segment 1
and Segment 2, respectively. Institution E
maintains documentation to support its
method of estimating loan losses for Segment
1 and Segment 2, including the average loss
rate used, the analysis of historical losses by

Q&A #6—Consolidating the Loss Estimates—
Documenting the Reported ALLL
Facts: Institution F determines its ALLL
using an established systematic process. At
the end of each period, the accounting
department prepares a summary schedule
that includes the amount of each of the
components of the ALLL, as well as the total
ALLL amount, for review by senior
management, the Credit Committee, and,
ultimately, the board of directors. Members
of senior management and the Credit
Committee meet to discuss the ALLL. During
these discussions, they identify changes that
are required by GAAP to be made to certain
of the ALLL estimates. As a result of the
adjustments made by senior management, the
total amount of the ALLL changes. However,
senior management (or its designee) does not
update the ALLL summary schedule to
reflect the adjustments or reasons for the
adjustments. When performing their audit of
the financial statements, the independent
accountants are provided with the original
ALLL summary schedule that was reviewed
by senior management and the Credit
Committee, as well as a verbal explanation of
the changes made by senior management and
the Credit Committee when they met to
discuss the loan loss allowance.
Question: Are Institution F’s
documentation practices related to the
balance of its loan loss allowance in
compliance with existing documentation
guidance in this area?
Interpretive Response: No. An institution
must maintain supporting documentation for
the loan loss allowance amount reported in
its financial statements. As illustrated above,
there may be instances in which ALLL
reviewers identify adjustments that need to
be made to the loan loss estimates. The
nature of the adjustments, how they were
measured or determined, and the underlying
rationale for making the changes to the ALLL
balance should be documented. Appropriate
documentation of the adjustments should be
provided to the board of directors (or its
designee) for review of the final ALLL
amount to be reported in the financial
statements. For institutions subject to
external audit, this documentation should
also be made available to the independent
accountants. If changes frequently occur
during management or credit committee
reviews of the ALLL, management may find
it appropriate to analyze the reasons for the
frequent changes and to reassess the
methodology the institution uses.

4 These groups of loans do not include any loans
that have been individually reviewed for
impairment under FAS 114 and determined to be
impaired as defined by FAS 114.

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Appendix B—Application of GAAP
An ALLL recorded pursuant to GAAP is an
institution’s best estimate of the probable
amount of loans and lease-financing
receivables that it will be unable to collect
based on current information and events.1 A
1 This Appendix provides guidance on the ALLL
and does not address allowances for credit losses
for off-balance sheet instruments (e.g., loan

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creditor should record an ALLL when the
criteria for accrual of a loss contingency as
set forth in GAAP have been met. Estimating
the amount of an ALLL involves a high
degree of management judgment and is
inevitably imprecise. Accordingly, an
institution may determine that the amount of
loss falls within a range. An institution
should record its best estimate within the
range of loan losses.2
Under GAAP, Statement of Financial
Accounting Standards No. 5, Accounting for
Contingencies (FAS 5), provides the basic
guidance for recognition of a loss
contingency, such as the collectibility of
loans (receivables), when it is probable that
a loss has been incurred and the amount can
be reasonably estimated. Statement of
Financial Accounting Standards No. 114,
Accounting by Creditors for Impairment of a
Loan (FAS 114) provides more specific
guidance about the measurement and
disclosure of impairment for certain types of
loans.3 Specifically, FAS 114 applies to loans
that are identified for evaluation on an
individual basis. Loans are considered
impaired when, based on current information
and events, it is probable that the creditor
will be unable to collect all interest and
principal payments due according to the
contractual terms of the loan agreement.
For individually impaired loans, FAS 114
provides guidance on the acceptable methods
to measure impairment. Specifically, FAS
114 states that when a loan is impaired, a
creditor should measure impairment based
on the present value of expected future
principal and interest cash flows discounted
at the loan’s effective interest rate, except
that as a practical expedient, a creditor may
measure impairment based on a loan’s
observable market price or the fair value of
collateral, if the loan is collateral dependent.
When developing the estimate of expected
future cash flows for a loan, an institution
should consider all available information
reflecting past events and current conditions,
including the effect of existing environmental
factors. The following Illustration provides
an example of an institution estimating a
loan’s impairment when the loan has been
partially charged-off.
commitments, guarantees, and standby letters of
credit). Institutions should record liabilities for
these exposures in accordance with GAAP. Further
guidance on this topic is presented in the American
Institute of Certified Public Accountants’ Audit and
Accounting Guide, Banks and Savings Institutions,
2000 edition (AICPA Audit Guide). Additionally,
this Appendix does not address allowances or
accounting for assets or portions of assets sold with
recourse, which is described in Statement of
Financial Accounting Standards No. 140,
Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities—a
Replacement of FASB Statement No. 125 (FAS 140).
2 Refer to FASB Interpretation No. 14, Reasonable
Estimation of the Amount of a Loss, and Emerging
Issues Task Force Topic No. D–80, Application of
FASB Statements No. 5 and No. 114 to a Loan
Portfolio (EITF Topic D–80).
3 EITF Topic D–80 includes additional guidance
on the requirements of FAS 5 and FAS 114 and how
they relate to each other. The AICPA is currently
developing a Statement of Position (SOP) that will
provide more specific guidance on accounting for
loan losses.

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Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices
Begin Text Box—Illustration (Interaction of
FAS 114 With an Adversely Classified Loan,
Partial Charge-off, and the Overall ALLL): An
institution determined that a collateral
dependent loan, which it identified for
evaluation, was impaired. In accordance with
FAS 114, the institution established an ALLL
for the amount that the recorded investment
in the loan exceeded the fair value of the
underlying collateral, less costs to sell.
Consistent with relevant regulatory guidance,
the institution classified as ‘‘Loss,’’ the
portion of the recorded investment deemed
to be the confirmed loss and classified the
remaining recorded investment as
‘‘Substandard.’’ For this loan, the amount
classified ‘‘Loss’’ was less than the
impairment amount (as determined under
FAS 114). The institution charged off the
‘‘Loss’’ portion of the loan. After the chargeoff, the portion of the ALLL related to this
‘‘Substandard’’ loan (1) reflects an
appropriate measure of impairment under
FAS 114, and (2) is included in the aggregate
FAS 114 ALLL for all loans that were
identified for evaluation and individually
considered impaired. The aggregate FAS 114
ALLL is included in the institution’s overall
ALLL. End Text Box
Large groups of smaller-balance
homogeneous loans that are collectively
evaluated for impairment are not included in
the scope of FAS 114.4 Such groups of loans
may include, but are not limited to, credit
card, residential mortgage, and consumer
installment loans. FAS 5 addresses the
accounting for impairment of these loans.
Also, FAS 5 provides the accounting
guidance for impairment of loans that are not
identified for evaluation on an individual
basis and loans that are individually
evaluated but are not individually considered
impaired.
Institutions should ensure that they do not
layer their loan loss allowances. Layering is
the inappropriate practice of recording in the
ALLL more than one amount for the same
probable loan loss. Layering can happen
when an institution includes a loan in one
segment, determines its best estimate of loss
for that loan either individually or on a group
basis (after taking into account all
appropriate environmental factors,
conditions, and events), and then includes
the loan in another group, which receives an
additional ALLL amount.5
While different institutions may use
different methods, there are certain common
elements that should be included in any loan
loss allowance methodology. Generally, an
institution’s methodology should:6
4 In addition, FAS 114 does not apply to loans
measured at fair value or at the lower of cost or fair
value, leases, or debt securities.
5 According to the Federal Financial Institutions
Examination Council’s Federal Register Notice,
Implementation Issues Arising from FASB
Statement No. 114, Accounting by Creditors for
Impairment of a Loan, published February 10, 1995,
institution-specific issues should be reviewed when
estimating loan losses under FAS 114. This analysis
should be conducted as part of the evaluation of
each individual loan reviewed under FAS 114 to
avoid potential ALLL layering.
6 Refer to paragraph 7.05 of the AICPA Audit
Guide.

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(1) Include a detailed analysis of the loan
portfolio, performed on a regular basis;
(2) Consider all loans (whether on an
individual or group basis);
(3) Identify loans to be evaluated for
impairment on an individual basis under
FAS 114 and segment the remainder of the
portfolio into groups of loans with similar
risk characteristics for evaluation and
analysis under FAS 5;
(4) Consider all known relevant internal
and external factors that may affect loan
collectibility;
(5) Be applied consistently but, when
appropriate, be modified for new factors
affecting collectibility;
(6) Consider the particular risks inherent in
different kinds of lending;
(7) Consider current collateral values (less
costs to sell), where applicable;
(8) Require that analyses, estimates,
reviews and other ALLL methodology
functions be performed by competent and
well-trained personnel;
(9) Be based on current and reliable data;
(10) Be well documented, in writing, with
clear explanations of the supporting analyses
and rationale; and
(11) Include a systematic and logical
method to consolidate the loss estimates and
ensure the ALLL balance is recorded in
accordance with GAAP.
A systematic methodology that is properly
designed and implemented should result in
an institution’s best estimate of the ALLL.
Accordingly, institutions should adjust their
ALLL balance, either upward or downward,
in each period for differences between the
results of the systematic determination
process and the unadjusted ALLL balance in
the general ledger.7
Bibliography
American Institute of Certified Public
Accountants’ Audit and Accounting Guide,
Banks and Savings Institutions, 2000
edition
Auditing Standards Board Statement on
Auditing Standards No. 61,
Communication With Audit Committees
(AICPA, Professional Standards, vol. 1, AU
sec. 380)
Emerging Issues Task Force Topic No. D–80,
Application of FASB Statements No. 5 and
No. 114 to a Loan Portfolio (EITF Topic D–
80 and attachments), discussed on May 19–
20, 1999
Financial Accounting Standards Board
Interpretation No. 14, Reasonable
Estimation of the Amount of a Loss (An
Interpretation of FASB Statement No. 5)
Financial Accounting Standards Board
Statement of Financial Accounting
Standards No. 5, Accounting for
Contingencies
Federal Deposit Insurance Act, Section 39,
Standards for Safety and Soundness (12
U.S.C. 1831p–1)
Federal Financial Institutions Examination
Council’s Instructions for Preparation of
Consolidated Reports of Condition and
Income

Financial Accounting Standards Board
Statement of Financial Accounting
Standards No. 114, Accounting by
Creditors for Impairment of A Loan (An
Amendment of FASB Statements No. 5 and
15)
Financial Accounting Standards Board
Statement of Financial Accounting
Standards No. 118, Accounting by
Creditors for Impairment of a Loan—
Income Recognition and Disclosures (An
Amendment of FASB Statement No. 114)
Financial Accounting Standards Board
Statement of Financial Accounting
Standards No. 140, Accounting for
Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities—a
Replacement of FASB Statement No. 125
Interagency Guidelines Establishing
Standards for Safety and Soundness,
established in 1995 and 1996, as amended
on October 15, 1998
Interagency Policy Statement on the
Allowance for Loan and Lease Losses
(ALLL), December 21, 1993
Joint Interagency Statement (regarding the
ALLL), November 24, 1998
Joint Interagency Letter to Financial
Institutions (regarding the ALLL), March
10, 1999
Joint Interagency Letter to Financial
Institutions (regarding the ALLL), July 12,
1999
Securities and Exchange Commission
Financial Reporting Release No. 28,
Accounting for Loan Losses by Registrants
Engaged in Lending Activities, December
1, 1986
Securities and Exchange Commission
Securities Act Industry Guide 3, Statistical
Disclosure by Bank Holding Companies
Securities and Exchange Commission Staff
Accounting Bulletin No. 99, Materiality,
August 1999
Securities Exchange Act of 1934, Section
13(b)(2)–(7) (15 U.S.C. 78m(b)(2)–(7))
United States General Accounting Office
Report to Congressional Committees,
Depository Institutions: Divergent Loan
Loss Methods Undermine Usefulness of
Financial Reports, (GAO/AIMD–95–8),
October 1994
Dated: July 2, 2001.
Keith J. Todd,
Executive Secretary, Federal Financial
Institutions Examination Council.
[FR Doc. 01–16973 Filed 7–5–01; 8:45 am]
BILLING CODES 6710–01–P; 6714–01–P; 6720–01–P;
4810–33–P

7 Institutions should refer to the guidance on
materiality in SEC Staff Accounting Bulletin No. 99,
Materiality.

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Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102