Previously, we provided an overview of the Allowance for Loan and Lease Losses (ALLL), and now let’s discuss how community banks should apply the guidance. A typical loan loss reserve methodology would provide for the timely identification of potentially impaired loans as defined under the Accounting Standards Codification (ASC) 310 Receivables, the Loan Impairment guidance. Examples of sources for identifying loans to be evaluated for impairment could include specific materiality criterion, past due reports, non-accrual listings, regulatory examination reports, “watch lists,” and insider loan listings.
3 Acceptable Methods for Measuring Community Bank Loan Impairments
Once identified as impaired, loans should be measured for impairment using one of three acceptable methods under the ASC:
- Present value of expected future cash flows discounted at the loan’s effective interest rate.
- Observable market price.
- Fair value of the underlying collateral for collateral dependent loans.
The difference between the recorded investment in an impaired loan and the valuation under the ASC provides the basis for the related loan loss reserve amount (or loss as applicable for collateral dependent loans). Loans not identified as impaired under the ASC should be evaluated with the remainder of the portfolio under ASC 450-20 on Loss Contingencies. In general, these loans should be grouped with other loans having similar characteristics, with estimated losses being calculated for each group.
For most community banks, the aforementioned groupings would most likely be derived from the same sources as those used to classify loans by type for regulatory reporting purposes. In addition, the starting point for estimating probable losses would be the historical loss percentages for each individual group of loans. However, these percentages would be considered quantitative in nature and would need to be supplemented by certain qualitative factors. The statement provides the following list of examples of qualitative/environmental factors that should be considered:
- Changes in lending policies and procedures, including changes in underwriting standards and charge-off/recovery practices.
- Changes in economic and business conditions that could impact collectability of certain types of loans.
- Changes in the nature and volume of the loan portfolio.
- Changes in the experience, depth, and expertise of lending personnel.
- Changes in the volume and severity of past due, non-accrual, and classified loans.
- Changes in the loan review function.
- Changes in the value of collateral associated with collateral dependent loans.
- The existence of and changes in concentrations of credit.
- Other external factors including legal, regulatory and competitive issues.
Once the above factors are taken in to consideration (as well as other factors deemed appropriate), the applicable percentages—combined with the historical loss percentages—should be applied to each group of loans, resulting in the ASC 450-20 portion of the loan loss reserve. This amount, when combined with the amounts aggregated to be reserved for impaired loans under ASC 310, results in the total loan loss reserve (plus an unallocated reserve if applicable and supportable).
The statement calls for the above described evaluation to be prepared on at least a quarterly basis and that it be “comprehensive, well-documented and consistently applied.”
Though the above discussion focuses primarily on the application of ASC 310 and ASC 450, the statement addresses a variety of other areas such as board of director and management responsibilities including written policies and procedures and review of judgments and estimates. It also addresses the use of ratio analysis, examiner responsibilities, loan review systems, loan classification and grading, and it is supplemented by a “Q&A” document.
While the guidance in the statement is comprehensive and technical in nature, most community banks employ many of the systems and processes that are described. In many cases, it may very well be a matter of obtaining an understanding the guidance, reformatting existing presentation, and formalizing documentation of controls/procedures currently in place.
ALLL can be a complicated subject for community banks, but CRI’s community banks CPA team understands the keys to success. Just give us a call.