WASHINGTON - Banks would be barred from reserving against unspecified losses and could only add to reserves after documenting that a loan is in or near default, under a proposal drafted by accounting standards authorities.
Written by the American Institute of Certified Public Accountants, the proposal is slated to be presented to the Financial Accounting Standards Board in September. FASB approved an outline of the statement, which was obtained by American Banker.
The professional organization of CPAs stepped in last year after federal regulators clashed over the proper level of loan loss reserves. The Securities and Exchange Commission sparked the controversy in 1998 by charging that banks use loan loss reserves as an "earnings management" tool.
The CPA trade group comes down squarely on the SEC's side.
"Losses should not be recognized before it is probable that they have been incurred, even though it may be probable based on past experience that losses will be incurred in the future," the draft states. Under generally accepted accounting principles, "additional or incremental components do not qualify for recognition under GAAP and should not be included in the allowance for loan losses."
The draft also proposes:
o Banks would have to disclose, in financial statements, how problem loans are identified and reviewed. Outstanding loans would have to be categorized by type, as defined by the bank. In each category, banks would have to disclose the portion of portfolio that is past due, 90-days past due and accruing, and non-accruing.
o Financial statements would also have to include information about banks' loan loss reserve accounts, including the balance at the beginning of the period covered by the statement; loan losses charged against income; losses charged against reserves, by loan type; recoveries of chargeoffs, by loan type; and the balance at the end of the period.
o For individual loans or pools of loans determined to be "impaired" the bank would be required to document the event or series of events that caused the downgrade.
Banking regulators are sure to oppose the CPA group's draft, but declined comment on it Friday.
The banking regulators were appalled when the SEC first tread on their turf in 1998 when it held up SunTrust Banks Inc.'s acquisition of Crestar Financial Corp. until the Atlanta-based bank agreed to restate three years' worth of earnings and reduce reserves by $100 million. The banking agencies told congressional leaders that reserve accounts provide a necessary cushion against unexpected problems.
Shrinking reserve accounts, regulators told Congress, "could have a profound effect on the continued safety and soundness of America's banking system and would not, in our judgment, be in the best interests of American taxpayers, the bank insurance funds, or shareholders."
The SEC is expected to embrace the CPA institute's findings as a way to give investors a clearer picture of a bank's fiscal health by preventing institutions from using overstuffed reserve accounts to pad their earnings in bad years.
The SEC and the banking agencies have tried, and failed, to resolve their differences.
In November 1998, all sides agreed to work together, and in March 1999 they reached a deal that many believed put the issue to rest. The SEC agreed not to require banks to restate earnings, in exchange for a promise that bank regulators would work to improve banks' disclosure of their loan loss accounting methods.
But that arrangement collapsed two months later, when in May 1999, the SEC endorsed an article by FASB officials calling for banks to only reserve for loans that have demonstrably gone bad and to remove them from the accounting for general reserves.
The SEC endorsement caused a split among bank regulators, with the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corp. all criticizing the change as dangerous to banks' safety and soundness. However, the Federal Reserve Board backed the SEC's position.
A 10-member AICPA task force was formed in March 1999 to clarify how generally accepted accounting principles apply to banks' loan loss reserves.
Specifically, it was charged with applying FASB Statement No. 5, which addresses "accounting for contingencies," to reserves for pools of loans, and FASB Statement No. 114, which addresses accounting "for impairment of a loan."
Martin F. Baumann, a partner in PricewaterhouseCoopers' insurance practice, is heading the task force, which is made up primarily of representatives of major accounting firms. David Morris, financial director at Chase Manhattan Corp., and Randall Black, account administrator with MBNA Corp., are the sole bankers in the group. Neither banker returned calls seeking comment on the draft recommendations. The Comptroller's Office, the SEC, and FASB are all represented on the task force by a non-voting observer.
Mr. Baumann said last week that the draft proposal will be submitted to the AICPA's Accounting Standards Executive Committee on July 26. He said he hopes to get the committee's approval and forward a final recommendation by Sept. 1 to FASB for review.
If FASB approves, he said, the plan would then be put out for public comment. Click here for the 34-page MS Word document.