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FASB Moves Allowance Proposal Forward

JANUARY 24, 2003


FASB Moves Allowance Proposal Forward

The Financial Accounting Standards Board (FASB) has given its initial approval for proposed changes to accounting rules that address how banks set their allowances for loan and lease losses. The draft rules, which will be released in the next few weeks, could significantly change how many banks set their allowances, eliminating the ability to put aside extra reserves in good times in anticipation of additional losses in bad times.

While the treatment of allowances is addressed in existing accounting literature, in some areas the guidance lacks clarity, which some critics believe allows creditors excessive flexibility in determining asset impairment and the amount to record for credit losses. Several years ago, disagreement between the Securities and Exchange Commission and bank regulators about how banks set their allowances arose after the SEC charged that Sun Trust had used its allowance to manage earnings. As a result, the SEC, FASB, bank regulators and the accounting industry began working together to clarify accounting guidance on allowance setting.

The draft reiterates current accounting treatment that an accrual of a loss must occur when it is probable an asset has been impaired and the amount of the loss can reasonably be estimated. A loan is impaired when, based on current information and events, it is probable a creditor will be unable to collect all amounts due according to the terms of the loan agreement. Loan impairments should not be recognized before it is probable that impairment has occurred, even though it may be expected that impairment will occur in the future.

An allowance for credit losses should be established only if current information indicates it is probable an asset has been impaired as of the balance-sheet date and the amount of the loss can be reasonably estimated. The process of estimating the allowance may result in either a specific amount or a range of possible amounts. However, a creditor should not default to the minimum amount to avoid recognizing its best estimate within the range.

The American Institute of Certified Public Accountants, which wrote the draft, plans to distribute the proposal for public comment. The FASB will vote again later on whether to issue a final statement, which would be effective for financial statements for fiscal years beginning after December 15, 2003.