Risk Library
   Documents by Author
     Committees at the Bank for International...
       Sound Practices for Loan Accounting, Cre...
         
         III. Accounting for Loans
         










 

Sound Practices for Loan Accounting, Credit Risk Disclosure and Related Matters

III. Accounting for Loans

  1. The previous section referred to general principles that are particularly important in managing credit risk and accounting for loans. This section outlines sound principles of a more specific nature.

      (a) Recognition, discontinuing recognition and measurement

    1. A bank should recognise a loan, whether originated or purchased, in its balance sheet when the bank becomes a party to the contractual provisions that comprise the loan.

  2. When a bank becomes a party to the contractual terms comprising the loan it controls the economic benefits associated with the loan. Normally, a bank becomes a party to the contractual provisions that comprise a loan (i.e., acquires legal ownership of the loan) on the date of the advance of funds or payment to a third party. As a result, a commitment to lend funds is not recognised as an asset on the balance sheet 18. In certain jurisdictions, the acquisition of legal ownership is viewed more as a process than a discrete event. However, providing consideration (the advancement of funds) is typically one of the more important factors constituting ownership.

    1. A bank should remove a loan (or a portion of a loan) from its balance sheet when the bank realises the rights to benefits specified in the contract, the rights expire or the bank surrenders or otherwise loses control of the contractual rights that comprise the loan (or a portion of the loan).

  3. Control of a loan is surrendered when the ability to obtain future economic benefits relating to the loan and the ability to restrict the access of others to those benefits is transferred to others. Control is not surrendered if there are terms that would require or economically compel the bank or the transferee to revoke the transfer and essentially put things back where they were. Moreover, control is not surrendered if the bank is entitled and obligated to purchase or redeem the transferred loans at a fixed or determinable price that effectively provides the transferee with a rate of return that is equivalent to interest on the funds it has provided to the bank. The bank's retention of servicing rights is not considered to be a factor in the determination of whether it has surrendered control over the underlying loans. An example of a case where control has not been surrendered is where a bank has transferred a loan with an obligation to repurchase it at a future date.

    1. A bank should measure a loan, initially, at cost, which is the fair value of the consideration given for it.

  4. A loan should initially be recorded at its fair value which represents its acquisition cost. For loans originated by the bank, the cost is the amount lent to the borrower 19. Where a loan has been acquired from a third party, the cost is the fair value of the consideration given to acquire the loan at the time of acquisition 20.

      (b) Impairment - recognition and measurement

  5. Before discussing sound practices for recognition and measurement of loan impairment, it should be noted that the philosophy behind the establishment of allowances differs in certain fundamental respects across countries.

  6. In some countries, there is considerable attention given to the procedure of determining an appropriate size of overall loan loss allowances. The main question is whether the level of loan loss allowances is sufficient to cover probable losses associated with the total loan portfolio. In these countries, all or the bulk of a bank's allowances are general allowances and identified losses are charged off at an early stage.

  7. In other countries, the focus is primarily on the procedure to arrive at the net book value of individual loans with the principal question being one of whether specific allowances are sufficient to cover all ascertained and expected losses inherent in those loans on an item-by-item basis. In these countries, identified but not yet finally determined losses are often recognised through specific allowances where these losses would have been charged off in the first set of countries 21. As a second step, banks in some of these latter countries establish additional general allowances to cover latent losses which are not yet identified but which are known to exist.

  8. Despite these differences, common sound practices for the establishment of loan loss allowances can be formulated as set out below. This guidance emphasises that three of supervisors' primary concerns should be a) the adequacy of an institution's process for determining allowances, b) the adequacy of the total allowance and c) the timely recognition of identified losses through either specific allowances or charge-offs.

    1. A bank should identify and recognise impairment in a loan or a collectively assessed group of loans when it is probable that the bank will not be able to collect, or there is no longer reasonable assurance that the bank will collect, all amounts due according to the contractual terms of the loan agreement. The impairment should be recognised by reducing the carrying amount of the loan(s) through an allowance or charge-off and charging the income statement in the period in which the impairment occurs.

  9. To ensure that impairment in loans is identified in a timely manner, loans should be reviewed for impairment in credit quality in the preparation of annual and interim financial reports, taking into consideration the economic and other conditions at the reporting date. Moreover, an evaluation of loan impairment should be made between reporting dates whenever substantive information exists that indicates a significant deterioration has occurred in the credit quality in all or part of the loan portfolio.

  10. The evaluation of each loan should be based upon the creditworthiness of the particular borrower. The focus of the assessment is the ability of the borrower to repay the loan. The assessment should reflect all relevant factors as of the evaluation date that affect the collectibility of principal and interest. Factors relevant to the assessment of the debtor's ability to repay may include the debtor's payment record, overall financial condition and resources, debt service capacity, financial performance, net worth and future prospects; the prospects for support from any financially responsible guarantors; the nature and degree of protection provided by the current and stabilised cash flow and value of any underlying collateral; and country risk. Consideration of one factor only, e.g., the value of the collateral, is normally not sufficient for the determination of impairment status. However, as other sources of repayment become inadequate over time, the importance of the collateral's value in the analysis increases.

  11. Collateral should be valued on a prudent basis. For example, for significant commercial real estate loans, banks should obtain sound appraisals of the current fair value of the collateral from qualified professionals either internal or external to the bank. Management should review each appraisal's assumptions and conclusions to ensure timeliness and reasonableness. Typically, appraisal assumptions are based on the current performance of the collateral or similar properties. Many supervisors also expect appraisals to take into account, on a discounted basis, the ability of the real estate to generate income over time based on reasonable and supportable assumptions.

  12. Recognition of impairment should be considered whenever circumstances cause uncertainty about whether the estimated realisable amount of a loan is lower than its carrying amount 22. Management should use both internal information, e.g., the borrower's delay in making principal or interest payments, and external information, e.g., public disclosure and other financial information on the borrower (liquidity, cash flow projections), downgrading of credit status by a credit rating agency and declines in the value of collateral and guarantees.

  13. One factor that generally indicates that there has been a deterioration in the credit quality of a loan is that the borrower has defaulted in making interest or principal payments when due on the loan. As a starting point, loans generally should be identified as impaired when payments are contractually a minimum number of days in arrears reflecting domestic payment practices for the type of loan in question (e.g., 30-90 days). As an exception, loans need not be identified as impaired when the loan is fully secured, and there is reasonable assurance that the collection efforts will result in repayment in a timely manner of principal and interest (including full compensation for overdue payments) 23. Clearly, the existence of significant payment arrears is only one of many factors to consider when identifying impairment. Loans that are not seriously delinquent, or indeed not delinquent at all, as well as overdrafts, also need to be reviewed for deterioration in credit quality 24. A special case is where a bank advances to a borrower, who is about to default on interest or principal payments on a loan, additional funds that enable the borrower to meet current payment obligations. In this situation, it is clear that the borrowers' current ability to pay does not justify classifying the loan as unimpaired.

  14. Inevitably, bank management has some discretion in determining when reasonable assurance of collecting the contractual amounts no longer exists. However, this discretion should be based on a sound and timely credit evaluation, and should be exercised in accordance with the considerations discussed in section 2 and should be subject to the disclosures outlined in section 4.

    1. A bank should measure an impaired loan at its estimated realisable value.

  15. The valuation of loans should reflect any diminution in the estimated realisable value below their recorded investment. The carrying amount of a loan that has been identified as impaired should therefore be reduced to its estimated realisable value. The determination of this amount should take into account all relevant information such as the current economic situation of the borrower, the solvency of the debtor, the enforceability of personal guarantees and the ability of guarantors to perform, the current value of collateral, and rating agency ratings. The estimated realisable value should be calculated by using the following methods: 25

    • The present value of expected future cash flows discounted at an appropriate interest rate, i.e., the effective interest rate inherent in the loan. The estimates of future cash flows should be the bank's best estimate based on reasonable and supportable assumptions and projections;
    • The fair value of the collateral 26 to the extent the loan is collateral-dependent. A loan is fully collateral-dependent if repayment of the loan is expected to be provided solely by the underlying collateral;
    • The observable market price, if it is a reliable indicator of the loan's estimated realisable amount.

  16. Larger-balance loans and, where practicable, other loans should be reviewed on an individual loan basis. Credit deterioration in individually identified loans should be timely recognised to the greatest extent possible through the establishment of specific allowances or through charge-offs. 27

  17. For groups of homogeneous loans of small amounts, e.g., portfolios of consumer loans, it is often not practicable to investigate the creditworthiness of each individual borrower on a regular basis. In such cases, the extent of impairment and the related allowances or charge-offs should be determined on a portfolio basis by applying formulae that take into consideration factors such as an analysis of arrears, ageing of balances, past loss experience, current economic conditions and other relevant circumstances.

  18. When latent losses are known to exist, but they cannot yet be ascribed to individual loans, general allowances should be established. General allowances include allowances against impairment that has been determined to be present in a group or pool of loans that share common identifiable characteristics. In some countries, general allowances are also established against the portfolio based on an analysis of its various components, including a review of all significant loans on an individual basis. General allowances are not a substitute for the establishment of adequate specific allowances or the recording of appropriate charge-offs.

  19. General allowances are often considered to represent an interim step pending the identification of losses on individual loans that are impaired. The occurrence of a loss event might not be immediately known to the bank. However, the effect of those events should ordinarily become apparent within a reasonable time frame through delinquency or the receipt of new financial statements or other information that triggers the classification of the loan. As soon as adequate information is available to identify losses on individually impaired loans, the general allowances would be replaced by specific allowances (or charge-offs).

  20. Past experience and current economic and other relevant conditions, including changes in factors such as lending policies, nature and volume of the portfolio, volume and severity of recently identified impaired loans and concentrations of credit should be taken into account in determining general allowances.

  21. General allowances should be determined by using one or several of a number of different methodologies including:

    • applying a formula to the group that takes into account the analysis of arrears, ageing of balances, past loss experience, current economic conditions and other relevant circumstances;
    • migration analysis; 28
    • various statistical methodologies; 29
    • estimating impairment in the group based on the bank's judgement of the impact of recent events and changes in economic conditions that indicate the existence of impairment.

  22. The bank should review the assumptions used against actual experience at regular intervals, as necessary, throughout the reporting period.

  23. Statistical methodologies are not appropriate in all cases. For instance, they are not appropriate for banks that do not have the capabilities of using these approaches. Moreover, the adequacy, accuracy and reliability of statistical methodologies need to be properly established.

  24. Allowances should be calculated in a conservative manner so that they cover the imprecision inherent in most estimates of credit losses.

      (c) Restructured troubled loans

    1. A bank should recognise a loan as a restructured troubled loan when the lender, for economic or legal reasons related to the borrower's financial difficulties, grants a concession to the borrower that it would not otherwise consider.

  25. Restructured troubled loans are loans for which the lender has granted a concession to the borrower due to a deterioration of the borrower's financial condition. The restructuring may include:

    • a modification of terms, e.g., a reduction in the interest from that originally agreed or a reduction in the principal amount. However, a loan extended or renewed at a stated interest rate equal to the current interest rate for new debt with similar risk is not a restructured troubled loan;
    • the transfer from the borrower to the bank of real estate, receivables from third parties, other assets, or an equity interest in the borrower in full or partial satisfaction of the loan.

  26. A restructuring may also involve the substitution or addition of a new debtor for the original borrower.

    1. A bank should measure a restructured troubled loan by reducing its recorded investment to net realisable value, taking into account the cost of all concessions at the date of restructuring. The reduction in the recorded investment should be recorded as a charge to the income statement in the period in which the loan is restructured. 30

  27. In conjunction with a restructuring of a loan, a bank should assess the collectibility of the loan and determine if a credit loss has been incurred and, if so, the amount of the loss. The recorded investment in the loan should be reduced with a charge to the income statement being recorded in the period in which the loan is restructured. 31

  28. A loss on the restructuring of a loan involving a modification of terms should be measured in accordance with the principles for measuring impaired loans, taking into account the cost of all concessions at the date of restructuring. A restructuring may also include the acceptance of property in partial satisfaction of the loan. In such a case, the recorded investment in the loan is reduced by the fair value less cost to sell the property received. The bank should measure any impairment on the remaining recorded investment in the restructured loan as for impaired loans.
  29. The method used to measure the reduction in the recorded investment in a restructured loan must be reasonable. The accrual of interest on restructured troubled loans is discussed in sub-section (e) below.

      (d) Adequacy of the overall allowance

    1. The aggregate amount of specific and general allowances should be adequate to absorb estimated credit losses associated with the loan portfolio.

  30. A bank should maintain an overall allowance at a level that is adequate to absorb estimated credit losses associated with the loan portfolio. The adequacy of specific and general allowances should be reviewed in the preparation of annual and interim reports or more frequently, if warranted, to ensure that the aggregate amount of allowances is consistent with current information about the collectibility of the loan portfolio.

  31. Estimates of credit losses should reflect consideration of all significant factors that affect the collectibility of the loan portfolio as of the evaluation date. The assessment of the appropriate level of allowances necessarily includes a degree of subjectivity. However, the exercise of management discretion should be subject to established policies and procedures in accordance with the considerations discussed in section 2. Assessments should be performed in a systematic way, in a consistent manner over time, in conformity with objective criteria and be supported by adequate documentation.

  32. The method of determining the overall allowance should ensure the timely recognition of loan losses. While historical loss experience and recent trends in losses are a reasonable starting point for the institution's analysis, these factors are not, by themselves, a sufficient basis to determine the appropriate level for the overall allowance. Management should also consider any current factors that are likely to cause losses associated with the bank's portfolio to differ from historical loss experience, including:

    • Changes in lending policies and procedures, including underwriting standards and collection, charge-off, and recovery practices.
    • Changes in national and local economic and business conditions and developments, including the condition of various market segments.
    • Changes in the trend, volume and severity of past due and classified loans; as well as trends in the volume of non-accrual loans, troubled debt restructurings and other loan modifications.
    • The existence and effect of any concentrations of credit, and changes in the level of such concentrations.
    • The effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the institution's current portfolio.

  33. When a bank uses this approach to determine the adequacy of the allowance, there must be documentation that clearly demonstrates the estimated impact of the changes in the factors on the historical loss experience.

  34. Ratio analysis can be useful as a supplemental check or tool for evaluating the overall reasonableness of the allowances by identifying divergent trends (compared with other institutions and over time) in the relationship between the overall allowance and various measures such as to past due and non-accrual loans, and to total loans. Although these comparisons may provide a useful benchmark for judging the adequacy of the allowances, they are not by themselves a sufficient basis for determining the adequacy of the overall allowance. In particular, they do not eliminate the need for a comprehensive analysis of the loan portfolio and the factors affecting its collectibility.

      (e) Income recognition

    1. A bank should recognise interest income on an unimpaired loan on an accrual basis.

  35. Interest earned on unimpaired loans should be recognised in the income statement on a level-yield basis as it accrues using the effective interest rate method, and not as it is received in cash or becomes due. The effective interest is calculated as the rate of interest required to discount the contractual cash flows over the term of the loan to equate to the acquisition cost of the loan 32. Interest revenue is then allocated to periods over the term of the loan by applying the effective interest rate so as to achieve interest being reported at a constant yield on the recorded investment. Interest includes the amount of amortisation of any discount or premium between the cost of a loan and its amount at maturity and the amortisation of any loan fees and costs.

    1. When a loan is identified as impaired, a bank should either cease the accrual of interest or continue to accrue interest but set aside a specific allowance for the full amount of interest being accrued. Where an impaired loan is carried at the present value of expected future cash flows, interest may be accrued on the carrying amount and included in net income to reflect updated present values.

  36. Interest on impaired loans should not contribute to net income if doubt exists concerning the collectibility of loan principal or interest. Therefore, for impaired loans a bank should either cease the accrual of interest or establish specific allowances to offset the full amount of interest being accrued 33. Uncollected interest that has been previously accrued should be reversed or included in the loan balance with an adequate specific allowance established against it. For impaired loans carried at the present value of expected future cash flows, interest may be accrued and reported in net income to reflect updated present values.

  37. Unless proscribed by law, regulation or supervisory requirements, some or all of the cash interest payments received on an impaired loan may be reported as interest income on a cash basis as long as the recorded investment in the loan less any specific allowance is deemed fully collectible in a timely manner. 34

  38. An impaired loan may be restored to unimpaired status when the contractual amount of principal and interest is deemed to be fully collectible. As a general principle, this should take place when (a) none of the loan's principal and interest is due and unpaid, and the bank expects repayment of the remaining contractual principal and interest in a timely manner, or (b) when it otherwise becomes well secured and in the process of collection. For purposes of this first criteria, the bank should have received repayment of past due principal and interest, unless (1) the loan has been formally restructured (as discussed below), (2) the loan has been acquired at a discount and the discount that is considered collectible is accreted in accordance with sound principles, or (3) the borrower has resumed paying the full amount of the scheduled contractual principal and interest payments for a reasonable period 35 and all contractual payments are deemed to be collectible in a timely manner.

  39. A loan that has been restructured so as to be reasonably assured of repayment and performance according to its modified terms, may be returned to normal accrual status. Circumstances that provide evidence of a relative improvement in the borrower's condition and debt service capacity include substantial and reliable sales, lease or rental contracts obtained by the borrower or other developments that are expected to significantly increase the borrower's cash flow and debt service capacity and the borrower's commitment to repay. Also, a reasonable period of sustained payment performance, whether prior or subsequent to the date of the restructuring, is an important factor in determining whether there is reasonable assurance of repayment and performance according to the loan's modified terms.

  40. A bank's determination of the ultimate collectibility of a loan, whether for purposes of reporting interest income on a cash basis or restoring an impaired loan to unimpaired status, should be supported by a current, well documented credit evaluation of the borrower's financial condition and prospects for repayment, including consideration of the borrower's repayment performance and other relevant factors. Similarly, the returning of a restructured loan to normal accrual status should be supported by a current, well documented credit evaluation.

Footnotes

Contact us * Risk Library * Documents by Author * Committees at the Bank for International Settlement (BIS) * Sound Practices for Loan Accounting, Credit Risk Disclosure and Related Matters