COMPTROLLER OF THE CURRENCY 

BANK ACCOUNTING ADVISORY SERIES 

 September 2003 

This edition of the Bank Accounting Advisory Series expresses the Office of the Chief 

Accountant's current views on accounting topics of interest to national banks. Banks prepare 

their Consolidated Reports of Condition and Income (call reports) using generally accepted 

accounting principles (GAAP). Accordingly, this series has been revised to incorporate the 

conversion to those principles. 

These advisories are not official rules or regulations of the Comptroller of the Currency 

(OCC). Rather, they represent either interpretations by the OCC's Office of the Chief 

Accountant of generally accepted accounting principles, or OCC interpretations of regulatory 

capital requirements. 

Nevertheless, national banks that deviate from these stated interpretations may be required to 

justify those departures to the OCC. The series is intended to inform the banking community 

of the Office's views and rationale on issues of broad accounting interest. Additional releases 

will be issued in the future on emerging accounting issues that affect banks. 

This edition has been reorganized to present the topics in an order that more closely conforms 

to financial statement presentation. This is consistent with the order that material is presented 

in the Instructions to the Consolidated Reports of Condition and Income (Call Reports) and the 

AICPA Audit and Accounting Guide. 

Two new topics, Topic 2E, Loans Held for Sale, and Topic 3A, Lease Classification, have 

added to the series. In addition, the following questions have been added or revised in this 

edition: 

1B. Other than Temporary Impairment Question 4 

2E. Loans Held for Sale Questions 1 - 17 

 3A. Lease Classification Questions 1 - 6 

5A. Real Estate Questions 1 - 5 

5B. Life Insurance and Deferred Compensation Question 3 

9A. Accounting for Asset Sales and Securitizations Question 10 

 

 Zane D. Blackburn 

 Chief Accountant 

 
1

BANK ACCOUNTING ADVISORY SERIES 

TABLE OF CONTENTS 

TOPIC 1: Investment Securities 

1A. Investments in Debt and Equity Securities 

1B: Other than Temporary Impairment 

TOPIC 2: Loans

2A. Troubled Debt Restructurings 

2B. Nonaccrual Loans

2C. Loan Commitments 

2D. Loan Origination Fees and Costs 

2E. Loans Held for Sale 

2F. Loan Recoveries

TOPIC 3: Leases

3A. Lease Classification

3B. Sale and Leaseback Transactions 

3C. Lease Cancellations

TOPIC 4: Allowance for Loan and Lease Losses 

4A. Allowance for Loan and Lease Losses 

TOPIC 5: Other Assets

5A. Real Estate 

5B. Life Insurance and Related Deferred Compensation

5C. Asbestos and Toxic Removal Costs

5D. Computer Software Costs 

5E. Data Processing Service Contracts 

TOPIC 6: Liabilities 

6A. Accounting for Contingencies 

TOPIC 7: Income Taxes 

7A. Deferred Taxes

7B. Tax Sharing Arrangements 

7C. Marginal Income Tax Rates 

TOPIC 8: Capital

8A. Capital Treatment for Asset Sales and Securitizations 

8B. Sales of Stock 

8C. Quasi-Reorganizations 
2

BANK ACCOUNTING ADVISORY SERIES 

TABLE OF CONTENTS, continued 

TOPIC 9: Income and Expense Recognition 

9A. Accounting for Asset Sales and Securitizations 

9B. Credit Card Affinity Agreements 

9C. Organization Costs 

TOPIC 10: Purchase Accounting and Corporate Reorganizations

10A. Accounting for Acquisitions 

10B. Intangible Assets 

10C. Push-Down Purchase Accounting 

10D. Corporate Reorganizations 

10E. Related Party Transactions (other than reorganizations) 

TOPIC 11: Miscellaneous Accounting

11A: Asset Disposition Plans 
3

TOPIC 1: INVESTMENT SECURITIES

1A. INVESTMENTS IN DEBT AND EQUITY SECURITIES 

Facts: 

Under Statement of Financial Accounting Standards No. 115 (SFAS 115) banks must classify 

their investment securities in one of three categories: available-for-sale, held-to-maturity, or 

trading. Securities categorized as held-to-maturity are reported at amortized cost, while 

available-for-sale and trading securities are reported at fair market value. Banks include the 

net unrealized holding gains and losses on available-for-sale securities in accumulated other 

comprehensive income (loss), rather than as part of the bank's net income (loss). Net 

unrealized holding gains and losses on trading securities are reported immediately in net 

income. 

However, national banks do not include the net unrealized holding gains and losses attributable 

to available-for-sale debt securities in their calculation of regulatory capital. The net 

unrealized holding gains and losses on available-for-sale equity securities that have readily 

determinable fair values are included in Tier 2 regulatory capital calculations, up to 45 percent 

of the pretax unrealized gain. 

Question 1: (September 2001)

Should the net unrealized holding gains and losses on available-for-sale securities be included 

in the calculation of a bank's lending limit? 

Staff Response: 

The net unrealized holding gains and losses attributable to available-for-sale securities do not 

affect the computation of a bank's legal lending limit (i.e., the amount that a bank can legally 

lend to one customer). This limit is based on an institution’s Tier 1 and Tier 2 capital, 

adjusted to included the portion of the ALLL that was excluded for capital purposes. 

Question 2: (September 2001)

How should a bank account for the unrealized gains or losses on investments denominated in a 

foreign currency? 

Staff Response: 

The net unrealized holding gains and losses on available-for-sale investments denominated in a 

foreign currency should be excluded from net income and reported in accumulated other 

comprehensive income. The entire unrealized gain or loss, including both of the portions 

related to interest rate and foreign currency rate changes, is accounted for as an unrealized 
4

holding gain or loss and reported in the separate component of stockholders' equity. 

Therefore, the income statement effect of foreign currency gains and losses is deferred until the 

security is sold. 

However, the gain or loss attributable to changes in foreign currency exchange rates would be 

recognized in income, if the investment is categorized as held-to-maturity. Banks should 

follow the accounting guidance provided in Statement of Financial Accounting Standards No. 

52 for such investments. 

Question 3: (September 2001)

What is the appropriate accounting for transfers between investment categories? 

Staff Response: 

Transfers between investment categories are accounted for as follows: 

• Held-to-maturity to available-for-sale - The unrealized holding gain or loss at the date 

of the transfer shall be recognized in accumulated other comprehensive income. 

• Available-for-sale to held-to-maturity - The unrealized holding gain or loss at the date 

of transfer shall continue to be reported in accumulated other comprehensive income, 

but shall be amortized over the remaining life of the security as a yield adjustment. 

This amortization of the unrealized holding gain or loss will offset the effect on income 

of amortization of premium or discount (see question 4). 

• All transfers to the trading category - The unrealized gain or loss at the date of transfer 

shall be recognized in earnings immediately. 

• All transfers from the trading category - The unrealized gain or loss at the date of 

transfer will have already been recognized in earnings and shall not be reversed. 

Facts: 

Bank A purchased a $100 million bond on December 31, 1996 at par. The bond matures on 

December 31, 2001. Initially, the bond was placed in the available-for-sale category. 

However, on December 31, 1997, the bank decides to transfer the security to the held-tomaturity portfolio. The market value of the security on the date of transfer is $92 million. 

Question 4: (September 2001) 

How should the bank account for the transfer? 
5

Staff Response: 

The bank should record the security at its market value, $92 million, at the date of transfer. In 

essence, this becomes the security's amortized cost. The $8 million unrealized holding loss on 

the date of transfer is not recognized in net income, but is included in accumulated other 

comprehensive income. In addition, the unamortized discount of $8 million remains as an 

offset to the security's face amount of $100 million, so that the security is valued at its market 

value ($92 million) when transferred. 

Furthermore, future net income from this discount will not be affected. Although the $8 

million discount is amortized to interest income over the remaining life of the security, the 

amount in accumulated other comprehensive income separate is amortized simultaneously 

against interest income. Those entries offset each other and future income is not affected. 

Question 5: (September 2001) 

Do any restrictions exist on the types of securities that can be placed in the held-to-maturity 

category? 

Staff Response:

Generally, there are few restrictions on how bank management chooses to allocate the 

securities in their portfolio among the investment categories. However, SFAS 140 amended 

SFAS 115 to require that a security, such as an IO strip, not be accounted for as held-tomaturity, if it can be prepaid contractually or otherwise settled, so that its holder would not 

recover substantially all of its recorded investment. 

Additionally, an institution may not include a convertible debt security as held-to-maturity. 

Convertible debt bears a lower interest rate than an equivalent security without such a feature, 

because it provides the owner with potential benefits from stock price appreciation. However, 

use of this feature requires the owner to dispose of the debt security prior to maturity. 

Accordingly, the acquisition of such a security implies that the owner does not intend to hold it 

to maturity. 

No restrictions prevent a bank from pledging held-to-maturity securities as collateral for a 

loan. A bank may also enter held-to-maturity securities into a repurchase agreement if the 

agreement is not effectively a sale. 

Question 6: (September 2001)

How should banks account for investments in mutual funds under SFAS 115? 
6

Staff Response:

By investing in a mutual fund, the bank gives up the ability to control whether the underlying 

securities are held to maturity. Therefore, at acquisition and each subsequent reporting date, 

the bank must evaluate whether the investment should be classified as "trading" or "availablefor-sale." A mutual fund bought principally for sales of the investment in the near term should 

be classified as trading and marked to market through net income. Otherwise, it should be 

classified as available-for-sale and recorded at its fair value. Net unrealized holding gains and 

losses on available-for-sale investments included in accumulated other comprehensive income 

until they are realized. 

Question 7: (September 2001) 

How should gains and losses be reported when the mutual fund investments are sold? 

Staff Response:

Realized gains and losses should be included in determining net income for the period in which 

they occur. They should be recorded as "Other noninterest income" or "Other noninterest 

expense," as appropriate. If mutual fund investments classified as available-for-sale are sold, 

the component in accumulated other comprehensive income should be adjusted to remove any 

previously included amounts applicable to them. 

Question 8: (December 2001) 

When may a bank sell held-to-maturity securities and not "taint" the portfolio? 

Staff Response: 

SFAS 115 establishes the following "safe harbors" under which held-to-maturity securities may 

be sold without tainting the entire portfolio: 

• Evidence of a significant deterioration in the issuer's creditworthiness. 

• A change in the tax law that eliminates or reduces the tax-exempt status of interest on 

the debt security (but not a change in tax rates). 

• A major business combination or disposition that necessitates the sale of the securities 

to maintain the bank's existing interest rate risk position or credit risk policy. 

• A change in statutory or regulatory requirements that significantly modifies either the 

definition or level of permissible investments that may be held. 

• A significant increase in regulatory capital requirements that causes the bank to 

downsize. 

• A significant increase in the risk weights of debt securities for risk-based capital 

purposes. 
7

There is also a limited exclusion for certain unusual events. 

Question 9: (December 2001)

What are the ramifications of selling debt securities that have been classified as held-tomaturity and that do not meet any of the "safe harbor" exemptions set forth in Question 8? 

Staff Response: 

A sale outside of the "safe harbor" exemptions would "taint" the portfolio. Once a portfolio is 

tainted, all remaining securities in the existing held-to-maturity portfolio must be transferred to 

the available-for-sale category. In addition, future purchases of securities must be classified as 

available-for-sale. Consistent with the views of the Securities and Exchange Commission, the 

prohibition from using held-to-maturity will apply for a two-year period. 

As available-for-sale securities are carried at fair value in the financial statements, the transfer 

of tainted held-to-maturity securities would result in an unrealized holding gain or loss at the 

date of transfer. The unrealized holding gain or loss should be included in other 

comprehensive income, a separate component of stockholders equity. However, amounts 

included in other comprehensive income are excluded in the determination of the bank's 

regulatory capital. 

In addition, SFAS 115 requires certain disclosures for sales or transfers of securities out of the 

held-to-maturity category. Specifically, the amortized cost, realized or unrealized gain or loss, 

and circumstances leading to the sale or transfer of held-to-maturity securities must be 

disclosed in the bank's financial statements. For call report purposes, the amortized cost of 

securities sold or transferred from the held-to-maturity category should be included on 

Schedule RC-B, Memoranda. 

Facts: 

A bank sells a portion of its investment securities that were included in the held-to-maturity 

portfolio. The securities were sold to gain additional liquidity. 

Question 10: (December 2001)

Would this sale of securities from the held-to-maturity portfolio "taint" the remaining securities 

in the portfolio? 

Staff Response: 

Yes. Except for the "safe harbor" exceptions stated in Question 8, transfers out of the held-tomaturity portfolio taint the portfolio. Sales for liquidity reasons are excluded from the SFAS 
8

115 "safe harbor" exceptions. As a result, the held-to-maturity portfolio would be considered 

tainted as of the sale date. 

Facts: 

In anticipation of converting from a taxable corporation to Subchapter S status, a bank sells 

some tax exempt municipal securities that had been included in the held-to-maturity portion of 

the investment portfolio. This resulted because the bank will no longer benefit from the taxfree status of the municipal securities and the individual shareholders do not need the taxexempt income. 

Question 11: (December 2001) 

Does the sale of these securities taint the entire held-to-maturity portfolio? 

Staff Response: 

Yes, selling securities from the held-to-maturity portfolio, because of a change in tax status of 

the bank to Subchapter S is not one of the "safe harbor" exceptions included in SFAS 115. 

Although SFAS 115 does provide an exception for changes in tax law that eliminate or reduce 

the tax-exempt status of interest, this exception does not extend to changes in the tax status of 

the bank. Accordingly, the held-to-maturity portfolio is tainted. 

This change resembles a change in tax rates more than a change in tax law. Therefore, it is 

not covered by the "safe harbor" exceptions in SFAS 115. 

Facts: 

A bank purchases trust preferred securities using its legal lending limit authority. 

Question 12: (September 2002) 

Should these securities be reported as loans or securities on the bank's financial statements? 

Staff Response: 

The trust preferred securities should be classified and reported as securities on the bank's 

financial statements, including call reports. The legal means for acquiring the security is not 

relevant for the accounting treatment. The financial statement classification is governed by 

GAAP, not the legal authority under which the assets are purchased. The trust preferred 

securities are debt securities subject to the accounting requirements of SFAS 115. 
9

Facts: 

In 1998 Bank A purchased $10 million of the 30 year capital securities of the Trust of Bank B. 

These securities have a fixed distribution (interest) rate, quarterly payment dates and a fixed 

maturity date. In accordance with SFAS 115, the Bank has classified these securities as 

available for sale debt securities. 

The Trust exists for the sole purpose of investing in junior subordinated deferrable interest 

debentures of Bank B. Accordingly, the ability of the Trust to pay the quarterly distribution is 

based solely on Bank B's ability to pay interest on the debentures. Interest on the debentures is 

paid quarterly, unless deferred by Bank B. The agreements allow Bank B to defer interest 

payments on the debentures for a period of up to 20 consecutive quarters without creating a 

legal default. If the interest payments on the debentures are deferred, the distribution payments 

on the capital securities are also deferred, without creating a legal default. However, the 

payments are cumulative. 

During 2001, Bank B began experiencing financial difficulties. Accordingly, in June of 2001 

Bank B announced that the interest payment on the debentures and the Trust's distribution 

payment on the capital securities scheduled for July 31 will be deferred. These payments will 

be deferred for the last two quarters of 2001. Resumption of payments in 2002 is dependent 

upon Bank B returning to profitable operations. Further, the capital securities are publicly 

traded and selling at a discount in excess of 25 percent of par value. 

Question 13: (September 2002) 

Should the accrual of interest income be discontinued on a debt type security (trust preferred) 

that is not paying scheduled interest payments, but is not in legal default according to the terms 

of the instrument? 

Staff Response: 

Bank A should discontinue the accrual of income on its investment in the Trust's capital 

securities and include the securities as a nonaccrual asset on Schedule RC-N of the call report. 

Previously accrued interest should be reversed. 

The glossary instructions to the call report set forth the criteria for placing an asset on 

nonaccrual status. Two of those criteria are: (1) principal or interest has been in default for a 

period of 90 days or more unless the asset is both well secured and in the process of collection, 

or (2) full payment of principal and interest is not expected. 

For the first criteria, both the 2001 third and fourth quarter distribution (interest) payments will 

not be made because of the financial condition and operating losses of Bank B. Payments may 

resume in 2002, but only if Bank B becomes profitable. Accordingly, there is no assurance 

that Bank A will receive these or future payments. 
10

While it is true that a legal default has not occurred, the staff believes that interest should not 

be accrued (for a period of up to five years) on an asset that is impaired or when the financial 

condition of the borrower is troubled. 

Although the nonaccrual policies of the banking agencies are not codified in GAAP, they are 

followed by financial institutions in the preparation of their financial statements. This has 

resulted in these policies being GAAP even though not specifically included in the accounting 

literature. 

Further, this 30-year debt investment is classified by Bank A as available for sale and is 

currently trading at a substantial discount from par. Therefore, in addition to the uncertainty 

about the collection of the income, concern exists about recovery of the principal. 

Question 14: (May 2003) 

Does the decline in value in this trust preferred security raise any other issues? 

Staff Response: 

The issue of whether the impairment in the trust preferred security should be considered as an 

other than temporary impairment must be addressed. Impairment of the security should be 

analyzed based on the criteria set forth in SFAS 115; the FASB Implementation Guide to SFAS 

115; and AICPA Statement of Auditing Standards No. 92. When the fair value of a security 

remains significantly below its cost basis for a substantial period of time, this guidance requires 

that an assessment of other than temporary impairment be made. See Topic 6B for a 

discussion of other than temporary impairment. 
11

1B. OTHER THAN TEMPORARY IMPAIRMENT 

Question 1: (June 2003) 

What is other than temporary impairment? 

Staff Response: 

SFAS 115 requires institutions to determine whether a decline in fair value below amortized 

cost in either available-for-sale or held-to-maturity securities is other than temporary. For 

example, if it is probable that the investor will be unable to collect all the amounts due 

according to the contractual terms of a debt security not impaired at acquisition, an other than 

temporary impairment should be considered to have occurred. Refer to Question 2 for 

guidance on making the assessment for other than temporary impairment. 

Question 2: (June 2003) 

How do you assess a security for other than temporary impairment? 

Staff Response: 

Under GAAP, there are two models to assess other than temporary impairment. EITF Issue 

No. 99-20 provides guidance for securitized financial assets that are not of high credit quality 

and which can be contractually prepaid or settled in a way that the holder would not recover 

substantially all of its recorded investment. Generally an other than temporary impairment 

should be recognized for these securities if the fair value of the investment is less than its 

carrying amount, and an adverse change in the estimated timing or amount of cash flows on the 

security has occurred since the cash flows were previously estimated. 

 

For all other securities, institutions should refer to the Statement on Auditing Standards No. 92 

and the SEC Staff Accounting Bulletin No. 59 which provide criterion that is helpful in making 

the other than temporary impairment assessment. This criterion considers factors used to 

evaluate the security, including but not limited to, the length of time and extent to which the 

fair value has been less than cost, the financial condition and industry environment of the 

issuer, downgrades of the security by rating agencies, and the intent and ability of the bank to 

hold the security for a period of time sufficient to allow for any anticipated recovery in fair 

value. 

Question 3: (June 2003) 

If a security’s decline is deemed to be other than temporary, how is the security accounted for? 
12

Staff Response: 

An institution should write the investment down to fair value. This write-down to fair value 

must be recognized in earnings in the period it occurred even if it has not been sold. Other 

than temporary impairment results in a new (i.e., lower) cost basis of the security. The new 

cost basis is not adjusted by subsequent recoveries of value at a later date. 

Question 4: (September 2003) 

What is an appropriate fair value? 

Staff Response: 

Fair value is the amount at which an asset could be bought or sold in a current transaction 

between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices 

in active markets are the best evidence of fair value and should be used as the basis for the 

measurement, if available. If a quoted market price is not available, the estimate of fair value 

should be based on the best information available in the circumstances. The estimate of fair 

value should consider prices for similar assets or similar liabilities and the results of valuation 

techniques to the extent available in the circumstances. This definition is consistent with 

SFAS 107. 
13

TOPIC 2: LOANS 

2A. TROUBLED DEBT RESTRUCTURINGS 

 

Facts: 

Borrower A cannot service his $100,000 loan from the bank. The loan is secured and bears 

interest at 10 percent, which is also the current market rate. On June 1, 1999, the loan is 

restructured, with interest-only payments of 5 percent required for two years and a final 

payment of $105,000 (principal plus interest at 5 percent) required at the end of the third year. 

The present value of the expected payments under the restructured terms, discounted at 10 

percent (the original loan interest rate), is $87,500. The loan is neither collateral dependent 

nor readily marketable. 

Question 1: (September 2001) 

How should a bank account for this restructuring? 

Staff Response: 

This modification of terms should be accounted for in accordance with Statements of Financial 

Accounting Standards Nos. 15, 114 and 118 (SFAS 15, 114 and 118), which require that 

impairment be measured based on the present value of the expected future cash flows, 

discounted at the effective interest rate in the original loan agreement. (However, as a 

practical expedient, impairment may be measured at the loan's observable market price, or the 

fair value of the collateral, if the loan is collateral dependent.) If the measure of the impaired 

loan is less than the recorded investment in the loan, the impairment is recognized through a 

valuation allowance. Accordingly, in this example, the difference between the present value of 

the payments ($87,500) of the restructured loan, discounted at the loan’s original rate of 

interest, and the recorded value ($100,000) is recognized through a valuation allowance 

($12,500). 

Facts: 

Same facts as question 1, except that Borrower A transfers the collateral to a new borrower 

(Borrower B) not related to Borrower A. The bank accepts Borrower B as the new debtor. 

The loan with Borrower B provides for interest-only payments of 5 percent for two years and a 

final payment of $105,000 (principal plus interest at 5 percent) at the end of the third year. 

The fair value of the loan, discounted at a current market rate of interest, is $87,500. 

Question 2: (September 2001)

How should a bank account for this restructuring? 
14

Staff Response: 

SFAS 15 requires that the receipt of a loan from a new borrower be accounted for as an 

exchange of assets. Accordingly, the asset received (new loan) is recorded at its fair value 

($87,500 in this example). In question 1, which involved a modification of terms, the 

impairment was recorded through a valuation allowance, whereas, here a loss is recognized 

and the new loan recorded at its fair market value. This conclusion is based on FASB 

Emerging Issues Task Force Consensus No. 87-19. 

Facts: 

A bank makes a construction loan to a real estate developer. The loan is secured by a project 

of new homes. The developer is experiencing financial difficulty and has defaulted on the 

construction loan. To assist him in selling the homes, the bank agrees to give the home buyers 

permanent financing at a rate that is below the market rate being charged to other new home 

buyers. 

Question 3: 

Must a loss be recorded on the permanent loan financings? 

Staff Response: 

Yes. The bank is granting a concession it would not have allowed otherwise, because of the 

developer’s financial condition. Therefore, this transaction is a troubled debt restructuring. 

Furthermore, it represents an exchange of assets. The permanent loans provided to the home 

buyers must be recorded at their fair value. The difference between fair value and recorded 

value in the loan satisfied is charged to the allowance for loan and lease losses. 

Facts: 

Assume that the real estate developer in question 3 has not yet defaulted on the construction 

loan. He is in technical compliance with the loan terms. However, because of the general 

problems within the local real estate market and specific ones affecting this developer, the bank 

agrees to give the home buyers permanent financing at below market rates. 

Question 4: 

Must a loss be recorded on these permanent loan financings? 

Staff Response: 

Yes. Even though the loan is not technically in default, the staff believes that the concession 

was granted because of the developer's financial difficulties. SFAS 15 does not require that a 
15

debtor's obligations be in default for a troubled debt restructuring to occur. It only requires 

that the creditor, for economic or legal reasons related to the debtor's financial difficulties, 

grant a concession it would not have permitted otherwise. 

Therefore, this restructuring would be accounted for as an exchange of assets under the 

provisions of SFAS 15. Again, the permanent loans provided to the home buyers must be 

recorded at their fair value. 

Facts:

A borrower owes the bank $100,000. The debt is restructured because of the borrower's 

precarious financial position and inability to service the debt. In satisfaction of the debt, the 

bank accepts preferred stock of the borrower with a face value of $10,000, but with only a 

nominal market value. The bank agrees to reduce the interest rate from 10 percent to 5 percent 

on the remaining $90,000 of debt. The present value of the combined principal and interest 

payments due over the next five years, discounted at the effective interest rate in the original 

loan agreement, is $79,000. 

Question 5: (September 2001)

How should the bank account for this transaction? 

Staff Response: 

Securities (either equity or debt) received in exchange for cancellation or reduction of a 

troubled loan should be recorded at fair (generally market) value. However, value should be 

assigned to the securities only when they have demonstrated worth. Such a value may not be 

possible to demonstrate, because of the borrower's precarious financial condition. 

Accordingly, a fair value of zero would not be unusual in such cases. 

The recorded amount of the debt ($100,000) is reduced by the demonstrable fair value of the 

preferred stock received. Any impairment in the remaining recorded balance of the 

restructured loan would be measured according to the requirements of SFAS 114. In this case, 

if the securities were valued at zero, the remaining loan balance of $100,000 would be 

compared with the present value of the expected future payments, discounted at the effective 

interest rate in the original loan agreement. An allowance of $21,000 is established through a 

provision for loan and lease losses. This represents the difference between the recorded 

balance ($100,000) and the present value of the expected future payments ($79,000), 

discounted at 10 percent (the original loan interest rate). 

Question 6: (September 2001)

Assume that the preferred stock has a determinable fair value of $6,000. How would a bank 

account for the transaction? 
16

Staff Response: 

The recorded value of the loan ($100,000) would be reduced by the fair value of the preferred 

stock received ($6,000). The remaining loan balance ($94,000) would be compared with the 

present value of the future payments of $79,000, and an allowance of $15,000 would be 

recorded. 

Facts:

Assume a borrower owes the bank $100,000, which is secured by real estate. The loan is 

restructured to release the real estate lien and requires no principal or interest payments for 10 

years. At the end of the tenth year, the borrower will pay the $100,000 principal. No interest 

payments are required. 

As security, the borrower pledges a $100,000 zero coupon bond that matures at the same time 

the loan is due (10 years). The borrower purchased the bond with funds borrowed from 

another financial institution. The real estate released in this restructuring was used as security 

to obtain those funds. The current fair value of the zero coupon bond is $40,000. 

Question 7: 

How should the bank account for this restructuring? 

Staff Response: 

In essence, the bank has received the security (zero coupon bond) as satisfaction of the loan. 

Because loan repayment is expected only from the proceeds of the security, the bank has 

effectively obtained control of the collateral. Accordingly, the loan should be removed from 

the books of the bank, and the security should be recorded in the investment account at its fair 

value ($40,000). The $60,000 difference is charged to the allowance for loan and lease losses. 

This conclusion is consistent with FASB Emerging Issues Task Force Consensus No. 87-18. 

Facts: 

A $10 million loan is secured by income producing real estate. Cash flows are sufficient to 

service only a $9 million loan at a current market rate of interest. The loan is on nonaccrual. 

The bank restructures the loan by splitting it into two separate notes. Note A is for $9 million. 

It is collateral dependent and carries a current market rate of interest. Note B is for $1 million 

and carries a below-market rate of interest. The bank charges off all of Note B, but does not 

forgive it. 

Question 8:

Can the bank return Note A to accrual status? 
17

Staff Response: 

Yes, but only if all of the following conditions are met: 

• The restructuring qualifies as a troubled debt restructuring (TDR) as defined by SFAS 

15. In this case, the transaction is a TDR, because the bank granted a concession it 

would not consider normally, a below market rate of interest on Note B. 

• The partial loan charge off is supported by a good faith credit evaluation of the loan(s). 

The charge off should also be recorded before or at the time of the restructuring. 

Under SFAS 5, a partial charge off may be recorded only if the bank has performed a 

credit analysis and determined that a portion of the loan is uncollectible. 

• The ultimate collectibility of all amounts contractually due on Note A is not in doubt. 

If such doubt exists, the loan should not be returned to accrual status. 

• There is a period of satisfactory payment performance by the borrower (either 

immediately before or after the restructuring) before the loan (Note A) is returned to 

accrual status. 

If any of these conditions are not met, or the terms of the restructuring lack economic 

substance, the restructured loan should continue to be accounted for and reported as a 

nonaccrual loan. 

Question 9: 

Can Note A be returned to accrual status immediately or is a six-month period of performance 

required? 

Staff Response:

AICPA Practice Bulletin 5 (PB 5) requires some period of performance for loans to troubled 

countries. The staff generally believes this guidance should also apply to domestic loans. 

Accordingly, the bank normally may not return Note A to accrual status until or unless this 

period of performance is demonstrated, except as described in question 10. 

However, neither PB 5 nor regulatory policy specify a particular period of performance. This 

will depend on the individual facts and circumstances of each case. Generally, we believe this 

period would be at least six months for a monthly amortizing loan. 
18

Question 10: (September 2001)

The previous response indicates that performance is required before a formally restructured 

loan can be returned to accrual status. When can a restructured loan be returned to accrual 

status without performance? 

Staff Response: 

The staff continues to believe that evidence of performance under the restructured terms is one 

of the most important considerations in assessing the likelihood of full collectibility of the 

restructured principal and interest. However, in rare situations, the TDR may coincide with 

another event that indicates a significant improvement in the borrower's financial condition and 

ability to repay. These might include substantial new leases in a troubled real estate project, 

significant new sources of business revenues (i.e., new contracts), and significant new equity 

contributed from a source not financed from the bank, etc. A preponderance of this type of 

evidence could obviate the need for performance or lessen the period of performance needed to 

assure ultimate collectibility of the loan. 

Question 11: 

Given that evidence of performance under the restructured terms will likely be relied upon to 

determine whether to place a TDR on accrual status, can performance prior to the restructuring 

be considered? 

Staff Response: 

Performance prior to the restructuring should be considered in assessing whether the borrower 

can meet the restructured terms. Often the restructured terms reflect the level of debt service 

that the borrower has already been making. If this is the case, and the borrower will likely be 

able to continue this level of performance and fully repay the new contractual amounts due, 

continued performance after the restructuring may not be necessary before the loan is returned 

to accrual status. 

Question 12: (September 2001)

How would the absence of an interest rate concession on Note B affect the accrual status of 

Note A? 

Staff Response: 

If the bank does not grant an interest rate concession on Note B nor make any other 

concessions, the restructuring would not qualify as a TDR. Accordingly, SFAS 15 would not 

apply. 
19

In substance, the bank has merely charged down its $10 million loan by $1 million, leaving 

a $9 million recorded loan balance. The remaining balance should be accounted for and 

reported as a nonaccrual loan. Partial charge off of a loan does not provide a sufficient basis 

by itself for restoring the loan to accrual status. 

Furthermore, the bank should record loan payments as principal reductions as long as any 

doubt remains about the ultimate collectibility of the recorded loan balance. When that doubt 

no longer exists, interest payments may be recorded as interest income on the cash basis. 

Question 13: 

Assume the bank forgives Note B. How would that affect the accounting treatment?

Staff Response: 

Forgiving debt is a form of concession to the borrower. Therefore, a restructuring that 

includes the forgiveness of debt would qualify as a TDR and SFAS 15 would apply. It is not 

necessary to forgive debt for SFAS 15 to apply, as long as some other concession is made. 

Question 14: (September 2001) 

Assume that Note B was not charged off, but was on nonaccrual. How would that affect the 

accrual status and call report TDR disclosure for Note A? 

Staff Response: 

When a loan is restructured into two or more notes in a TDR, the restructured loans should be 

evaluated separately. However, since the restructured loans are supported by the same source 

of repayment, both would be reported as nonaccrual. Additionally, because the interest rate on 

Note B was below a market rate, both notes would be reported in the TDR disclosures on the 

call report. 

Facts: 

Assume, as discussed in question 14, that Note B was not charged off prior to or at the time of 

restructuring. Also, expected cash flows will not be sufficient to repay Notes A and B at a 

market rate. The cash flows would be sufficient to repay Note A at a market rate. 

Question 15: (September 2001)

When appropriate allowances, if necessary, have been established for Note B, would Note A 

be reported as an accruing market-rate loan and Note B as nonaccrual? 
20

Staff Response: 

No. Even after a TDR, two separate recorded balances, supported by the same source of 

repayment, should not be treated differently for nonaccrual or TDR disclosure. All loans must 

be disclosed as nonaccrual, unless the combined contractual balance and the interest 

contractually due is expected to be collected in full. 

Facts: 

A bank negotiates a troubled debt restructuring on a partially charged-off real estate loan. The 

borrower has been unable to make contractually owed payments, sell the underlying collateral 

at a price sufficient to repay the obligation fully, or refinance the loan. The bank grants a 

concession in the form of a reduced contractual interest rate. In the restructuring, the bank 

splits the loan into two notes that require final payment in five years. The bank believes that 

market conditions will improve by the time the loan matures, enabling a sale or refinancing at 

a price sufficient to repay the restructured obligation in full. The original interest rate was 9 

percent. 

Note A carries a 9 percent contractual interest rate. Note B, equal to the charged off portion, 

carries a zero percent rate. Note A requires that interest be paid each year at a rate of 5 

percent, with the difference between the contractual rate of 9 percent and the payment rate of 5 

percent capitalized. The capitalized interest and all principal are due at maturity. 

Additionally, interest on the capitalized interest compounds at the 9 percent rate to maturity. 

Question 16: 

If the borrower makes the interest payments at 5 percent as scheduled, can Note A be on 

accrual status? 

Staff Response: 

No. The terms of the restructured loan allow for the deferral of principal payments and 

capitalization of a portion of the contractual interest requirements. Accordingly, these terms 

place undue reliance on the balloon payment for a substantial portion of the obligation. 

Generally, capitalization of interest is precluded when the creditworthiness of the borrower is 

in question. Other considerations about the appropriateness of interest capitalization are: 

• Whether interest capitalization was included in the original loan terms to compensate 

for a planned temporary lack of borrower cash flow, or; 

• Whether similar loan terms can be obtained from other lenders. 
21

In a TDR, the answer to each of these considerations is presumed to be negative. First, the 

bank, in dealing with a troubled borrower, must overcome the doubt associated with the 

borrower's inability to meet the previous contractual terms. To do this, objective and 

persuasive evidence must exist for the timing and amount of future payments of the capitalized 

interest. 

In this case, the repayment of the capitalized interest is deferred contractually until the 

underlying loan is refinanced or sold. A refinancing, or sale at a price adequate to repay the 

loan, was not possible at the time of restructuring. The bank has offered no objective evidence 

to remove the doubt about repayment that existed prior to the restructuring. It is relying solely 

on a presumption that market conditions will improve and enable the borrower to repay the 

principal and capitalized interest. Accordingly, the timing and collectibility of future payments 

of this capitalized interest are uncertain. 

Second, the temporary lack of cash flow is generally the reason for a TDR. Thus, 

capitalization of interest was not provided for in the original loan terms. Finally, the 

concession was granted, because of the borrower's inability to find other market financing to 

repay the original loan. 

Some loans, such as this example, are restructured to reduce periodic payments by deferring 

principal payments, increasing the amortization term relative to the loan term, and/or 

substantially reducing or eliminating the rate at which interest contractually due is periodically 

paid. These provisions create or increase the balloon payment significantly. Sole reliance on 

those types of payments does not overcome the doubt as to full collectibility that existed prior 

to the restructuring. Other evidence should exist to support the probability of collection before 

return to accrual status. The staff believes that this response is consistent with Appendix B of 

AICPA Practice Bulletin No. 6. 

In this example, the conditions for capitalization of interest were not met, and sole reliance for 

the full repayment was placed on the sale/refinancing. Accordingly, Note A should be 

maintained on nonaccrual status. To the extent that the recorded principal remains collectible, 

interest may be recognized on a cash basis. 

Facts:

A bank restructures a loan by forgiving a portion of the loan principal due and charging it off. 

Additionally, the bank requires that, should the borrower's financial condition recover, the 

borrower must pay a sum in addition to the principal and interest due under the restructured 

terms. 

Question 17: 

For the restructured loan to be eligible for return to accrual status, must the contingent 

payment also be deemed fully collectible? 
22

Staff Response: 

No. Contingent cash payments should not be considered in assessing the collectibility of 

amounts contractually due under the restructured terms. 

Facts: 

A $10 million loan is secured by income-producing real estate. As a result of a previous $1 

million charge-off, the recorded balance is $9 million. Cash flows are sufficient to service 

only $9 million of debt at a current market rate of interest. The loan is classified as nonaccrual 

and is restructured. However, the bank protects its collateral position by restructuring the loan 

into two separate payment "tranches," rather than two separate notes. Tranche A requires $9 

million in principal payments and carries a current market rate of interest. Tranche B requires 

$1 million in principal payments and carries a below-market rate of interest. 

Question 18: 

Can the bank return Tranche A to accrual status? 

Staff Response: 

The use of one note with two payment tranches, instead of two separate notes, does not prevent 

Tranche A from being returned to accrual status, as long as it meets the conditions set forth in 

the staff response to question 8. 

Facts:

A bank has a commercial real estate loan secured by a shopping center. The loan, which was 

originated 13 years ago, provides for a 30-year amortization with interest at Prime plus 2 

percent. Two financially capable guarantors, A and B, each guarantee 25 percent of the debt. 

The shopping center lost its anchor tenant two years ago and is not generating sufficient cash 

flow to service the debt. The guarantors have been providing funds to make up the shortfall. 

Because of the decrease in the cash flow, the borrower and guarantors asked the bank to 

modify the loan agreement. The bank agrees to reduce the interest rate to Prime, and in 

return, both guarantors agreed to increase their guarantee from 25 percent to 40 percent each. 

The guarantors are financially able to support this guarantee. However, even with the 

increased guarantee, the borrower could not have obtained similar financing from other sources 

at this rate. The fair market value of the shopping center is approximately 90 percent of the 

current loan balance. 
23

Question 19: (September 2002) 

Should the debt modification be reported as a troubled debt restructuring (TDR) since only the 

interest rate was reduced? 

Staff Response:

SFAS 15 states that a restructuring of a debt is a TDR if a creditor for economic or legal 

reasons related to the debtor’s financial difficulties grants a concession that it would not 

otherwise consider. This may include a reduction of the stated interest rate for the remaining 

original life of the debt. However, a consensus was reached in FASB Emerging Issues Task 

Force (EITF) Issue 02-4 that no single characteristic or factor, taken alone, determines whether 

a modification is a TDR. 

EITF 02-4 establishes a model to determine whether a modification or exchange of debt 

instruments falls within the scope of SFAS 15. The model first determines whether the 

borrower is experiencing financial difficulties, and if so, whether the creditor has granted a 

concession. If both factors are present, the restructuring will qualify as a TDR. 

The consensus lists six factors that indicate the debtor is experiencing financial difficulties. 

These factors are: 

• Default. 

• Bankruptcy. 

• Doubt as to whether the debtor will continue as a going concern. 

• De-listing of securities. 

• Insufficient cash flows to service the debt. 

• Inability to obtain funds from other sources at a market rate for similar debt to a nontroubled borrower. 

In this case, the borrower was experiencing financial difficulties, because the primary source 

of repayment (cash flows from the shopping center) was insufficient to service the debt, 

without reliance on the guarantors. Further, it was determined that the borrower could not 

have obtained similar financing from other sources at this rate, even with the increase in the 

guarantee percentage. The capacity of the guarantor to support this debt may receive favorable 

consideration when determining loan classification or allowance provisions. However, since 

the borrower was deemed to be experiencing financial difficulties and the bank granted an 

interest rate concession it normally would not have given, this restructuring would be 

considered a TDR. 
24

2B. NONACCRUAL LOANS 

Facts: 

The bank made an equipment loan and advanced funds in the form of an operating loan. Both 

loans have been placed on nonaccrual status, and a portion of the equipment loan has been 

charged off. The loan balances are classified, and doubt as to full collectibility of principal and 

interest exists. 

Question 1: (September 2001)

Can a portion of the payments made on these loans be applied to interest income? 

Staff Response: 

No. Interest income should not be recognized. The instructions to the call reports require 

that, when doubt exists about the ultimate collectibility of principal, wholly or partially, 

payments received on a nonaccrual loan be applied to reduce principal to the extent necessary 

to eliminate such doubt. 

Placing a loan in a nonaccrual status does not necessarily indicate that the principal is 

uncollectible, but it generally warrants revaluation. In this situation, because of doubt of 

collectibility, recognition of interest income is not appropriate. 

Facts: 

Assume the same facts as in question 1, except that cash flow projections support the 

borrower's repayment of the operating loan in the upcoming year. However, collectibility of 

the equipment loan is in doubt, because of the borrower's inability to service the loan and 

insufficient collateral values. 

Question 2: 

Can the bank accrue interest on the operating loan, even though the equipment loan remains on 

nonaccrual status? 

Staff Response:

Loans should be evaluated individually. However, the borrower's total exposure must be 

considered before concluding that doubt has been removed over the collectibility of either loan. 

Additionally, the analysis should consider a time period beyond the first year. 
25

Projections indicate that the borrower will be able to service only one of the loans for one 

year. Therefore, doubt still exists about total borrower exposure over the long term. 

Accordingly, interest recognition generally is inappropriate. 

Facts:

The bank has a loan on nonaccrual, and a portion of the principal has been charged off. The 

remaining principal has been classified as substandard, because of the borrower's historical 

nonperformance and questionable ability to meet future repayment terms. Collateral values 

covering the remaining principal balance are adequate. 

Question 3: (September 2001)

Since the collateral is sufficient, can payments be applied to income on the cash basis? 

Staff Response:

In determining the accounting for individual payments, the bank must evaluate the loan to 

determine whether doubt exists about the ultimate collectibility of principal. The overall 

creditworthiness of the borrower and the underlying collateral values should be considered. 

For example, doubt about collectibility of troubled loans often exists when regular payments 

have not been made, even when a loan is fully collateralized. Collateral values are not 

sufficient, by themselves, to eliminate the issue of ultimate collectibility of principal. 

When the bank can demonstrate doubt about the ultimate collectibility of principal no longer 

exists, subsequent interest payments received may be recorded as interest income on the cash 

basis. Banks may record the receipt of the contractual interest payment on a partially chargedoff loan by allocating the payment to interest income, reduction of principal, and recovery of 

prior charge-offs. Banks may also choose to report the receipt of this contractual interest as 

either interest income, reduction of principal, or recovery of prior charge-offs, depending on 

the condition of the loan, consistent with other accounting policies that conform to GAAP. 

Facts:

A loan is currently on nonaccrual status as a result of being delinquent in principal and interest 

payments for a period exceeding 90 days. The estimated uncollectible portion of the loan has 

been charged off. The remaining balance is expected to be collected. 

Question 4: 

Since the recorded balance of the loan is expected to be collected in full, can it be returned to 

accrual status? 
26

Staff Response:

No. The Glossary instructions to the call report preclude the accrual of interest for any asset 

for which full payment of contractual interest or principal is not expected. Therefore, accrual 

of interest on the loan would not be appropriate. 

Facts:

Bank A purchases a loan with a face value of $100,000. The loan is on nonaccrual status. 

Because of the risk involved and other factors, the loan is purchased at a substantial discount of 

$50,000. 

Question 5: 

Can Bank A accrete the discount to income consistent with Accounting Principles Board 

Opinion No. 21? 

Staff Response:

Accretion of discount may be appropriate when the loan is on a nonaccrual basis. AICPA 

Practice Bulletin 6, "Amortization of Discounts on Certain Acquired Loans," (PB 6) permits 

accretion of discount on certain acquired loans when it is not probable that all contractual 

principal and interest will be collected. 

Accretion of the discount is appropriate if the sum of the acquisition amount of the loan and the 

discount to be accreted does not exceed the undiscounted future cash collections that are both 

reasonably estimable and probable. A loan on nonaccrual status on the date acquired is 

presumed to fail this requirement. However, this presumption may be overcome if other 

factors indicate that collection of the acquisition amount plus the discount is probable, and the 

amounts and timing of collections can be estimated reasonably. 

Considerations in assessing collectibility include: 

• The financial condition of the borrower. 

• Substantial borrower equity in the underlying collateral. 

• Historical cash flows from the acquired loan. 

• The prospect of near-term cash flows. 

• Other repayment sources (i.e., irrevocable letters of credit, personal guarantees, and 

takeout commitments, etc.). 

• Cash flows expected to be generated by the assets underlying the loan. 
27

In the example, the collectibility of the acquisition amount of $50,000 should be assessed. If 

the borrower can be reasonably expected to make periodic payments totaling $75,000, Bank A 

could accrete $25,000 of the discount to income. Discount accretion should be taken over the 

period that the payments are probable of collection using the interest method. However, the 

amounts and timing of collections must be reasonably estimable and probable. Otherwise, 

payments should be applied to reduce the acquisition amount of the loan. 

Facts:

Continuing with the example, Bank A pays $50,000 for a loan with a face value of $100,000. 

The loan is on nonaccrual status. The bank renegotiates the loan with the borrower. The new 

loan has a face value of $125,000, and the borrower receives $25,000 of new funds. In return, 

the borrower pledges additional collateral, the value of which is sufficient to support the face 

amount of the new loan. 

Question 6: 

Upon refinancing the loan, may Bank A record a $50,000 gain (the amount of the discount)? 

Staff Response:

No, it is not appropriate to recognize any gain on this refinancing. Further, the loan should 

remain on nonaccrual status until the borrower has demonstrated the ability to comply with the 

new loan terms. Additionally, Bank A must assess the appropriateness of accreting the 

discount in accordance with the requirements of PB 6. When the borrower has demonstrated 

the ability to perform, the loan can be returned to accrual status. At that time, if previously 

precluded from doing so, the bank would also begin to accrete the discount to income. 

Facts:

A bank has two loans to a real estate developer for two different projects. Loan A is secured 

by a fully leased office building. The collateral value exceeds the loan obligation. Loan B is 

secured by an apartment building with relatively few units leased to-date. A collateral shortfall 

exists relative to the loan obligation. The obligors are separate corporations wholly owned by 

the developer. However, there is no cross-collateralization of the notes and no personal 

guarantees by the developer. Loan A is current and the bank expects to be repaid in full as to 

principal and interest. Cash flows from the project's rentals are adequate to fully service 

principal and interest. Loan B is placed on nonaccrual status because of cash flow deficiency 

and collateral shortfall. An appropriate allowance has been recorded in accordance with SFAS 

114.
28

Question 7:

Must the bank automatically place both loans to the borrower on nonaccrual status when one 

loan becomes nonaccrual?

Staff Response:

No, not automatically. When one loan to a borrower is placed on nonaccrual, a bank should 

examine the surrounding circumstances to determine whether its other loans to that borrower 

should be placed on nonaccrual. 

In this case, the two loans are not linked legally. Although these loans comprise the bank's 

total relationship with a single real estate developer, they are actually two separate obligations 

having no personal guarantee by the developer and no cross-collateralization. Accordingly, the 

collectibility of each loan should be evaluated separately. Because Loan A is current and is 

expected to be repaid in full, it may remain on accrual status. 

Question 8: 

The bank subsequently negotiates a cross-collateralization agreement with the developer. Must 

Loan A also be placed on nonaccrual status? 

Staff Response:

The cross-collateral agreement alone should not stop interest accrual on Loan A. The bank has 

merely taken steps to improve its relative position with the borrower. Thus, to the extent that 

cross-collateralization does not change the repayment pattern of the notes or endanger Loan 

A's full repayment in due course, Loan A can remain on accrual status, even if Loan B is on 

nonaccrual status. 

Facts:

Loans A and B are related to separate real estate projects of a borrower and are not crosscollateralized. Loan A is fully performing and has expected cash flows sufficient to repay in 

full. The cash flows from Project B are, and clearly will be, insufficient to repay Loan B in 

full. The bank has an obligation to fund additional monies on Project B. Because Project A 

had sufficient equity, additional funding was provided by a second mortgage, Loan C, on 

Project A. However, because of current economic conditions, the cash flows from Project A 

can no longer keep Loan C current. The debt service required on Loans A and C combined 

exceeds available cash flows. Also, the loan-to-value ratio on this project exceeds 100 percent. 

An appropriate allowance has been recorded under SFAS 114. 
29

Question 9: 

Can Loan A remain on accrual status? 

Staff Response:

Neither Loans A or C should be on accrual status. Senior and junior liens on the same 

property generally should be considered as one loan. Regardless that Project A can fully 

support and repay the original Loan A, it may not be able to repay both Loans A and C. 

Accordingly, until both Loans A and C are current and fully expected to be repaid, they both 

must be placed on nonaccrual status. 

Facts:

Loans A and B are related to separate real estate projects of a borrower and were crosscollateralized initially. Loan A is fully performing and has expected cash flows sufficient to 

repay in full. The cash flows from Project B are, and clearly will be, insufficient to repay 

Loan B in full. But Project A has excess cash flows to meet the shortfall on Project B to 

provide for the debt service shortfall on Loan B and to ensure its full contractual collectibility. 

The developer can and does use these funds to keep Loan B current. 

Question 10: 

Can both Loans A and B be reported as accruing loans? 

Staff Response:

Yes. The borrower has made this possible, by making the excess cash flow and equity of 

Project A available to service and fully repay Loan B. The borrower services debt obligations 

to the bank as if they were one, i.e., using any available funds to keep both obligations 

current. The bank should assess the accrual status by comparing the aggregate cash flows 

available from all repayment sources with the combined obligation. 

In this situation, both Loans A and B can stay on accrual status if the combined cash flows 

from primary and secondary sources are considered adequate and remain available to meet 

fully the combined contractual obligations, and the loans remain current. 

Facts:

Loans A and B are related to separate real estate projects of a borrower and were crosscollateralized initially. Project A has the cash flows to repay Loan A in full, but no excess to 

meet the shortfall in Project B. Accordingly, Project B is past due. 
30

However, in this case, the developer has not dedicated cash flows from Project A to the 

timely repayment of Loan A. The developer has used available cash at its discretion to make 

periodic payments on Loan B and other obligations. Loan A is less than 90 days past due, but 

would be current if the developer applied all Project A cash flows to Loan A. An appropriate 

allowance has been recorded under SFAS 114.

Question 11: 

Can Loan A be maintained on accrual status? 

Staff Response:

No, both loans should be placed on nonaccrual status. In this instance, the total obligation of 

the developer should be evaluated to consider the total cash flows. The developer effectively 

handles these two loans as one obligation. The relative equity of the developer in each 

property and its value to the developer drive the debt service. Because, in this example, the 

combined available cash flows are not likely to be sufficient to repay the combined principal 

and interest due on Notes A and B, both loans should be placed on nonaccrual. 

Facts:

Same facts as in question 11, except that the developer has personally guaranteed both notes 

and provides a significant source of outside cash flow. 

Question 12: 

Must both notes be placed on nonaccrual status? 

Staff Response:

No, not necessarily. If the developer can and intends to meet the debt service requirements of 

both notes, the bank could leave both loans on accrual status. 

If the developer has some financial capability, but is unlikely to be able to support both notes, 

they both should be placed on nonaccrual. Because the notes are cross-collateralized, 

collectibility must be evaluated on a combined basis. Furthermore, the developer, as guarantor 

on both notes, is the ultimate source of repayment for the total debt. Thus, placing only Note 

B on nonaccrual would not reflect properly the fact that the collectibility of the entire debt, not 

only Note B, is in doubt. 

Facts:

Loans A and B are related to separate real estate projects of a borrower and were crosscollateralized initially. Project A has the cash flows to repay Loan A in full, but no excess to 
31

make up the shortfall in Loan B. In the aggregate, the combined cash flows of Projects A 

and B are not likely to repay the outstanding principal and interest in full on both loans. But, 

Loan A is current and has a consistent dedicated source of repayment. Although Loan B is 

both collateral and cash flow deficient, the bank asserts that the cross-collateralization of the 

loans is unlikely to hinder the ability of Loan A to be repaid fully according to the contractual 

terms. An appropriate allowance on Note B has been recorded under SFAS 114.

Question 13: 

Can Loan A be maintained on accrual status? 

Staff Response:

Possibly. However, the assertion that cross-collateralization of the loans will not affect the 

orderly and contractual repayment of Loan A must be supported. Support would include the 

existing lender-borrower relationship and the bank's history in working with troubled 

borrowers. This includes the current likelihood of the lender to work with the borrower to 

avoid foreclosure or of the borrower to take steps to cure Loan B and preserve some equity in 

Project A. If facts exist to support the bank's assertion that the timely and complete repayment 

of Loan A will proceed in due course, Loan A can remain on accrual status. 

Facts:

A bank takes a partial charge off on a loan because it believes that part of the obligation will be 

uncollectible ultimately. The loan is also placed on nonaccrual status. One year later, with 

two years remaining in the loan term, the borrower's financial condition improves 

dramatically. The loan is brought contractually current, and the bank now fully expects to 

collect the original contractual obligation, including the amount previously charged off. 

Question 14:

Can the loan be returned to accrual status? 

Staff Response:

Yes. If the doubt about full collectibility, previously evidenced by the charge off, has been 

removed, the loan meets the call report definition for return to accrual status. 

Facts:

A loan with a borrower is past due in principal and interest. The bank takes a partial charge 

off on the loan because it believes that it will be unable to collect part of the obligation. The 

loan is also placed on nonaccrual status. One year later, the borrower's financial condition 

improves dramatically. The borrower has made regular monthly payments and is paying 
32

additional amounts to reduce the past due amount. However, although the bank now fully 

expects to collect the original contractual obligation, including the amount previously charged 

off, the loan is not yet contractually current. 

Question 15: (September 2001) 

Can this loan be returned to accrual status? 

Staff Response:

Yes. A loan, on which the borrower has resumed paying the full amount of the scheduled 

contractual obligation, may be returned to accrual status, even though it has not been brought 

fully current if: (a) all principal and interest amounts contractually due are reasonably assured 

of repayment within a reasonable period of time; and, (b) there is a sustained period of 

repayment performance by the borrower. 

Facts:

A bank placed a loan on nonaccrual status, because the borrower's financial condition has so 

deteriorated that it does not expect full repayment of contractual principal and interest. 

Simultaneously, the bank reversed previously accrued and unpaid interest in accordance with 

the call report Instructions. The bank's credit evaluation concludes that no charge-off of 

principal is necessary. However, because of doubt about collectibility, certain interest 

payments were applied to reduce principal. 

One year later the borrowers' financial condition has improved. During the past year some 

principal and interest payments have been made, and although the loan is not yet contractually 

current, the bank now expects full payment of contractual principal and interest. Accordingly, 

the bank no longer has any doubt about the full repayment of all amounts contractually due. 

Question 16: (September 2001)

Can the bank, either now or when the loan is brought contractually current, reverse the 

application of interest payments to principal? 

Staff Response:

No. Application of cash interest payments to principal was based on a determination that 

principal may not be recovered. It should not be reversed when that determination changes. 

The staff believes that in those situations, the previously foregone interest should be 

recognized as interest income when received. 
33

The staff also disagrees with reversing the application of interest payments to principal in 

those cases, because such treatment is analogous to using a "suspense account" to record 

interest payments when doubt exists about the collectibility of recorded principal. 

If the loan eventually returns to accrual status, interest income would be recognized based on 

the effective yield to maturity on the loan. This effective interest rate is the discount rate that 

would equate the present value of the future cash payments to the recorded amount of the loan. 

This will result in accreting the amount of interest applied to principal over the remaining term 

of the loan. 

Facts: 

A bank has a $500,000 loan, of which $400,000 is classified doubtful and $100,000, as 

substandard. A $10,000 payment, designated by the borrower as interest, is received. The 

bank applies $8,000 to reduce principal and $2,000 as interest income on the premise that this 

proration reflects the collectibility of the differently classified portions of the loan. 

Question 17:

Is this an acceptable treatment? 

Staff Response: 

No. Because doubt exists about the ultimate collectibility of the recorded loan balance, all 

payments must be applied to reduce principal until such doubt is removed. 

Facts:

A loan is guaranteed by the U.S. government (or a government-sponsored agency). The 

guarantee covers 90 percent of the principal and interest. The borrower experiences financial 

difficulty and is past due more than 90 days on loan payments. Collection of the guaranteed 

portion is expected. However, collection of the unguaranteed portion is uncertain. 

The bank proposes to place 90 percent of the loan (the guaranteed portion) on accrual status 

and classify the remaining 10 percent as nonaccrual. Interest income would also be recognized 

accordingly. 

Question 18: 

Is the proposed accounting treatment that would place the guaranteed portion of the loan on 

accrual status and recognize interest income thereon acceptable? 
34

Staff Response:

No. The call report Instructions require that accrual of interest income cease on a loan when it 

is 90 days or more past due, unless it is both well secured and in the process of collection. 

These Instructions apply to the remaining contractual obligation of the borrower. In this 

situation, collection of the full contractual balance is not expected. Accordingly, the entire 

loan must be placed on a nonaccrual status. 

Question 19:

In determining when a loan is "in the process of collection," a 30-day collection period has 

generally been applied. Is this 30-day collection period intended as a benchmark or as an outer 

limit? 

Staff Response:

The 30-day period is intended as a benchmark, not as an outer limit. Each loan must be 

evaluated separately when determining whether it should be considered "in the process of 

collection." When the timing and amount of repayment is reasonably certain, a collection 

period of greater than 30 days should not prevent a loan from being considered to be "in the 

process of collection." 

Facts:

A bank placed a loan on nonaccrual status, because the borrower's financial condition had so 

deteriorated that it did not expect full repayment of contractual principal and interest. As a 

result of the bank's credit evaluation, a charge-off of principal was recorded. 

However, one year later the borrowers financial condition has improved greatly, and the bank 

expects to recover all amounts contractually due. 

Question 20: (September 2001)

Can the bank reverse the charge-off and rebook the loan? 

Staff Response:

No. This charge-off was based on a determination that the principal was not expected to be 

recovered. Accounting Principles Board Opinion No. 20 (APB 20) cites collectibility 

determinations as an example of an accounting estimate. APB 20 further requires that changes 

in accounting estimates be accounted for on a prospective basis. Accordingly, payments would 

be accounted for in accordance with GAAP, and recoveries recorded as received. 
35

Previous regulatory accounting policy allowed for rebooking charged-off loans in certain 

limited circumstances. However, with the adoption of GAAP, rebooking of the loan is not 

appropriate. 

 

Facts: 

A bank pursues collection efforts on a past due loan by a state mandated mediation process. 

The state requires mediation before banks may foreclose on real estate. Sufficient collateral 

exists to support all contractual principal and interest. The Call Report Instructions indicate an 

asset is “in the process of collection” if collection of the asset is proceeding in due course 

through legal action, including judgment enforcement procedures. 

Question 21: (June 2003)

Can this loan remain on accruing status because it is “in process of collection”? 

Staff Response: 

No. The meaning of “in process of collection” requires that the timing and amount of 

repayment be reasonably certain. The definition entails more than initiating legal action or 

pursuing a well-reasoned plan for collection. The commencement of collection efforts, plans 

to liquidate collateral, ongoing workouts, foreclosing on or repossessing collateral, 

restructuring or settlement do not, in and of themselves, allow a loan to meet the definition. 

There must be evidence that collection in full of amounts due and unpaid will occur shortly. 

The same reasoning applies to a mandated mediation process, which may be part of a welldocumented plan of liquidation. In actuality, the mediation process will likely prolong the 

collection process and infuse additional uncertainty into the timing and amount of repayment. 

 

Facts: 

Bank A has designated a loan of $200,000 in non-accrual status. The bank had previously 

accrued late fees of $500 prior to the loan’s designation in non-accrual status. 

Question 22: (June 2003) 

Is it permissible for Bank A to continue to accrue late fees on a loan that has been designated in 

non-accrual status? 

Staff Response: 

No. Loan fees, including late fees, should not be accrued on a loan designated in non-accrual 

status. Since the loan was placed on non-accrual because of the uncertainty of future payments 
36

on principal and interest, it is the staff’s position that other expected payments from the 

borrower are also uncertain. 

Question 23: (June 2003) 

How should the late fee receivable of $500 be accounted for because of this uncertainty? 

Staff Response: 

As set forth in the Call Report Instructions for previously accrued interest, one acceptable 

accounting treatment includes a reversal of all previously accrued, but uncollected, amounts 

applicable to assets placed in a non-accrual status against appropriate income and balance sheet 

accounts. Hence the late fees that are also accrued, but uncollected, should also be reversed. 

This would also apply to any other fees that may have been accrued on this loan. 
37

C. LOAN COMMITMENTS 

Question 1: (September 2001)

Should a bank record a provision for losses on standby letters of credit to the ALLL or to a 

separate liability account? 

Staff Response:

In accordance with GAAP, credit losses related to off-balance-sheet instruments, such as 

standby letters of credit, should be accrued and reported separately as liabilities if the criteria 

set forth in Statement of Financial Accounting Standards No. 5 (SFAS 5) are met. These 

criteria require recognition of a loss if the loss is both probable and the amount reasonably 

estimatable. 

Question 2: (September 2001)

Can the bank include this liability account for off-balance-sheet credit exposure in Tier 2 

capital for risk-based capital purposes? 

Staff Response: 

Yes. The accounting requirement set forth in Question 1 results from the AICPA’s Audit and 

Accounting Guide for Banks and Savings Institutions. This requirement has been incorporated 

into the call report instructions. Previously, the ALLL often included a component for this 

off-balance-sheet credit exposure. Accordingly, the risk-based capital requirements have been 

revised so that banks may continue to include this liability for off-balance-sheet credit exposure 

in Tier 2 capital, as had been previously allowed. From a risk-based capital perspective, this is 

not a policy change, but rather a continuation of previous requirements. 

 

Facts:

Bank A has issued a firm commitment to lend money to Company X. It is likely the company 

will exercise the commitment. Because of the troubled financial condition of Company X, the 

bank concludes that it will be required to fund the commitment, even though Company X will 

be unable to repay the loan. 

Question 3: (September 2002)

How should the bank account for the loss on this off-balance sheet loan commitment? 
38

Staff Response: 

As noted in Question 1, SFAS 5 requires recognition of a loss when the loss is both probable 

and the amount reasonably estimable. In this situation, the bank concludes that it has incurred 

a loss because it must fund the commitment and does not expect Company X to repay the 

resulting loan. Accordingly, the requirements of SFAS 5 are met. Bank A must recognize the 

loss and record a liability to a separate liability account for the expected obligation. The bank 

cannot wait until Company X actually exercises the commitment to record the loss. 

A bank must report its "allowance for credit losses on off-balance sheet credit exposures" as an 

“other liability” and not as part of its "allowance for loan and lease losses." The provision for 

credit losses on off-balance sheet credit exposures is reported as "other noninterest expense." 

For risk-based capital purposes, the "allowance for credit losses on off-balance sheet credit 

exposures" is combined with the "allowance for loan and lease losses" and the total of these 

two allowances is included in Tier 2 capital up to a limit of 1.25 percent of a bank's gross 

risk-weighted assets. 

Question 4: (June 2003) 

Under what circumstances would a loan commitment be recorded as a derivative in accordance 

with Statement of Financial Accounting Standards No. 133 (SFAS 133)? 

Staff Response: 

SFAS 133 defines a derivative as a financial instrument or other contract with the following 

characteristics: (1) it has one or more underlyings and one or more notional amounts, (2) it 

requires no initial net investment, and (3) its terms require or permit net settlement. Loan 

commitments typically satisfy characteristics (1) and (2). However, certain loan commitments 

may meet the net settlement provisions required by characteristic (3) and others will not. 

SFAS 149 provides guidance for the classification of loan commitments as derivatives. It states 

that loan commitments related to mortgages that will be held-for-sale when funded by the 

institution meet the definition of a derivative. This conclusion is based on the existence of a 

market mechanism to facilitate net settlement. Residential mortgage commitments that will be 

held in the permanent portfolio once funded would not qualify as derivatives. Additionally, 

other commitments, such as those related to commercial or other types of loans, are not 

considered derivatives. 

Question 5: (June 2003) 

How should a bank account for the change in the fair value of the loan commitment accounted 

for as a derivative? 
39

Staff Response: 

Changes in the fair value of the loan commitment are included in earnings for the period in 

which the change occurs. In estimating the fair value of a portfolio of loan commitments (i.e., 

the “pipeline”), the bank must consider the probability that it will actually originate the 

committed loans (i.e., “the pull-through rate”). 

Facts: 

A bank maintains a mortgage operation that originates 1- 4 family residential mortgages to be 

sold in the secondary market under various loan programs. The bank chooses to hedge its 

mortgage pipeline through the use of forward sale agreements. 

Question 6: (June 2003)

How should the bank account for this hedging strategy? 

Staff Response: 

Commitments related to 1- 4 family mortgages that will be sold by the bank meet the definition 

of a derivative according to the FASB Derivatives Implementation Group (DIG) Interpretation 

C13. Additionally, the forward sale agreements also meet the definition of a derivative under 

SFAS 133. 

SFAS 133 requires that all derivatives be recorded on the balance sheet at fair value with any 

changes in fair value reflected through earnings in the period in which the change occurs. 

Accordingly, this strategy provides for both the loan commitment and the forward sale 

agreement to be marked to market through earnings. Accordingly, the related gains and losses 

will be recognized in the same period. Specifically designating such a strategy as a hedge in 

accordance with SFAS 133 is not appropriate, because the standard does not provide for hedge 

accounting when the hedge relationship is between two derivatives. 
40

2D. LOAN ORIGINATION FEES AND COSTS 

Question 1: (September 2001) 

Does a bank have to apply SFAS 91 if it does not charge loan origination fees? 

Staff Response:

Yes. SFAS 91 requires that both net fees and costs be deferred and amortized. The fact that 

the failure to adopt SFAS 91 would lower income and lead to a "conservative" presentation 

does not relieve the bank of its obligation to comply with generally accepted accounting 

principles. 

Question 2: 

May a bank use average costs per loan to determine the amount to be deferred under SFAS 91? 

Staff Response:

SFAS 91 provides for deferral of costs on a loan-by-loan basis. However, the use of averages 

is acceptable provided that the bank can demonstrate that the effect of a more detailed method 

would not be materially different. Usually, averages are used for large numbers of similar 

loans, such as consumer or mortgage loans. 

Facts:

A bank purchases loans for investment. As part of those purchases, the bank incurs internal 

costs for due diligence reviews on loans that were originated by another party (the seller). 

Question 3:

Can the bank capitalize these internal costs as direct loan origination costs? 

Staff Response:

No. The bank's investment in a purchased loan or group of purchased loans is the amount paid 

to the seller, plus any fees paid or less any fees received. Under SFAS 91, additional costs 

incurred or committed to purchase loans should be expensed. Furthermore, only certain direct 

loan origination costs should be deferred under SFAS 91. Because the loans have been 

originated already by the seller, additional costs incurred by the buyer do not qualify as direct 

loan origination costs. 
41

Question 4:

SFAS 91 requires that loan origination fees and direct loan origination costs be deferred and 

accounted for as an adjustment to the yield of the related loan. How should these amounts be 

amortized for balloon or bullet loans? 

Staff Response:

SFAS 91 was designed to recognize the effective interest over the life of the loan. In addition, 

accounting is based usually on the economic substance of a transaction when it differs from the 

legal form. Therefore, the terms of the loan and the historical relationship between the 

borrower and the lender must be analyzed. 

The net deferred fees should be amortized over a normal loan period for that type of loan, if 

the balloon repayment date is merely a repricing date. In such cases, additional fees to 

refinance the loan generally are not charged or are nominal in amount. In substance, the 

balloon loan is nothing more than a floating rate loan that reprices periodically. 

On the other hand, if the bank prepares new loan documentation and performs a new credit 

review and other functions typical of funding a new loan, the old loan has essentially been 

repaid at that date. In this case a fee is often charged on the refinancing. As a result, the net 

deferred fees from the original loan should be amortized over the contractual loan period to the 

balloon date. This results because the lender has, insubstance, granted a new loan to the 

borrower. 

Question 5:

What period should be used to amortize fees and costs for credit card originations? 

Staff Response:

Credit card fees and related origination costs should be deferred and amortized over the period 

that the cardholder is entitled to use the card. This is consistent with the FASB Implementation 

Guide for SFAS 91. Normally, the customer is entitled to use the credit card for a period of 

one to three years. In some cases the actual period of repayment on advances from the card 

may exceed that period. However, the amortization period is deemed to be the period that the 

cardholder can use the card, not the expected repayment period of the loan. 

Facts:

A bank has an outstanding unfunded letter of credit. It originally determined the chances were 

remote that the letter of credit would be exercised. Accordingly, a portion of the commitment 

fees was recognized as income. However, all remaining fee income was deferred after the 

bank concluded that the underlying obligor’s financial difficulties made it no longer remote that 
42

the letter of credit would be drawn upon. Additionally, the bank has incurred substantial 

legal fees to prevent future losses and assure collection on the letter of credit. 

Question 6:

Can those legal costs be offset against the unamortized deferred fee income? 

Staff Response:

No. Legal fees incurred by the bank for litigation should be expensed as incurred. Only legal 

fees that represent the direct costs of originating the commitment can be offset against the 

deferred fee income. SFAS 91 requires fees and direct costs of originating a loan commitment 

to be offset similar to loan origination fees and costs. However, legal fees to recover or 

prevent potential losses are not direct costs of origination under SFAS 91 and should be 

expensed as incurred. 

Question 7: (September 2001) 

How should the premiums and discounts resulting from the purchase of collateralized mortgage 

obligations (CMOs) be accounted for? 

Staff Response:

Statement of Financial Accounting Standards No. 91 (SFAS 91) generally requires the 

amortization of premiums and discounts on securities over their contractual life. However, an 

exception exists for CMOs. Estimated prepayments should be considered when a bank holds a 

large number of similar loans for which prepayments are probable and subject to reasonable 

estimation. Therefore, when mortgages that secure the CMO are subject to such estimation, 

amortization of the premiums or discounts should give consideration to these prepayments. 

Facts:

A bank purchased a CMO tranche, classified as held to maturity, that has moderate prepayment 

risk. The acquisition price includes a premium over par. Prepayment estimates have been 

considered in establishing the constant yield rate under SFAS 91. 

Question 8: (September 2001) 

If the underlying mortgages that collateralize this CMO experience prepayments at a rate 

significantly different from the estimated rate, how should the difference be accounted for? 
43

Staff Response:

A difference in the rate of prepayments on the mortgages backing this CMO instrument should 

be accounted for according to SFAS 91. That statement requires that the bank recalculate the 

effective yield on the investment to reflect the actual prepayment results and anticipated future 

prepayments. The net investment in the CMO should be adjusted to the amount that would 

have existed had the new amortization rate (effective yield) been applied since acquisition of 

the CMO. The corresponding charge or credit should be made to interest income. 

Question 9: (December 2001) 

The bank enters into an agreement with a related party, such as its holding company, to 

perform certain loan solicitation and origination activities. How should these costs be 

accounted for? 

 

Staff Response: 

These costs should be accounted for in the same manner as if they had been incurred by the 

bank. Accordingly, if the costs meet the requirements of paragraph 6 of SFAS 91 for 

capitalization, they would be capitalized. All other lending related costs should be expensed as 

incurred. This is consistent with the guidance included in the FASB's implementation guide 

for SFAS 91. 

Facts: 

In accordance with SFAS 91, a bank capitalized net direct origination costs relating to credit 

card accounts. Subsequently, the bank identifies specific credit card accounts and transfers the 

receivable balances (but not account relationships) to a revolving credit card securitization 

trust. The trust issues certificates that are sold to third party investors in a transaction that 

qualifies as a sale pursuant to SFAS 140. The identified credit card accounts are assigned to 

the trust such that if there are future balances and future collections of fees and finance 

charges, those balances and collections will be transferred or remitted to the trust. The bank is 

limited in its ability to remove specific accounts from the trust. 

Question 10: (September 2002) 

Should the deferred origination costs be included in the gain/loss on the sale at the time of the 

first transfer? 

Staff Response: 

No. The bank has sold the receivable balances, but not the relationship that allows the 

customer to borrow funds. SFAS 91 requires that credit card fees (and expenses) be deferred 
44

and recognized over the period that the cardholder is entitled to use the card. In this 

context, SFAS 91 considers the origination fees to be loan commitment fees and requires 

amortization over the period that the cardholder may use the card. The FASB Guide to 

Implementation of Statement 91 establishes the same treatment for origination costs. 

Facts: 

Bank A originates $100,000,000 of residential mortgage loans, which it intends to sell. It 

charged loan origination fees totaling $2,000,000 and incurred direct loan origination costs of 

$1,000,000. The bank holds the loans for two months and sells them for $99,500,000. 

Question 11: (June 2003) 

How should Bank A account for its investment in the loans held for sale? 

Staff Response: 

The net fees or net costs related to these loans held for sale are reported as part of the recorded 

investment in the loans, the same as they would be for any other loans. Accordingly, the 

recorded investment in the loans should be $99,000,000 ($100,000,000 less the net fees and 

costs of $1,000,000). However, on loans held for sale, the loan origination fees and direct 

loan origination costs are not amortized. Consistent with SFAS 91, these fees and costs are 

deferred until the loan is sold. 

Question 12: (June 2003) 

What should Bank A record for the sale of the loans? 

Staff Response

When the loans are sold, the difference between the sales price and the recorded investment in 

the loans is the gain or loss on the sale of the loans. In this case, Bank A would record a gain 

on the sale of $500,000 ($99,500,000 less $99,000,000). Since the bank was not amortizing 

the loans’ origination fees and costs, the basis remains at $99,000,000 until the loans are sold. 
45

2E. LOANS HELD FOR SALE 

Question 1: (September 2003)

What loans are covered under the Interagency Guidance on Certain Loans Held for Sale? 

Staff Response: 

The Interagency Guidance on Certain Loans Held for Sale applies when: 

• An institution decides to sell loans that were not originated or otherwise acquired with 

the intent to sell, and 

• The fair value of those loans has declined for any reason other than a change in the 

general market level of interest or foreign exchange rates. 

Question 2: (September 2003) 

What loans are not covered under the Interagency Guidance on Certain Loans Held for Sale? 

Staff Response: 

Loans not covered by this guidance include mortgage loans held for sale that are subject to 

SFAS 65 and other loans originated with the intent to sell, including syndicated credits and 

other loans, or portions of other loans, originated with the intent to sell. 

Facts: 

A bank decides to sell a portion of a loan that is not considered impaired. However, some 

negative trends have developed that have caused the loan's fair value to decline. For example, 

the industry sector has slowed down, and the borrower has recently experienced weaker 

financial performance, but not enough to warrant a downgrade on the loan. If there is no 

decision to sell, the amount of the allowance for loan and lease losses (ALLL) associated with 

this loan would not change. 

Question 3: (September 2003) 

What is the proper accounting for the portion of the loan to be sold? 

Staff Response: 

Although the loan is not considered impaired, its fair value has declined due to 

credit quality concerns. Once the decision to sell has been made, the portion of the loan to be 

sold should be transferred to a held for sale (HFS) account at the lower of cost or fair value. 
46

Any reduction in value should be reflected as a write-down of the recorded investment 

resulting in a new cost basis. This write-down should be charged against the ALLL. To the 

extent that the loan's reduction in value has not already been provided for in the ALLL, an 

additional loss provision should be made to maintain the ALLL at an adequate level. 

Question 4: (September 2003) 

With respect to the loan in question 3, should the bank also write down the portion of the loan 

remaining in the loan portfolio? 

Staff Response: 

No, not necessarily. HFS accounting does not apply to the portion of the loan remaining in the 

loan portfolio that the bank does not intend to sell. The need for any write-down on that 

portion of the loan should be evaluated in accordance with the bank's normal credit review and 

charge-off policies. 

Facts: 

A bank has identified certain loans in its portfolio that it may sell in the future, but there is no 

definitive sales plan or sale date. Although these loans are not considered impaired, the fair 

value may be less than the carrying amount. 

Question 5: (September 2003) 

Should adjustments be made to reflect any decrease in fair value? 

Staff Response: 

No. If the bank has not made the decision to sell these loans, they should continue to be 

accounted for on a historical cost basis and evaluated in accordance with the bank's normal 

credit review policies. HFS accounting is not applicable until the bank has made a decision to 

sell the loans. 

Facts: 

A bank is targeting obligors or industries for exposure reduction in general, without identifying 

a specific loan. 

Question 6: (September 2003) 

At what point should such loans be transferred to HFS? 
47

Staff Response: 

A bank should transfer the loans to HFS and begin applying the HFS guidance once it has 

decided to sell the loans and identified the specific loans, or portions of loans, that it intends to 

sell. 

Facts: 

Banks that syndicate loans will offer these loans periodically in the secondary market. This 

may occur because of desirable pricing, or the bank’s needs to reduce outstanding balances to 

allow for future transactions. 

Question 7: (September 2003) 

Does the HFS guidance imply that all syndicated loans are to be reclassified as HFS, since in 

effect they remain held for sale even after the initial distribution period has closed? 

Staff Response: 

If syndicated loans are originated or acquired with the intent to sell all or at least a portion of 

the loans, they do not fall within the scope of this guidance. However, all loans originated 

with the intent to sell are reported at the lower of cost or fair value. 

Facts: 

A bank purchased a loan at a premium, but its fair value has declined because of credit quality 

concerns. The bank has decided to sell the loan, and its fair value is less than the recorded 

investment. 

Question 8: (September 2003) 

How should the bank treat the unamortized premium on the loan at the time of the transfer to 

HFS? 

Staff Response: 

In accordance with SFAS 91, the premium is part of the recorded investment in the loan. The 

bank should compare the loan's recorded investment with its fair value to determine the 

amount of the write-off. This difference is then recorded as a credit loss, and the loan is 

written down by that amount, resulting in a new cost basis at the time of the transfer to HFS. 
48

Facts: 

A bank has guaranteed student loans that it may sell once the loans begin repaying. The 

repayment stage may not begin until a few years after the loans were originated. 

Question 9: (September 2003) 

When should these loans be reported as held for sale? 

Staff Response: 

The bank has not yet decided to sell the loans. Accordingly, HFS accounting would not apply 

until the decision to sell a specific loan or loans is made. 

Facts: 

A bank that transfers a loan to HFS must record the initial fair value reduction as a write-down 

of the recorded investment and a charge to the ALLL, unless the change in fair value is due 

only to changes in general market rates and not credit concerns on the loan. 

Question 10: (September 2003) 

What factors should be considered in determining whether the decline in the fair value of a 

loan that a bank has decided to sell was caused by reasons other than credit concerns? 

Staff Response: 

The HFS guidance presumes that declines in the fair value of loans are attributable to declines 

in credit quality. Any exceptions to this presumption should be adequately supported by 

objective, verifiable evidence and properly documented. This evidence should show that the 

fair value decline resulted only from changes in interest or foreign exchange rates. 

Appropriate documentation showing that the decline in fair value was related solely to these 

market factors would be necessary, even if the loans were sold very shortly after they were 

originated or purchased. 

Question 11: (September 2003)

How should the transfer to HFS be accounted for if it can be demonstrated that the decline in fair 

value resulted from reasons other than credit concerns? 
49

Staff Response: 

The loan to be sold should be transferred to the HFS account at the lower of cost or fair value. 

The reduction in value is reflected as a write-down of the recorded investment resulting in a 

new cost basis. However, this write-down should be charged to other non-interest expense. 

Facts: 

In the loan market, revolving credit facilities tend to trade at lower prices than funded termloan facilities of the same company, even though the remaining term to maturity may be 

shorter. For example, Bank A has granted both a $10 million term loan and a $10 million 

revolving credit facility to Company B. Both loans have the same interest rate. The revolving 

facility is currently funded at 50 percent or $5 million, while the term loan is funded fully at 

$10 million. A commitment fee is charged on the unfunded portion of the revolving facility. 

The secondary market generally is unwilling to pay the same price (as a percentage of 

outstanding balances) for both the term loan and the partially funded revolving credit facility. 

This is because the loss of expected interest income if the unused commitment on the revolving 

credit is never funded. Thus, the fair value of the partially funded revolving credit facility is 

less than the fair value of the term loan. 

Question 12: (September 2003) 

If Bank A decides to sell the revolving credit facility, how would the difference between the 

fair values of the revolving credit and the term loan be viewed when determining whether the 

revolving credit facility should be classified as HFS? 

Staff Response: 

If Bank A decides to sell the partially funded revolving credit facility, Bank A should 

determine the reasons for any decline in the fair value of this facility. As indicated in the 

response to question 10, the HFS guidance presumes that declines in the fair value of loans are 

attributable to declines in credit quality. Unless it can be determined that the decline in the fair 

value of the partially funded revolving credit facility is attributable only to a change in interest 

or foreign exchange rates, the decline would be considered a decline in credit quality. 

Accordingly, the differences between the fair value of these two credit facilities would not be a 

factor. 

Question 13: (September 2003)

Is there any prohibition on designating loans as HFS, and then subsequently transferring them 

back into the loan portfolio? 
50

Staff Response: 

There is no prohibition on transferring HFS loans back into the loan portfolio. However, the 

loan must be transferred into the portfolio at the lower of cost or fair value on the transfer 

date, thereby establishing a new cost basis for that loan. After the transfer back into the 

portfolio, the loan should be evaluated in accordance with the bank's normal credit review 

policies. 

Facts: 

Upon origination or purchase, a bank "intends to sell" a portion of a loan and designates it as 

HFS, but the bank is not successful in selling it. 

Question 14: (September 2003)

Is there a period of time within which the bank would be allowed to move this portion of the 

loan back into HTM at its original cost basis? 

Staff Response: 

Once a decision has been made to sell a loan or portion of a loan, HFS accounting applies. 

There is not a period of time within which the bank is allowed to initially designate loans as 

HFS, and then move them into the loan portfolio at their original cost basis. Rather, as 

indicated in the response to question 13, loans should be transferred from HFS to the loan 

portfolio at the lower of cost or fair value on the transfer date. 

Facts: 

An institution originates or acquires a loan and intends to sell a portion of it on a "best efforts" 

basis. However, the institution is unable to sell this portion of the loan. 

Question 15: (September 2003) 

Is the unsold portion considered HFS? 

Staff Response: 

If an institution intends to sell a loan or a portion of a loan on a "best efforts" basis, the loan, 

or portion thereof, should be reported as HFS. If some portion of this loan cannot be sold, the 

HFS designation of that portion does not change. Question 13 discusses the accounting if a 

bank subsequently transfers a credit that is designated as HFS to the loan portfolio. 
51

Facts: 

A bank enters into a contract to sell a specified group of loans that have declined in credit 

quality. However, the contract contains several conditions that must be met before the sale can 

be consummated. 

Question 16: (September 2003) 

Should the bank wait until all of the conditions have been met before transferring the loans to 

HFS? 

Staff Response: 

No. By entering into a sales contract, the bank has demonstrated that it has decided to sell the 

loans. The HFS guidance requires that loans be transferred to HFS when the decision to sell 

the loans has been made. 

Question 17: (September 2003)

How should the origination fees and costs associated with loans transferred to the HFS account 

be accounted for? 

Staff Response: 

SFAS 91 provides accounting guidance for loan origination fees and costs. The net fees or 

costs are part of the recorded investment in a loan. Under SFAS 91, on a loan held for sale, 

loan origination fees and costs are deferred until the loan is sold (rather than be amortized). 

Therefore, if a loan is transferred to the HFS account, amortization of the deferred net 

origination fees or costs ceases. When the loan is sold, the difference between the sales price 

and the recorded investment in the loan is the gain or loss on the sale of the loan. 
52

2F. LOAN RECOVERIES 

Facts:

The bank had previously charged off an $800,000 loan as uncollectible. Subsequently, the 

borrower agreed to transfer a paid-up whole life insurance policy to the bank in full satisfaction 

of the loan. The borrower has a fatal disease, which according to actuarial studies, will cause 

death in three years. The cash surrender value of the policy at the transfer date is $250,000, 

and the death benefit proceeds amount to $600,000. 

Question 1: 

Since the actuarial studies indicate death will result in three years, can the bank record the 

present value of the $600,000 death benefit proceeds as a loan loss recovery at the transfer 

date? 

Staff Response:

No. The staff believes that the anticipated proceeds at death are a contingent gain. SFAS 5 

indicates that contingent gains are usually not booked, since doing so may result in revenue 

recognition prior to its realization. However, because the bank can currently realize the cash 

surrender value of the policy, a loan loss recovery of $250,000 should be recorded at the 

transfer date. 

Facts:

Bank A repossesses the collateral securing a loan with an outstanding balance of $100,000. 

The bank records the collateral as other assets at its fair value of $50,000 and charges $50,000 

to the allowance for loan and lease losses. The asset is later sold for $40,000, and the bank 

records a loss on the sale of $10,000. The bank files a judgment against the borrower for the 

$60,000 difference between the loan amount and the proceeds from the sale of the collateral. 

Question 2: 

How should the bank’s recovery of the entire $60,000 judgment be recorded? 

Staff Response:

The $60,000 judgment represents a recovery of both a previously charged-off loan and the loss 

on the sale of the collateral. Accordingly, the bank would record $50,000 as a loan loss 

recovery and $10,000 as other noninterest income. 
53

Facts:

A bank made a $500,000 unsecured loan to a corporation that is 100 percent owned by one 

person. The corporation experienced economic problems and was unable to perform on the 

loan. Collection of the loan was considered unlikely, and it was charged-off. 

Subsequently, the bank advanced an additional $400,000 to the owner of the corporation. In 

exchange, the bank received title to five undeveloped building lots that had an appraised value 

in excess of $900,000. The exchange agreement provides the borrower with a four-year option 

to repurchase the land. Additionally, the agreement provides that during this four-year period 

the bank is precluded from disposing of the property. 

The agreement also provides for a repurchase price of $930,000 during the first year. That 

price increases in each of the next three years. Further, the borrower pays the bank an annual 

renewal fee for the repurchase option. This fee is approximately equal to the real estate taxes 

the bank pays. 

Question 3: 

Can a loan loss recovery be recorded on this transaction? 

Staff Response:

No. The substance of the transactions is that the bank restructured the unsecured loan with the 

borrower into a four-year loan secured by real estate. In exchange for receiving collateral, the 

bank also agreed to advance additional funds. The bank effectively does not have economic 

control of the property. 

Accordingly, the bank should report the $400,000 advance as a loan. The acquisition of the 

real estate should not be reported as other real estate owned. Since $500,000 of the loan has 

been previously charged-off, only the $400,000 amount would be included in the recorded loan 

amount. Recovery of the previously charged-off portion is not appropriate, until it is 

converted into cash or cash equivalents. Further, because of the financial condition of the 

borrower and the uncertainty of loan collectibility, income on the loan should not be accrued. 
54

TOPIC 3: LEASES 

3A. LEASE CLASSIFICATION 

Question 1: (September 2003)

From the standpoint of the bank as a lessor, what is the difference between a capital (direct 

financing) lease and an operating lease? 

Staff Response: 

With a capital lease, the lessor, having transferred substantially all of the risks and rewards of 

ownership, removes the leased asset from its financial statements and records a lease 

receivable. Lease payments received are accounted for as interest income and principal 

reduction. Since the lessor does not record the leased asset on its financial statements, no 

depreciation is recorded. 

If the lease is an operating lease, the leased asset remains on the lessor’s financial statements, 

and depreciation is recorded. Payments received are recorded as rental income. 

Question 2: (September 2003) 

What criteria must be met for a bank, as lessor, to classify a lease as a capital lease? 

Staff Response: 

Statement of Financial Accounting Standards No. 13 (SFAS 13) establishes two sets of criteria 

that must be considered. For capital lease treatment, the bank, as lessor, must meet at least 

one of the ownership criteria and both of the realizability criteria. 

Ownership Criteria

• The lease transfers ownership of the property to the lessee. 

• The lease contains a bargain purchase option. 

• The lease term equals or exceeds 75 percent of the economic life of the property. 

• The present value of the minimum lease payments equals or exceeds 90 percent of 

the fair value of the property at the inception of the lease. 

Realizability Criteria

• Collectibility of payments is reasonably predictable. 

• There are no important uncertainties surrounding the amount of unreimbursable cost 

yet to be incurred by the lessor. 
55

Question 3: (September 2003)

One of the ownership criteria is based on the value of the minimum lease payments. What is 

included in the minimum lease payments? 

Staff Response: 

Minimum lease payments include the rental payments, the bargain purchase option amount, the 

guaranteed residual value, and the penalty for failure to renew. From the standpoint of the 

lessor, the residual value guarantee may be from the lessor or an independent third party. 

Therefore, insurance contracts may be used to satisfy this requirement. 

Facts: 

Bank A (lessor) has a portfolio of automobile leases that are classified and accounted for as 

capital leases by the bank. In classifying these leases, the bank is relying on the minimum 

lease payment criteria to satisfy the ownership criteria. In this respect, the bank purchased an 

insurance policy that guarantees the required minimum residual value on a portfolio basis. 

That is, the guarantee is for a portfolio of leased automobiles that are subject to separate leases, 

but not for any individual lease. 

As an example, assume the bank has an insurance contract that guarantees the residual values 

so that the minimum lease payments are 90 percent. Also assume that the calculation of 

minimum lease payments, without including the effects of the insurance contract, is 95 percent 

on half of the automobiles in the portfolio and 85 percent on the other half. If the insurance 

contract covers each individual automobile, the bank would receive a payment from the 

insurance company on those automobiles for which the minimum lease payment was only 85 

percent. However, if the insurance contract covers the portfolio as a whole, the bank would 

not be entitled to any payment from the insurance company because the portfolio as a whole 

has 90 percent coverage. 

Question 4: (September 2003) 

Can the bank include the residual value guarantees for a portfolio of leased assets in the 

calculation of minimum lease payments of an individual lease? 

Staff Response: 

No. SFAS 13 is lease specific and requires that the determination of the lease classification be 

performed on a lease-by-lease basis. The residual value guarantees of a portfolio of leased 

assets preclude a lessor from determining the amount of the guaranteed residual value of any 

leased asset within the portfolio at the inception of the lease. Accordingly, the guarantee from 

the insurance contract may not be included in the minimum lease payments. This accounting is 
56

established in a Securities and Exchange Commission (SEC) announcement to FASB 

Emerging Issues Task Force Topic No. D-107. 

Question 5: (September 2003) 

Should the bank restate its financial statements for any leases when the residual value guarantee 

is on a portfolio basis? 

Staff Response: 

Not necessarily. In the announcement discussed in question 4, the SEC advised registrants 

who are lessors that if the residual value guarantee insurance contracts are revised prior to the 

end of 2003, the lessor would not need to restate prior period financial statements. The OCC 

concurs with this arrangement. 

Facts: 

Bank B (lessor) entered into an equipment lease contract with a lessee. At the time the lease 

was entered into there was no residual value guarantee was in place. Subsequently, the bank 

entered into an arrangement with a third party to provide the guarantee. 

Question 6: (September 2003) 

May the bank include this guarantee when calculating the minimum lease payments? 

Staff Response: 

SFAS 13 requires that the calculation of the minimum lease payments be performed at the 

inception of the lease. Therefore, this guarantee would not be included in the calculation. 

Any previously issued financial statements should be revised accordingly, if material. 
57

3B. SALE AND LEASEBACK TRANSACTIONS 

Statement of Financial Accounting Standards No. 98 (SFAS 98) requires that sale/leaseback 

transactions involving real estate qualify as a sale under the provisions of Statement of 

Financial Accounting Standards No. 66 (SFAS 66) for sales treatment to be used. Otherwise, 

the transaction will be accounted for either as a financing or under the deposit method. 

Accordingly, in the following examples, it is assumed that the transaction qualifies for sales 

recognition under SFAS 98. 

Facts:

A bank transfers its premises (building) to its holding company through a dividend. The 

holding company sells the building to a third party, who leases it back to the bank. 

Question 1:

How should this transaction be accounted for? 

Staff Response:

Interpretive Ruling 7.6120 requires that a "dividend in kind" be recorded on the basis of the 

fair (appraised) value of the property. Therefore, the book value of the building is increased to 

its fair value. The fair value is charged to undivided profits as a dividend. However, an 

effective sale/leaseback has occurred in the bank’s leasing of the premises back from the 

purchasing third party. 

Statement of Financial Accounting Standards No. 13 (SFAS 13) requires that the resulting gain 

from the increase from book value to fair value be deferred and amortized over the lease term. 

Involvement by the holding company is ignored (except for the dividend transaction), since the 

substance of the transaction is the same as if the bank had actually sold the building, leased it 

back, and distributed the sales proceeds by dividend to the holding company. In this example, 

capital has been reduced since the dividend is recorded on the basis of fair value, but the gain 

is deferred. 

Question 2:

Assume the same situation in question 1, except that the holding company returns the sales 

proceeds to the bank in the form of a capital contribution. How is this transaction accounted 

for? 

Staff Response:

The accounting for this transaction would be the same as in question 1, except that the bank 

would also record the amount of the capital contribution. Therefore, total capital remains 
58

essentially the same as it was prior to the sale/leaseback. However, the bank's ability to pay 

future dividends has decreased, because undivided profits have been reduced by the amount of 

the dividend, and the capital contribution has been credited to surplus. 

Question 3:

A bank transfers its premises to its holding company through a dividend. The holding 

company leases the building back to the bank. The lease may be either on a short-term basis 

(i.e., one or two years) or month to month. How should this transaction be accounted for? 

Staff Response:

As previously discussed, a dividend in kind is recorded on the basis of the fair value of the 

property transferred. Therefore, the book value of the building is increased to its fair value, 

and a dividend is recorded based on this amount. 

SFAS 13 requires that the resulting gains (from the increase to fair value) be deferred and 

amortized over the minimum lease term. However, in a related party lease, the stated lease 

term often does not represent the intent of the parties. This results because the bank usually 

intends to remain in the building for many years, even though the lease term is often very short 

and does not represent this intent. 

Therefore, the staff has concluded that gains resulting from related party sale/leaseback 

transactions be deferred and amortized over the remaining useful economic life of the building. 

This conclusion assumes that the holding company controls the bank and the terms of the lease. 

A rare exception has been granted when the bank could demonstrate that the lease terms were 

representative of transactions with independent third-party lessors available in their local 

marketplace. 

As in question 1, capital has been reduced since the dividend is recorded at fair value, but the 

gain is deferred. 

Question 4: 

Assume the same facts as in question 3, except that instead of a dividend, the holding company 

purchases the building at fair (appraised) value and leases it back to the bank. How should this 

transaction be accounted for? 
59

Staff Response:

The sale at fair value to the holding company results in a gain which, as in question 3, would 

be deferred and amortized over the remaining useful life of the building. Capital has not been 

reduced, since a dividend is not involved and the building was actually sold to the holding 

company for cash. However, the deferral of the gain results in no immediate increase to 

capital. 

Question 5:

Assume, as in question 4, that the holding company purchases the building. However, the 

purchase price equals the recorded cost basis of the building rather than fair value. How 

should this transaction be accounted for? 

Staff Response:

Since transactions between affiliates must be recorded at fair value (Interpretative Ruling 

7.6120), a dividend would be recorded for the difference between the fair value of the property 

and the amount paid by the holding company. Again, because of the lease provisions, the 

resulting gain on the sale would be deferred and amortized over the remaining life of the 

building. 

Question 6:

In some cases the sale/leaseback may occur with a related party other than the holding 

company. It could be with a major shareholder or a partnership composed of major 

shareholders and/or board members. How should such transactions be accounted for? 

Staff Response:

The accounting for related party transactions should be used when the same person, persons, 

or control group exert significant influence over both entities (i.e., the bank and the 

purchaser). Such determination is made case by case. However, the control group does not 

always have to possess a voting majority (over 50 percent in each entity) to be considered as 

exerting significant influence. In a bank that has numerous shareholders, a person possessing a 

15 or 20 percent stock interest can be deemed to have significant influence. 

However, a shareholder with 40 percent interest may not possess such influence if another 

shareholder has controlling interest. Therefore, one should use judgment in making that 

determination. 
60

3C. LEASE CANCELLATIONS 

Facts:

The bank has a remaining lease that exceeds one year on a branch office site. The lease is 

accounted for as an operating lease. The bank has decided to close the branch and abandon it 

without canceling the related lease. The bank must make payments on the lease in the future. 

Question 1: (September 2001) 

How should the bank account for the lease payments due after the closing of the branch site? 

Staff Response:

All costs and expenses directly associated with the decision to abandon the branch should be 

recognized as a loss for the period in which management decides to close the branch. These 

costs and expenses include all future payments contractually required by the existing lease. 

This loss should be recorded when management commits to a formal plan to abandon the 

branch site. 

Financial Accounting Standards Board Interpretation No. 27 (Interpt 27) and FASB Emerging 

Issues Task Force Consensus No. 88-10 support this accounting. Interpt 27 requires that the 

cash flows from the original lease be considered in determining the loss on the abandonment. 

Question 2:

How should the loss be determined? 

Staff Response:

The future lease payments required from the bank are discounted to their present value. This 

discounted value should be added to the other costs and expenses in determining the loss from 

closing the branch. 

Question 3:

In the previous example, the bank had decided to abandon the branch. Would the response be 

different if the bank intended to sublease the branch premises or use them for other purposes? 

Staff Response:

Yes. Anticipated future revenues from sublease income, proceeds from the disposal of any 

branch assets, and other future income would be considered in the calculation. A loss should 

be recognized at the measurement date based on the amount that the estimated costs and 
61

expenses exceed anticipated future revenues. Anticipated future revenues in excess of costs 

and expenses would result in a gain. However, under APB 30, its recognition is deferred until 

actually realized. 

The lack of an existing sublease contract at the measurement date does not preclude 

anticipating future sublease income. Future rental income should be considered, if the bank 

probably will sublease the branch site. 

This conclusion is based on APB 30 and FASB Interpretation 27. They require that anticipated 

future cash flows from the original lease and any subleases and the carrying amount of any 

related recorded assets or obligations be considered in determining the total loss or gain. 

Question 4: 

Would the responses to the previous questions be different if the leased property was 

equipment the bank would no longer use instead of a branch office site? 

Staff Response:

No. The decision to stop using leased equipment has the same economic effect as abandoning 

a branch site. The leased equipment has no substantial future use or benefit. Consequently, 

the remaining lease payments, reduced by any anticipated sublease income, should be 

recognized as a loss. This conclusion is consistent with FASB Emerging Issues Task Force 

Consensus No. 88-10. 
62

ALLOWANCE FOR LOAN AND LEASE LOSSES 

4A. ALLOWANCE FOR LOAN AND LEASE LOSSES 

The AICPA currently is developing a Statement of Position that will address accounting 

for the allowance for loan and lease losses (ALLL). It is expected to provide guidance on 

how banks should determine the ALLL in accordance with the various pronouncements of 

the FASB. This section will be revised, as necessary, upon release of that document. 

Question 1: (September 2001)

Regulatory guidance included in the Comptroller’s Handbook “Allowances for Loan and Lease 

Losses” discusses the concept of "inherent loss." What is "inherent loss," and how does it 

differ from "future loss?" 

Staff Response:

In defining "inherent loss," the handbook does not introduce a new concept to estimate the 

ALLL. Rather, it describes the use of concepts developed in Statement of Financial 

Accounting Standards No. 5 (SFAS 5), a process that bankers, accountants, and examiners 

have performed for years. 

"Inherent losses" are losses that meet the criteria in SFAS 5 for recognition of a charge to 

income. This requires a conclusion that an asset has probably been impaired. Proper 

accounting recognition of a loan impairment requires that a provision be made to the ALLL in 

the period when the loss event probably occurred, and the loss amount can be estimated. 

Earnings would be charged at that time. It is inappropriate to wait to charge earnings until the 

loss is confirmed or realized (i.e., the asset is charged off). 

A "loss event" is an event that probably has occurred that impairs the value of a loan. If such 

a loss event occurred, even though it cannot be identified specifically, a charge is made to 

earnings and a provision to the ALLL. The occurrence of a "confirming event" results in the 

asset being classified loss and charged off against the ALLL. 

A provision to the ALLL ensures that impairments or loss events that have occurred, but have 

not yet been identified specifically, are provided for in the period in which they occurred. 

Thus, the ALLL is an estimate. 

Question 2: 

Does criticism of a loan indicate an inherent loss? 
63

Staff Response:

Criticism of a loan, an important signal, does not always indicate existence of an inherent loss 

in the credit. The degree of criticism is important. For example, all loans classified doubtful 

have, by definition, inherent loss. The risk of loss on the loan is probable, even though the 

timing and exact amount has not been determined. 

In a substandard credit, the loan is inadequately protected by the current sound worth and 

paying capacity of the borrower or the collateral. Although a distinct possibility exists that the 

bank may sustain a loss if weaknesses in the loan are not corrected, this is only potential loss. 

Further, in substandard loans, inherent loss generally cannot be identified on a loan-by-loan 

basis. 

Nevertheless, inherent losses do exist in the aggregate for substandard (and to a lesser extent, 

special mention and pass) loans. This inherent, but unidentified, loss on such loans should be 

provided for in the ALLL. This provision usually is based on the historical loss experience, 

adjusted for current conditions, for similar pools of loans. 

Question 3: 

What are some examples of loss events and confirming events affecting pools of loans? 

Staff Response:

Loss events for loans in pools are the same as those for individual loans. Commercials loans 

could suffer from a decline in the economy or in profits, or an event that affects their future 

prospects. Consumer loans might be affected by the loss of a job or personal bankruptcy. 

Delinquency statistics are the most common indicators of the level of inherent losses in pools. 

However, external events, such as changes in the local or national economy, can also signal 

problems for a pool of loans before one can see change in delinquency rates. 

Confirming events for pools of loans will differ between consumer and commercial credits. 

Again, the confirming event occurs when information reveals that the loan is no longer 

bankable and should be charged off. In consumer pools, charge offs are typically taken based 

on established thresholds (i.e., a specific number of days past due) rather than on specific 

adverse information about a borrower. A charge-off should be taken if adverse information 

about a specific borrower is received before the threshold date. Specific adverse information 

about borrowers usually causes the decision to charge off commercial loans analyzed in pools. 

Facts:

A local military base, which employs a significant percentage of the local civilian work force, 

may close. Goods and services supplied to the base by local businesses contribute greatly to 

their economy. 
64

Question 4: 

How should the local bank, in analyzing the adequacy of its ALLL, respond to rumors that the 

military base may appear on the list of possible closures? 

Staff Response:

On a continuous basis, the bank should review the concentrations of credit risk arising from its 

loans to businesses and individuals associated with or dependent upon the base. The bank's 

assessment of the effect of the closing on the local economy and its borrowers should be 

regularly updated. But an unsubstantiated rumor is not an event that would require increased 

provisions to the ALLL. However, a concentration of credit centered on the military base is 

relevant to the assessment of the bank's capital adequacy. 

Question 5:

Suppose that the rumors of the local base as a closure candidate are confirmed, and the 

decision is expected in six months. How would that affect the analysis? 

Staff Response:

The consideration of the possible base closure does not, by itself, trigger a need for provisions 

to the ALLL on any individual credit. Further, in considering possible subjective adjustments 

to the historical loss rates on pools of loans, it is also premature to increase the loss factor. 

This conclusion results from the absence of a firm decision and adequate information. 

However, the bank should continue to review and refine its estimate of the possible effect of a 

base closing on it and its borrowers. 

Question 6: 

How would an announcement of base closure over an 18-month period, beginning in six 

months, affect the evaluation of the ALLL adequacy? 

Staff Response:

A loss event has now occurred that probably will result in the bank subsequently charging off 

loans to a number of its borrowers. The bank's loan review system should identify those 

significant, individual borrowers that probably will be adversely affected. The bank should 

begin to evaluate the likelihood of default on individual credits and its exposure to that loss 

credits. For example, the bank should address issues, such as the effect of the closing on: 

• Borrowers with investments in the local real estate and housing rental markets. 
65

• Borrowers operating businesses dependent on the base or its employees, and general 

retail trade. 

For previously criticized loans, an increased provision to the ALLL may be warranted, 

depending on whether the base closing affects the bank's estimate of the probable loss on these 

credits. The bank should begin to adjust the historical loss rates as its estimates of probable 

loss increase for smaller criticized loans in a pool of similar loans, especially those credits that 

are currently performing and not criticized, but that are likely to be affected adversely by the 

base closing. The bank should review and monitor such credits. Although the amount of 

probable loss on those individual uncriticized credits cannot be estimated yet, it can be 

measured for pools of similar loans. Those pools should encompass all uncriticized loans 

expected to be affected by the base closing, including loans in the commercial, real estate, and 

consumer portfolios. The more homogeneous are the pools, the easier it will be to analyze and 

adjust the historical loss rates. The ALLL should reflect the probable increased exposure to 

loss arising from loans to this group of borrowers. 

The staff recognizes that the estimates of the adjustments are subjective. Accordingly, they 

must be reviewed and refined as it becomes easier to measure the effects of the base closing. 

Question 7: 

How is the bank's analysis of the ALLL affected in the 12- to 18-month period following the 

announcement by the base closing? 

Staff Response:

The bank should continue to focus on identifying, monitoring, and measuring the effect of the 

base closing on its borrowers, and on adjusting the ALLL to cover its best estimate of the 

inherent loss in its portfolio. Estimates of the probable loss should be refined as significant, 

previously criticized, and loans deteriorate. Additional provisions should be made to the 

ALLL, when necessary, and a loan charged off when it is no longer a bankable asset. 

As significant, previously uncriticized, loans affected by the base closing deteriorate, their risk 

ratings should be adjusted and attempts made to estimate probable loss. If probable loss cannot 

be estimated on individual loans, they should be provided for in the pool of similarly criticized 

loans. 

As the actual effect of the base closing becomes easier to measure, the bank should continue to 

adjust the loss rates it applies to pools of loans, both criticized and uncriticized. In time, the 

bank can identify most of its borrowers that may be affected and have risk rated and provided 

appropriately for their loans. Estimates of probable losses on individual loans and pools of 

loans will continue to be refined, and appropriate adjustments made to historical loss 
66

factors and the balance of the ALLL. This is an ongoing process, and should not be 

calendar driven. 

Facts:

State government officials announce their decision six months after the base closing to open a 

new minimum security prison facility on the former base site. Conversion of the site will 

begin in three months, and the prison will open in 12 months. 

Question 8: 

How will this announcement affect the analysis of the adequacy of the ALLL? 

Staff Response:

The bank should begin to consider the possible effects of this "good" news on the local 

economy and its borrowers. The following questions should be raised: 

• Will the business opportunities provided by the new facility improve repayment 

prospects? 

• What will be the effect of the new facility on local employment? 

• What will be its effect on the demand for residential and commercial real estate? 

Over the next 12 months these questions will become easier to answer. As the local economy 

and the condition of the credits improve, the bank may be able to revise downward its 

estimates of probable losses and an adequate level for the ALLL. 

Facts: 

A bank evaluates a real estate loan for inherent loss. The loan was made during a recent boom 

period for the real estate industry. However, both the general real estate market and the loan 

currently are troubled. Loan repayment will come primarily from the operation and eventual 

sale or refinancing of the collateral. Further, the value of the underlying collateral is 

declining. A properly performed appraisal indicates that the value of the property is 95 percent 

of the outstanding loan balance. 

Historically, three real estate cycles have occurred in the last 25 years. In each cycle, real 

estate values fluctuated significantly. However, it is not possible at this time to determine 

whether local real estate properties will experience additional declines in value. 
67

Question 9: 

How should the bank determine the amount of loss inherent on the loan? 

Staff Response:

First, the loan may be an impaired loan under the definition in SFAS 114. However, the 

implications of SFAS 114 will not be considered in this response. 

The bank should base the adequacy of the ALLL for this loan on the information in the current 

collateral appraisal, because it is the best estimate of current value and impairment. This 

current appraisal, which reflects the facts and conditions that presently exist, measures the loss 

that has probably occurred as opposed to future loss. Future impairments will be recognized in 

the periods in which the evidence indicates they probably occurred. Current recognition of 

those potential declines would amount to recognition of future losses rather than inherent ones. 

Question 10: 

Can a bank remove a loan from a pool and specifically allocate an amount for that loan? 

Staff Response:

There are valid reasons to review a loan individually rather than in a pool of loans. Loans 

should be evaluated separately when sufficient information exists to make a reasonable estimate 

of the inherent loss. Individual loan review is common practice for large or otherwise 

significant (i.e., classified doubtful) credits, loans to companies in a deteriorating industry, or a 

combination of the above. In such situations, substantial information on the credit should be 

available, and a separate review is appropriate. 

Pool evaluation is most appropriate when information is insufficient to make such an estimate 

for an individual loan. 

Question 11: 

Can a bank review substandard loans individually, if such analysis results in a lower estimate 

of inherent loss? 

Staff Response:

Pool analysis is used because there is generally insufficient information to reach loan-by-loan 

conclusions about the exposure to loss on substandard loans. Accordingly, adequate 

measurement of the inherent loss may require a pool analysis. As noted in question 2, inherent 

losses do exist in the aggregate for substandard loans and an estimate of the inherent loss in a 
68

pool of loans generally can be made. The estimate is based on the bank's historical loss 

experience, adjusted for current conditions, on similar pools of loans. 

To estimate the level of ALLL required for all substandard loans, some banks differentiate 

between levels of exposure to loss on significant, individual credits in the substandard 

category. However, the assertion that individually analyzed substandard loans require a level 

of allowances that is significantly below the historical loss rate for pools of similar loans must 

be supported clearly by the nature of the collateral or other circumstances that distinguish the 

loan from similarly classified credits. 

Further, removal of loans with less exposure to loss changes the pool's characteristics. No two 

loans are alike, and the substandard classification is applied to loans with varying degrees of 

risk. If the lower risk loans are removed from the pool and analyzed individually, the 

remaining pool will consist of loans with a higher degree of exposure to loss. In providing for 

the inherent loss in this pool, consideration must be given to the current characteristics of the 

pool. This generally will lead to increased provisions to the ALLL for this pool. 

Question 12: 

How does this removal of the loan from the pool affect the calculation of the historical loss 

rate? 

Staff Response:

Loans that have been analyzed individually and provided for in the ALLL should be included 

in their respective pools of similar loans to determine the bank's historical loss experience. 

This will provide a more meaningful analysis of loss ratios or percentages on loans with similar 

characteristics. However, to avoid double counting of inherent loss, any loan that has been 

provided for should be excluded from the current pool of loans when applying the historical 

loss factor to estimate the losses in the remaining pool. 

Question 13: 

Assume a substandard credit has a specific allocation. Does a percentage relationship between 

the allocation amount and loan balance suggest the assignment of nonaccrual status and/or 

doubtful classification? 

Staff Response:

There is no allocation percentage that would require automatically a doubtful classification 

and/or nonaccrual status for a substandard loan. However, specific allocations for individual 

substandard loans in the ALLL raise some difficult questions. First, doesn’t a bank's estimate 

of the amount of allowance necessary for the loan present prima facie evidence that there is 

doubt about its collectibility? Further, if there is doubt about its collectibility, shouldn't the 
69

loan be classified doubtful and put on nonaccrual? The answer to both questions is, "not 

necessarily." 

No two loans are alike. Each classification definition must be applied to loans that possess 

varying degrees of risk. In most portfolios, a few substandard loans will fall on the line 

between special mention and substandard, and a few others will be almost doubtful. Although 

some loans classified as substandard are weaker than others, it may be appropriate to determine 

that those weaknesses are not so severe as to warrant a doubtful classification. Based on the 

individual facts and circumstances, it must be decided whether these borderline 

substandard/doubtful credits should remain in accrual status. 

One must keep in mind when deciding whether to make individual allocations for substandard 

loans that two elements of risk are reflected in our classification system. The risk that the loan 

will not perform as agreed (the risk of default), and the risk that it will not be repaid in full 

(the risk of loss). 

Loans are classified as substandard because their weaknesses do not reflect the risk of default 

that warrants a doubtful classification. Nevertheless, in the event of default, varying degrees 

of exposure to loss will occur within the substandard category. Consideration of collateral, 

guarantees, etc., are necessary. Exposure to loss on a large, unsecured substandard loan may 

be substantially greater than on a similarly sized substandard loan that is secured by real estate. 

Question 14: 

Assume the loan review and allocation process operates satisfactorily, and losses are 

recognized promptly. Is it acceptable for there to be no provision to the ALLL for a pool of 

uncriticized loans? 

Staff Response:

By definition, uncriticized loans do not have inherent loss individually. However, experience 

indicates that some loss could occur even when loan review systems provide timely problem 

loan identification. A lack of information or misjudgment could result in failure to recognize 

that an uncriticized credit has become impaired. 

 

Accordingly, banks must include a provision in the ALLL for those existing, but unidentified, 

losses in pools of uncriticized loans. The loss factor for pools of pass loans in banks 

possessing a reliable loan review system should be much smaller than it is in banks lacking 

adequate loan review systems. 

Question 15: 

What is a migration analysis and when is it used? 
70

Staff Response:

Migration analysis is a methodology for determining, through the bank's experience over a 

historical analysis period, the rate of loss incurred on pools of similar loans. Migration 

analysis may take many forms, ranging from a simple average of the bank's historical loss 

experience over time to a sophisticated analysis that also weighs differences in underwriting 

standards, geographic locations, seasoning of loans, etc. The staff has not identified any 

particular form of migration analysis as being the best, or most appropriate, for all banks. 

Migration analysis is often applied to pools of past due and/or classified loans, because their 

classification reflects the fact that a loss event has probably already occurred. 

Question 16: 

Do specific guidelines exist for the "qualitative" or "environmental" adjustment factors? 

Staff Response:

These factors require judgments that cannot be subjected to exact mathematical calculation. 

There are no formulas for translating them into a basis-point adjustment of the bank's historical 

loss rate for a pool of loans. The adjustment must reflect management's overall estimate of the 

extent to which current losses on a pool of loans will differ from historical loss experience. It 

would include management's opinion on the effects of current trends and economic conditions 

on a loss rate derived through historical analysis of a pool of loans. 

Those adjustments are highly subjective estimates that should be reviewed at least quarterly in 

light of current events and conditions. Management should document carefully the qualitative 

factors considered and the conclusions reached. 

Question 17: 

Do "trends" in describing the qualitative factors imply recognition of future losses? 

Staff Response: 

The word "trends" refers to the effect of current trends on the historical rate of loss. It refers 

only to effects through the evaluation date and does not imply that the bank should try to 

capture the effects of possible future events in its adjustment for historical loss factors. 

Qualitative adjustments to historical loss experience are important in estimating the level of loss 

inherent in the current loan portfolio. As an example, a recent adverse trend in delinquencies 

and nonaccruals reflects loss events that have already occurred. The resulting increase in 

charge-offs may not yet be reflected fully in the historical loss experience. However, this 

trend must be considered when determining the adequacy of the ALLL. 

Similarly, a recent deteriorating trend in the local economy is, in itself, an event that has 
71

adversely affected the bank's borrowers and will probably result in its charging off loans at a 

greater rate than its historical loss experience indicates. The bank's historical loss factor 

should, therefore, be adjusted to provide for an increased level of charge-offs. 

Finally, a recent change in the volume and terms of loans being originated may affect (either 

positively or negatively) charge-offs. If, for example, the bank tightened its approval 

standards for new credit card borrowers, or increased the level of holdback on discounted 

paper, it could reasonably expect lower levels of loss on those pools of loans in the future. 

Question 18: 

In the "Interagency Policy Statement on the Review and Classification of Commercial Real 

Estate Loans," the discussion of the ALLL urges consideration of ". . . reasonably foreseeable 

events that are likely to affect the collectibility of the loan portfolio." Does this statement 

conflict with the guidance given in the previous responses? 

Staff Response:

The staff does not believe that conflict exists. The interagency policy statement addresses 

troubled, collateral-dependent real estate loans. For such a loan, the value of the collateral is 

critical in determining the loan classification and the level of the ALLL. Expectations about 

the effects of reasonably foreseeable events are inherent in the valuation of real estate. 

For example, a real estate loan may be secured by a property with a significantly above market 

(but soon to expire) lease. This lease will not be renewed at its current rate. This reasonably 

foreseeable event should be considered in valuing the property. Another reasonably 

foreseeable event would be construction of a new commuter rail station. It would almost 

certainly affect nearby property values in a positive manner. 

The departure of the tenant and completion of construction resemble "confirming events" more 

than "loss events." In the first example, the value decline is inherent in the fact that an 

existing lease will expire and will no longer generate the current above market level of income. 

In the second example, property values will increase well before construction is complete. 

Question 19: 

Will a bank be subject to criticism if its methodology is inadequate, but its ALLL balance is 

adequate? 

Staff Response:

Yes. The OCC places increased emphasis on an ALLL evaluation process that is sound, based 

on reliable information, and well documented. Even if a bank's current ALLL balance is 
72

adequate, management does not have a sound basis for determining an adequate level for the 

ALLL on an ongoing basis if its evaluation process is deficient. 

Question 20: 

Must bank management analyze the adequacy of the ALLL quarterly? 

Staff Response:

The adequacy of the ALLL must be reviewed at least quarterly. Otherwise, management may 

not be able to determine the accuracy of the bank's call reports. However, significant loans 

analyzed individually should be monitored regularly, and provisions made to the ALLL as 

events occur. This should be a continuous, and not calendar driven, process. 

The amount of time that elapses between reviews for pools of loans and other less significant, 

individually analyzed loans affects the strength of the loan review process. The process should 

also react to internal and external events that might indicate problems in a particular credit or 

group of credits. 

Question 21: (September 2001)

Do materially excessive allowances also pose a problem? 

Staff Response:

The risk of error or imprecision is inherent in the entire allocation process. Accordingly, as 

noted in EITF Topic D-80, most guidance has discussed the ALLL in the context of a range of 

reasonable estimates. A bank should recognize its best estimate within its estimated range of 

losses. In this process, banks should take into account all available information existing as of 

the measurement date, including "environmental" factors. 

However, an ALLL that clearly and substantially exceeds the required level misstates both the 

earnings and condition of the bank and constitutes a violation of 12 USC 161. Elimination of 

such excess ALLL should be accounted for as a credit to (or reduction in) the provision for 

loan and lease losses. If an improper estimate or error is discovered after a call report is filed, 

the guidance in the call report instructions for accounting changes should be consulted. 

Facts: 

A bank has overdraft accounts of approximately $2 million. As of the reporting period date, 

approximately $200,000 is deemed to be uncollectible. 
73

Question 22: (June 2003) 

How should the bank account for losses related to the overdraft accounts? 

Staff Response: 

Any losses related to these accounts should be charged against the ALLL. In accordance with 

the AICPA Audit and Accounting Guide for Banks and Savings Institutions, checking accounts 

that are overdrawn should be reclassified as loans and should, therefore, be evaluated for 

collectibility as part of the evaluation of the ALLL. 

Question 23: (June 2003) 

Since the Call Report Instructions do not require consumer credit card loans to be placed on 

nonaccrual based on delinquency status, how should a bank determine that income is recorded 

accurately? 

Staff Response: 

Because a portion of the accrued interest and fees on credit card accounts is generally not 

collectible, banks must evaluate the collectibility of the accrued interest and fees. In this 

respect, a bank may provide a loss allowance for these uncollectible interest and fees, or place 

the delinquent loans and impaired receivable on nonaccrual status. This allowance may be 

included in the ALLL, as a contra account to the credit card receivables, or in other liabilities. 

 However, regardless of the method employed, banks must ensure that income is measured 

accurately. 

Question 24: (June 2003) 

How should banks treat over-limit credit card accounts in their ALLL methodologies? 

Staff Response: 

Bank ALLL methodologies do not always recognize fully the loss inherent in over-limit credit 

card accounts. For example, if borrowers are required to pay over-limit and other fees, in 

addition to the minimum payment amount each month, roll rates and estimated losses may be 

higher than indicated on the overall portfolio analysis. Accordingly, banks should ensure that 

their ALLL methodology addresses the incremental losses that may be inherent on over-limit 

credit card accounts. 

Question 25: (June 2003) 

How should banks provide for the loss inherent in credit card workout programs? 
74

Staff Response: 

Banks should ascertain that their ALLL provides appropriately for the inherent probable loss in 

credit card workout programs. Accounts in workout programs should be segregated for 

performance measurement, impairment analysis, and monitoring purposes. When the bank has 

multiple programs with different performance characteristics, each program should be 

reviewed separately. 

An adequate allowance should be established and maintained for each program. Generally, the 

ALLL allocation should equal the estimated loss in each program based on historical 

experience adjusted for current conditions and trends. These adjustments should take into 

account changes in economic conditions, volume and mix of the accounts, terms and conditions 

of each program, and collection history. 

Question 26: (June 2003) 

After a credit card loan is charged off, how should banks account for subsequent collections on 

the loan? 

Staff Response: 

Recoveries represent collections on amounts that were previously charged off against the 

ALLL. Accordingly, the total amount credited to the ALLL as a recovery on a credit card 

loan (which may include amounts representing principal, interest, and fees) is limited to the 

amount previously charged off against the ALLL on that loan. Any amounts collected in 

excess of the amount previously charged off should be recorded as income. 

In certain instances the OCC has noted that the total amount credited to the ALLL on an 

individual loan exceeds the amount previously charged off against the ALLL for that loan. 

Such a practice understates a bank’s net charge-off experience, which is an important indicator 

of the credit quality and performance of a bank’s portfolio. Accordingly, such a practice is not 

acceptable. 

 

 
75

 TOPIC 5: OTHER ASSETS 

5A. Real Estate

Question 1: (September 2003) 

How should banks account for their investment in other real estate owned (OREO) property? 

Staff Response:

Detailed accounting guidance has been removed from the OREO regulation and replaced with a 

reference to the call report instructions. These instructions require that OREO and its sales be 

accounted for in accordance with generally accepted accounting principles. In this respect, 

Statement of Financial Accounting Standards No. 144 (SFAS 144) provides the general 

guidance for the recording of OREO. Sales of OREO are accounted for in accordance with 

Statement of Financial Accounting Standards No. 66 (SFAS 66). 

Upon receipt of the real estate, OREO should be recorded at the fair value of the asset less the 

estimated sales costs, and the loan account reduced for the remaining balance of the loan. This 

transfer at fair value results in a new cost basis for the OREO property. The amount by which 

the recorded investment in the loan exceeds the fair value (net of estimated sales costs) of the 

OREO is charged to the ALLL. 

Subsequent declines in the fair value of OREO below the new cost basis are recorded through 

the use of a valuation allowance. Changes in fair value must be determined on a property-byproperty basis. An allowance allocated to one property may not be used to offset losses 

incurred on another property. Unallocated allowances are not acceptable. Subsequent 

increases in the fair value of a property may be used to reduce the allowance, but not below 

zero. 

Although the fair value of the property normally will be determined by an appraisal (or other 

evaluation), circumstances may justify a more conservative approach in establishing the 

allowance. Examples of such circumstances include changed economic conditions since the 

last appraisal, stale appraisals, or imprecision and subjectiveness in the appraisal process (i.e., 

actual sales for less than the appraised amount). 

Facts:

A bank recently began foreclosure proceedings on a borrower’s residential real estate. State 

law requires a six-month redemption period before the bank can take possession of the 

property. During this period, the borrower may continue to occupy the property, and the bank 

does not have the ability to enter the property or take any action to sell the property. 
76

Question 2: (September 2003)

Should the bank transfer this loan to OREO at the time foreclosure is instituted?

Staff Response:

No, the bank should not yet transfer the property to OREO. Under SFAS 114, a collateral 

dependent loan is classified as real estate only if the bank has taken physical possession of the 

property. This generally would not occur until the redemption period has expired and the 

borrower has vacated the property. 

Facts: 

A bank is in the process of foreclosing on a $150,000 loan. It is secured by real estate with a 

fair value, based on a current appraisal, of $180,000. The cost to sell this property is 

estimated at $15,000. 

Question 3: (September 2003) 

At what value should the OREO be recorded? 

Staff Response: 

Upon receipt of the real estate, the property should be recorded at $165,000 in accordance with 

SFAS 144. This represents the fair value of $180,000 less the $15,000 cost to sell the 

property. However, because of safety and soundness concerns, the fair value determined in 

the appraisal should be scrutinized closely. Since the appraisal indicates that the borrower has 

equity in the property, the bank should address the issue of why the borrower would risk 

losing the property in foreclosure. If concern exists about the accuracy of the appraisal, 

further analysis should be performed. However, if the appraisal properly supports the fair 

value, the $15,000 increase in value is recorded at the time of foreclosure. 

Facts: 

A bank acquires real estate in full satisfaction of a $200,000 loan. The real estate has a fair 

value of $190,000 at acquisition. Estimated costs to sell the property are $15,000. Six months 

later the fair value of the property has declined to $170,000. 

Question 4: (September 2003) 

How should the OREO be accounted for? 
77

Staff Response: 

Upon receipt of the real estate, the property should be recorded at $175,000. This represents 

the fair value ($190,000) at acquisition less the cost to sell ($15,000) the property. The 

amount by which the recorded investment in the loan ($200,000) exceeds the fair value less 

cost to sell ($175,000) should be recorded as a charge against the ALLL. Accordingly, a 

$25,000 charge against the ALLL is recorded. 

Subsequent to the acquisition date, the OREO is carried at the lower of cost ($175,000) or fair 

value less cost to sell. When the fair value declines to $170,000, the fair value less cost to sell 

would be $155,000. This represents a $20,000 decline in value, which is recorded through a 

valuation allowance. 

Facts: 

Continuing with question 4, two years later the fair value of the property is $195,000. 

Question 5: (September 2003) 

 

How should the increase in value be accounted for? 

Staff Response: 

The increase in the fair value ($25,000) can be recognized only up to the new recorded cost 

basis of the OREO, which was determined at the foreclosure date. Accordingly, the valuation 

allowance of $20,000 would be reversed. The additional $5,000 increase in value would not 

be recognized. 

Question 6: (September 2002) 

May a bank retroactively establish a valuation for properties that was reduced previously by 

direct write-off? 

Staff Response:

No. Since the bank did not establish an allowance at the time the properties were initially 

written down, a new basis of accounting was established. Reversing the previous write-down 

and rebooking the charged off asset is not in accordance with generally accepted accounting 

principles. 

Question 7: (September 2001) 

How should the revenues and expenses (including real estate property taxes) resulting from 

operating or holding OREO property be accounted for? 
78

Staff Response:

Generally, the revenues and expenses from OREO property should be included in the 

Statement of Income for the period in which they occur. The call report Instructions require 

that gross rentals from OREO be included in "Other noninterest income." The expenses of 

operating or holding the property, including depreciation when appropriate, should be included 

in "Other noninterest expense." 

Statement of Financial Accounting Standards No. 67 (SFAS 67) provides an exception for real 

estate property taxes incurred “during periods in which activities necessary to get the property 

ready for its intended use are in progress.” Therefore, real estate taxes incurred during the 

construction period can be capitalized, up to the fair value of the property. However, such 

costs incurred at other times must be expensed as incurred. In this respect, SFAS 67 states that 

“costs incurred for such items after the property is substantially complete and ready for its 

intended use shall be charged to expense as incurred.” This limited exception would not cover 

periods in which the bank is merely holding property for future sale. 

Facts:

A bank forecloses on a loan secured by a second lien on a piece of property. The bank does 

not formally assume the senior lien. 

Question 8: 

How should the bank account for the senior debt? 

Staff Response:

Although a bank may not assume formally the liability of the senior lien on the property, the 

amount of any senior debt should be reported as a liability at the time of foreclosure. The 

OREO balance would be increased by a corresponding amount. However, the resultant 

carrying value of the OREO cannot exceed the fair value, net of sales costs, of the property. 

Any excess should be charged against the allowance for loan and lease losses at the time of 

foreclosure. 

Question 9:

The bank pays delinquent real estate taxes on a property to avoid lien attachment by the taxing 

authority. Is this accounted for in the same manner as assuming a prior lien? 

Staff Response:

No. Although a tax delinquency effectively creates a prior lien, the accounting differs. All 

costs of foreclosure should be expensed as incurred. The staff believes that settling real estate 
79

tax delinquencies are costs incidental to foreclosure and must be expensed. Additionally, 

real estate taxes on property held as OREO are considered holding costs and expensed as 

incurred. An exception to this rule exists for property under construction. Generally accepted 

accounting principles allow for capitalization of property taxes during the development period 

of the property. 

Question 10: 

When can a sale of OREO be accounted for under the full accrual method of accounting? 

Staff Response:

The full accrual method may be used when all of the following conditions have been met: 

• A sale has been consummated. 

• The buyer's initial investment (down payment) and continuing investment (periodic 

payments) are adequate to demonstrate a commitment to pay for the property. 

• The receivable is not subject to future subordination. 

• The usual risks and rewards of ownership have been transferred. 

Question 11: 

What constitutes an adequate down payment for use of the full accrual method of accounting? 

Staff Response:

The down payment requirement of SFAS 66 considers the risk involved with various types of 

property. The required down payments range from 5 percent to 25 percent of the sales price 

of the OREO. 

For example, only a 10 percent down payment is required for commercial property subject to a 

long-term lease and that has cash flows sufficient to service all indebtedness. On the other 

hand, a 25 percent down payment is required for commercial property, such as hotels, motels, 

or mobile home parks, in a start-up phase or having cash flow deficiencies. 

Question 12:

If a transaction does not qualify as a sale under the full accrual method of accounting, what 

other methods are available for accounting for the transaction? 
80

Staff Response:

SFAS 66 provides four other methods for accounting for sales of real estate. They are: the 

installment method, the cost recovery method, the reduced-profit method, and the deposit 

method. 

In the past, many banks have used only the deposit method to account for dispositions of 

OREO that did not qualify for immediate sales recognition under the full accrual method. 

However, depending on the circumstances, use of one of the other methods may be more 

appropriate. Often a disposition will qualify for immediate sales recognition under the 

installment method. This method recognizes a sale and the corresponding loan. Any profits 

on the sale are recognized as the bank receives the payments from the purchaser. 

This method is used when the buyer's down payment is not adequate to allow use of the full 

accrual method, but recovery of the cost of the property is reasonably assured if the buyer 

defaults. Assurance of recovery requires careful judgment case by case. Factors that should 

be considered include: the size of the down payment, loan to value ratios, projected cash flows 

from the property, recourse provisions, and guarantees. 

Since default on the loan usually results in the seller's reacquisition of the real estate, 

reasonable assurance of cost recovery may often be achieved with a relatively small down 

payment. This is especially true for loans with recourse to borrowers who have verifiable net 

worth, liquid assets, and income levels. Reasonable assurance of cost recovery may also be 

achieved when the purchaser/borrower pledges additional collateral. 

Dispositions of OREO that do not qualify for either the full accrual or installment methods may 

be accounted under the cost recovery method. It recognizes a sale and the corresponding loan, 

but all income recognition is deferred. 

The deposit method is used when a sale of the OREO has not been consummated. It may also 

be used for dispositions that could be accounted for under the cost recovery method. Under 

this method, a sale is not recorded and the asset continues to be reported as OREO. Further, 

no profit or interest income is recognized. Payments received from the borrower are reported 

as a liability until sufficient payments or other events have occurred that allow the use of one 

of the other methods. 

The reduced-profit method is used when the bank receives an adequate down payment, but the 

continuing investment is not adequate. This method recognizes a sale and corresponding loan, 

and apportions any profits over the life of the loan, based on the present value of the lowest 

level of periodic payments. 
81

Facts:

A bank sells a parcel of OREO property (undeveloped land) for $100,000 and receives a 

$40,000 down payment. But the bank agrees to extend a line of credit for $35,000 to the 

buyer. 

Question 13:

Does this transaction qualify as a sale under the full accrual method of SFAS 66? 

Staff Response:

No. SFAS 66 requires that funds provided directly or indirectly to the buyer by the seller 

(bank) be subtracted from the buyer's down payment in determining whether the down 

payment criteria have been met. Therefore, in determining the buyer's initial investment, the 

$40,000 down payment is reduced by the $35,000 line of credit. 

There is one exception to this rule. If the bank makes a loan conditional on the proceeds being 

used for specified development or construction activities related to the property sold, the loan 

need not be subtracted in determining the buyer's investment in the property. However, the 

loan must be on normal terms and at fair market interest rates. 

Facts:

The bank sells a parcel of OREO (undeveloped land) at a profit. The sales price is $200,000 

and the bank receives a $50,000 down payment. The terms of the mortgage require that the 

purchaser make interest only payments for five years. The entire principle balance is due at 

that time. 

Question 14: 

May the bank account for this sale using the full accrual method of accounting? 

Staff Response: 

No. SFAS 66 establishes the requirements for recording the transaction under the full accrual 

method. It requires that the buyer's continuing investment (periodic payments) be at least 

equal to the level annual payments needed to amortize the debt over 20 years for land and the 

customary first mortgage period (usually 20 to 30 years) for other types of property. 

In this situation, the loan balance is not being amortized during the five-year period. 

Therefore, this transaction does not qualify for recognition under the full accrual method of 

accounting. The reduced-profit method probably would be used. 
82

Facts:

OREO property with a book value of $110,000 is sold for $120,000. The bank finances the 

sale and receives no cash down payment. The terms of the note require 120 monthly payments 

of $1,000 plus interest at market rates. SFAS 66 requires a minimum initial investment of 20 

percent for this type of property. Because of the inadequate initial investment, the bank has 

accounted for the sale using the deposit method of accounting. During the first year, the bank 

receives a total of $26,000 in payments - $12,000 in principal and $14,000 in interest. 

Question 15: 

Have the minimum initial investment requirements of SFAS 66 been met at the end of the first 

year? 

Staff Response:

Yes. The minimum initial investment requirements of SFAS 66 have been met. This results 

because SFAS 66 allows the inclusion of both principal and interest payments in determining 

whether the down payment is adequate. Therefore, the $26,000 received by the bank during 

the first year exceeds 20 percent of the sales price ($24,000). 

Facts:

A bank owns a piece of OREO recorded at an appraised value of $15 million. The bank 

agrees to sell the property for $13.5 million to a buyer after negotiating from an original offer 

of $11 

million. Immediately prior to closing, the buyer has difficulty obtaining financing for the 

purchase, and the deal falls through. 

Question 16: 

Must the bank adjust its recorded investment in the OREO? 

Staff Response: 

Yes, the bank should reduce the carrying value of the OREO to $13.5 million. The bank 

received a better indication of the asset value by negotiating a fair sale price with a willing 

buyer. The fair value definition in SFAS 15 points out that the best determination of fair value 

is a fair market transaction between a willing buyer and a willing seller. But for the buyer's 

last minute difficulties in obtaining financing, the bank (a willing seller) would have sold the 

property at a loss in a market transaction. 
83

Question 17: 

Assume the appraised value is the same as in question 11, except that the bank places the 

property for sale in an auction. The bank must set a minimum acceptable bid to attract only 

serious bidders. The bank sets a minimum of $11 million. Must the bank write the OREO 

down to $11 million, if the property is not sold? 

Staff Response: 

Not necessarily. If the bid is set for the purpose described and the bank is not required to 

accept an $11 million bid if it is the only bid, then $11 million may not be a fair price 

negotiated by a willing buyer and seller. 

Also, the absence of bids does not necessarily mean that the minimum bid was unacceptable to 

any buyer. In these situations, evidence of a market price is inconclusive because a market has 

not been established, i.e., no willing buyer or willing seller. Accordingly, a source of fair 

value independent of a single market transaction, such as an appraisal, would continue to be 

used to determine the carrying value of the property. 

Facts: 

In June 200x, a bank sells for $2 million OREO property (a motel) with a book value of $1.9 

million, and receives a cash down payment of $300,000 (15 percent of the sales price). At the 

time of sale, the cash flow from the motel is not sufficient to service all indebtedness. 

Because of the insufficient cash flows, SFAS 66 requires a minimum initial investment (down 

payment) of 25 percent for use of the full accrual method of accounting in this situation. Had 

the motel been generating sufficient cash flows to service all indebtedness, only a 15 percent 

down payment would have been required. Accordingly, this sale is accounted for using the 

installment method of accounting, and only a portion of the gain is recognized at the time of 

sale. This portion of gain recognized is based on the ratio of the down payment to the sales 

price. In this case, 15 percent of the gain or $15,000 is recognized at the time of sale. The 

remainder of the gain is deferred. 

Question 18: (December 2001) 

Can the bank recognize periodic interest income on this loan that is accounted for under the 

installment method of accounting? 

Staff Response: 

Yes. Under the installment method, interest income is recognized at the contractual interest 

rate. In addition, a portion of the deferred gain (from the sale) would be recognized with each 

payment. However, should the loan experience delinquency problems, the non-accrual rules

would apply.
84

Question 19: (December 2001) 

Five months later, in November 200x, the motel's business is thriving and its cash flows are 

now sufficient and are expected to remain sufficient to service all indebtedness. Can the bank 

now reduce the down payment requirement to 15 percent and recognize the sale under the full 

accrual method? 

 

Staff Response: 

Yes. Appendix B to SFAS 66 states that if the transaction later meets the requirements for the 

full accrual method, the seller (bank) may change to that method. The requirements for use of 

the full accrual method are met when the borrower's cash flow became sufficient to service the 

debt. Accordingly, at that time the bank can change to the full accrual method of accounting. 

Question 20: (December 2001) 

Would the remainder of the deferred gain be recognized at this time? 

Staff Response: 

Yes. The deferred gain would be recognized in earnings at the time of the change to the full 

accrual method of accounting. 
85

5B. LIFE INSURANCE AND RELATED DEFERRED COMPENSATION 

Facts: 

Bank A has purchased split-dollar life insurance policies on the life of several key officers. 

These are cash value policies wherein both the bank and the officer's family are beneficiaries. 

The bank's benefit is limited to a refund of the gross premiums paid. All other benefits are 

designated for the officer's beneficiaries. 

Question 1:

How should these split-dollar life insurance policies be accounted for? 

Staff Response:

Consistent with FASB Technical Bulletin No. 85-4, the bank should record the amount that it 

could realize under the insurance policy (i.e., its portion of the cost surrender value) as of the 

date of the financial statements as an "other asset." Further, the bank should determine 

whether a reportable obligation for post-retirement benefits has been incurred under Statement 

of Financial Accounting Standards No. 106 (SFAS 106). 

Facts: 

Bank A has purchased "key-man" life insurance policies on the life of several key officers. 

These are cash value policies. However, they differ from the policies discussed in question 1 

in that the bank is the sole beneficiary. 

Questions 2: (September 2002) 

 

How should these "key man" life insurance policies be accounted for? 

Staff Response: 

Consistent with FASB Technical Bulletin No. 85-4, the bank should record the amount that it 

could realize under the insurance policy (i.e., the cash surrender value) as of the date of the 

financial statements as an "other asset." The change in cash surrender value during the period 

is an adjustment of the premium paid in determining the expense (other noninterest expense) or 

income (other noninterest income) to be recognized for the period. 

Facts: 

A bank purchases a single premium bank-owned life insurance (BOLI) policy to provide funds 

for a deferred compensation agreement with a bank executive. The agreement states that the 

bank executive is entitled to receive deferred compensation based on the “excess earnings” of 
86

this insurance policy. The compensation agreement provides for a base earnings amount on 

the initial investment in the policy to be computed using a defined index. All earnings over 

this base amount (the “excess earnings”) accrue to the benefit of the employee, both during 

employment and retirement years. However, payment is made to the employee during his/her 

retirement years. 

The deferred compensation agreement provides for a “primary” and “secondary” benefit. 

The earnings on the policy that accumulate for the employee’s benefit prior to retirement are 

paid out in ten equal installments upon retirement and is the “primary benefit.” The 

“secondary benefit” is the earnings that accrue for the employee’s benefit after retirement. 

These amounts are paid each year in addition to the primary benefit. The secondary benefit 

will continue to accrue and be paid to the employee throughout his/her life. 

Question 3: (September 2003) 

How should the bank account for the costs associated with this deferred compensation 

agreement? 

Staff Response: 

The present value of the expected future benefits to be paid to the employee from the deferred 

compensation plan should be based on the terms of the individual contract. It should be accrued 

in a systematic and rational manner over the required service periods to the date the employee is 

fully eligible for the benefits.

The fact that the future payment amount is not guaranteed, but is based on the expected 

performance of the insurance policy, does not release the bank from the requirement that it 

recognize the compensation expense over the employee’s expected service period. However, 

the estimate of the expected future benefits should be reviewed periodically and revised, if 

needed. Any resulting changes should be accounted for prospectively, as a change in 

accounting estimate. 

These benefits should be accounted for in accordance with AICPA Accounting Principles 

Board Opinion No. 12, as amended by SFAS 106. 
87

5C. ASBESTOS AND TOXIC WASTE REMOVAL COSTS 

Facts: 

Various federal, state, and local laws require the removal or containment of dangerous asbestos 

or environmental contamination from building and land sites. Such removal or containment of 

dangerous materials can be expensive, often costing more than the value of the property. 

However, in certain jurisdictions the property owners may be required to "clean-up" the 

property, regardless of cost. Further, sometimes a company may be required to clean-up 

property that it does not currently own. For banks, this liability may extend, not only to bank 

premises, but also to other real estate owned. 

Question 1:

Should asbestos and toxic waste treatment costs incurred for clean-up be capitalized or 

expensed? 

Staff Response:

Clean-up costs for asbestos may be capitalized only up to the fair value of the property. Cleanup costs for asbestos discovered when the property was acquired are part of the acquisition 

costs. Costs incurred to "clean-up" waste on existing property represent betterments or 

improvements. This opinion is consistent with FASB Emerging Issue Task Force Consensus 

No. 89-13. 

Generally, environmental contamination (toxic waste) treatment costs should be charged to 

expense. However, when recoverable, these costs may be capitalized if one of the following is 

met: 

• The costs extend the life, increase the capacity, or improve the safety or efficiency of 

property owned by the company. 

• The costs mitigate or prevent future environmental contamination. In addition, the 

costs improve the property's condition as compared with its condition when constructed 

or acquired, if later. 

• The costs are incurred in preparing for sale a property currently held for sale. 

This opinion is consistent with FASB Emerging Issues Task Force Consensus No. 90-8. 

 
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5D. COMPUTER SOFTWARE COSTS 

Question 1: (September 2001) 

How should a bank account for the costs associated with the development of software for 

internal use? 

Staff Response:

In 1998 the AICPA issued Statement of Position (SOP) 98-1 with respect to the accounting for 

costs associated with the development of software for internal use. This SOP requires the 

capitalization of certain costs associated with obtaining or developing internal use software. 

Specifically, the software development process is separated into three stages. They are: the 

preliminary project stage, application development stage, and post-implementation/operational 

stage. The costs associated with the application development stage (the second stage) are 

capitalized. This includes the external direct costs of materials and services, salary and related 

expenses directly associated with the project, and certain interest expense. All costs associated 

with the first and third stages are expensed as incurred. 
89

5E. DATA PROCESSING SERVICE CONTRACTS

Facts:

A bank decides to convert from its current in-house data processing arrangement to a thirdparty data processing servicer. The bank enters into a long-term contract (e.g., seven years) 

with the servicer. The contract states that the servicer will purchase the bank's data processing 

equipment at book value ($1,000,000), although fair value is significantly less ($400,000). 

Question 1:

May the bank record the sale of its equipment at book value ($1,000,000), recognizing no loss 

on the sale? 

Staff Response:

Generally, no. In most cases, the bank is borrowing from the servicer the amount received in 

excess of the fair value of the equipment. The rebuttable presumption is that the servicer will 

recoup this excess payment over the life of the service contract. 

Therefore, the bank should record the sale of its equipment at fair value, recognizing the loss 

of $600,000 ($1,000,000 - $400,000). Furthermore, the bank should record a liability to the 

servicer for $600,000, and amortize this amount in accordance with the terms of the contract. 

In addition, interest expense should be recorded on the unamortized portion of this liability in 

accordance with APB 21. 

Facts:

A bank decides to convert from its current in-house data processing arrangement to a thirdparty data processing servicer. The bank enters into a long-term contract (e.g., seven years) 

with the servicer. The bank will continue to own its data processing equipment, but anticipates 

that most of it will be replaced once conversion to the servicer occurs. 

Question 2:

Is the bank required to adjust the carrying amount of its data processing assets as a result of 

entering into this contract? 

Staff Response:

Yes. By entering into the contract, the bank effectively has removed its data processing 

equipment from active, productive use. Such an abandonment requires the bank to reflect the 

equipment on its books at the lower of amortized cost or fair value. Therefore, when the 

contract is entered into, the bank should determine which equipment will be used productively, 
90

and which will be effectively abandoned. For the latter, an adjustment to fair value should 

be recorded if it is less than amortized cost. In addition, subsequent adjustments should be 

made as the equipment's fair value declines. 
91

TOPIC 6: LIABILITIES 

6A. ACCOUNTING FOR CONTINGENCIES 

Facts: 

A legal action was brought against bank A. The court issued a judgment against the bank, and 

it has appealed. The bank has not provided any provision (liability) for the possible loss 

resulting from this litigation. 

Question 1:

Should bank A provide a provision for this loss since a judgment has been awarded against it? 

Staff Response:

Generally accepted accounting principles (SFAS 5) require that a loss contingency be recorded 

when a loss is probable and the amount can be estimated reasonably. In making a 

determination of whether a loss is probable, the expected outcome of the bank's appeal must be 

assessed. This is a legal determination that requires an evaluation of the bank's arguments for 

reversal of the judgment. Therefore, the bank's counsel should provide a detailed analysis of 

the basis for the appeal and the probability of reversal. 

The circumstances of the case and the opinion of legal council will be used to determinate 

whether a loss is probable and the amount can be estimated reasonably. Sound judgment must 

be exercised in reaching that determination. Furthermore, if it can be shown that a loss is 

probable, but there is a range of possible losses, a liability should be recorded for at least the 

minimum amount of loss expected. 

If counsel cannot provide an opinion or analysis to support the position that the judgment will 

be reversed or reduced substantially, the staff believes that a liability should generally be 

recorded for its amount. This is based on the fact that a lower court has decided against the 

bank, and no additional information is being provided to support its position. 

Facts: 

Fraudulent acts by former officers cost a bank losses totaling $2 million ($1,900,000 in loan 

losses and $100,000 in legal fees). The bank filed a claim with its fidelity bond carrier for 

payment of the total amount of coverage under the bond, aggregating $2 million. The losses 

have reduced bank capital below a level that the regulator’s find acceptable. 

Question 2:

Should a bank record a receivable for the $2 million when the claim is filed with the insurer? 
92

Staff Response:

No. It is usually inappropriate for a fidelity claim to be recognized before a written settlement 

offer has been received from the insurer. The staff believes that the potential recovery of the 

loss from anticipated insurance proceeds is a contingent asset. SFAS 5 indicates that 

contingent assets usually are not recorded, because revenue might be recognized prior to its 

realization. Further, recognition of the actual loss should not be deferred, because of the 

possibility of future recovery under fidelity insurance coverage. 

This conclusion is based on the uncertainty that often exists for insurance coverage of bonding 

claims. Bonding polices normally are complicated and contain numerous exceptions. 

Accordingly, it is not certain whether the claim will be honored ultimately and, if so, for what 

amount. Insurers investigate these claims carefully and generally do not acknowledge their 

validity or the amount for which they are liable until shortly before payment. 

Question 3: 

Assume the previous facts, but the insurer offers a settlement of $1 million. How would the 

accounting differ? 

Staff Response:

As noted in the previous question, a gain contingency may be recorded when the contingent 

event has a high probability of occurring, and the amount of the gain may be estimated with a 

reasonable degree of accuracy. If management and counsel can conclude that these conditions 

have been met because of the settlement offer from the insurer, it would be appropriate to 

record the amount of the offer. 
93

TOPIC 7: INCOME TAXES

7A. DEFERRED TAXES

Facts:

Banks must report income tax amounts, including deferred tax assets, in the call report in 

accordance with Statement of Financial Accounting Standards No. 109 (SFAS 109). 

However, the amount of certain deferred tax assets that national banks can include in 

regulatory capital is limited to the lesser of: 

• The amount of deferred tax assets that the institution expects to realize within one year 

of the quarter-end report date, based on its projection of future taxable income 

(exclusive of tax carryforwards and reversal of existing temporary differences for the 

year); or 

• Ten percent of Tier 1 capital, net of goodwill and all identifiable intangible assets other 

than servicing rights and purchased credit card relationships, and before any disallowed 

deferred tax assets are deducted. 

The amount of deferred tax assets reported on the bank's call report in excess of the 

recommended limitation is to be deducted from Tier 1 capital and reported on Schedule RC-F, 

memorandum item 1, "Deferred tax assets disallowed for regulatory capital purposes." 

Question 1: (September 2001) 

How do changes in the tax law, including tax rate changes, affect a bank's deferred tax assets 

and liabilities? 

Staff Response:

A bank must adjust its deferred tax assets and liabilities to reflect changes in tax rates or other 

provisions of tax law. The bank should recalculate deferred tax assets and liabilities to 

consider the provisions and rates of any new tax law. Any resulting adjustments should be 

recorded in the period that the new legislation is signed into law. 

Question 2: (September 2001)

The regulatory capital limit applies only to "deferred tax assets that are dependent upon future 

taxable income." How are such deferred tax assets determined? 
94

Staff Response: 

A bank's deferred tax assets that depend upon future taxable income are those deferred tax 

assets that the bank will realize only if it generates sufficient taxable income in the future. To 

apply the regulatory capital limit, the amount of those deferred tax assets that depend upon 

future taxable income is equal to: 

• The bank's net deferred tax assets (net of deferred tax liabilities and any valuation 

allowance) from Schedule RC-F, item 2, 

less 

• The amount of income taxes previously paid that are potentially recoverable through the 

carryback of net operating losses (carryback potential). 

Question 3: (September 2001) 

May a bank use existing forecasts of future taxable income that it prepared for its budget to 

estimate realizable amounts under SFAS 109 or to apply the regulatory capital limit? 

Staff Response:

Banks routinely prepare budgets and income forecasts for the future. These projections will 

typically serve as the starting point for the bank's estimate of future taxable income in applying 

SFAS 109, as well as the regulatory capital limit. The assumptions underlying these 

projections must be reasonable, and supported by objective and adequately verifiable evidence. 

Question 4: (September 2001) 

A banks' income projections are prepared typically each fiscal year. When applying the 

regulatory capital limit at an interim quarter-end report date, may a bank use the income 

projections for its fiscal year to approximate its income for the one-year period following the 

report date? 

Staff Response:

Yes. A bank may use its fiscal-year income projections when applying the proposed capital 

limit at an interim quarter-end report date, provided that those projections are not expected to 

differ significantly from the estimate of future taxable income for the one-year period following 

the quarter-end report date. 
95

Question 5: (September 2001) 

In determining the regulatory capital limit, is there a specific method a bank must follow to 

estimate the amount of deferred tax assets it expects to realize within one year of the quarterend report date? 

Staff Response:

A bank may use any reasonable approach to estimate one year's future taxable income. 

However, whatever method the bank chooses, it must make the calculation exclusive of tax 

carryforwards and reversals of existing temporary differences. 

One acceptable approach is to estimate future taxable income by taking the bank's pretax 

income (per the amount reported in the call report) and adjusting it for events or transactions 

that do not have tax consequences. The pretax income is adjusted for those items by deducting 

the amount of income that is never subject to income tax (e.g., tax-free interest income on 

municipal securities) and adding the amount of expenses that are never deductible (e.g., the 

disallowed portion of meals and entertainment expense). The projected taxable income is 

multiplied by the applicable tax rate. (The tax rate expected to apply during the one-year 

period following the report date based on the tax law existing at the report date.) 

However, the OCC recognizes that other methods of estimating future taxable income are also 

acceptable. Accordingly, banks may calculate one year's future taxable income using any 

reasonable method. 

Question 6: (September 2001) 

Are any adjustments required when applying the 10 percent of the Tier 1 capital portion of the 

limit? 

Staff Response:

Yes. A bank should apply the 10 percent limit to Tier 1 capital before the deduction of 

disallowed servicing assets, disallowed purchased credit card relationships, and disallowed 

deferred tax assets. This amount can be determined by subtracting goodwill and other 

intangible assets, except servicing assets and purchased credit card relationships, from the 

components of Tier 1 capital. 

Question 7: (September 2001)

How does the valuation allowance that may be required under SFAS 109 relate to the 

regulatory capital limit? 
96

Staff Response: 

The required valuation allowance (if any) under SFAS 109 is not the same as the amount of 

deferred tax assets that must be deducted from regulatory capital under its limit. The 

regulatory capital limitation is based on the net amount after deducting the required valuation 

allowance. 

A bank should determine the amount of deferred tax assets for reporting on its call report in 

accordance with SFAS 109. Under SFAS 109, a bank calculates deferred tax assets by 

multiplying its deductible temporary differences by the applicable tax rate (the rate expected to 

apply during the period in which the deferred tax assets will be realized). 

If necessary, a bank should record a valuation allowance to reduce the amount of deferred tax 

assets to an amount that is "more likely than not" to be realized. A bank should consider all 

available positive and negative evidence in assessing the need for a valuation allowance. 

Banks should report the amount of their net deferred tax assets (i.e., deferred tax assets net of 

any valuation allowance and net of deferred tax liabilities) on Schedule RC-F, item 2. This net 

deferred tax asset amount is the starting point for applying the proposed capital limit. 

Question 8: (September 2001)

When both positive and negative evidence exists of a bank's ability to earn future taxable 

income, what specific guidance should a bank follow to determine if a valuation allowance is 

needed? 

Staff Response:

All available evidence, both positive and negative, should be considered to determine whether 

a valuation allowance is needed. Accordingly, a bank should consider its current financial 

position and the results of operations for current and preceding years. Historical information 

should be supplemented by currently available information for future years. 

A bank must use judgment when both positive and negative evidence exist. In such situations, 

examples of positive evidence that might support a conclusion for no valuation allowance 

include: 

• A strong earnings history, exclusive of the loss that created the future tax deduction, 

coupled with evidence that the loss was an unusual or extraordinary item. 

• A change in operations, such as installation of new technology, that permanently 

reduces operating expenses. 
97

• A significant improvement in the quality of the loan portfolio. 

Examples of negative evidence include: 

• A history of operating losses or tax credit carryforwards expiring unused. 

• An expectation that operating losses will continue in early future years, and that 

positive income will not be realized until the more distant future. 

• Unsettled circumstances that if unfavorably resolved would continuously affect future 

operations and profit levels adversely in future years. 

The weight given to the potential effects of negative and positive evidence should be 

commensurate with the extent to which it can be verified objectively. For example, a history 

of operating losses would likely carry more weight than a bank's assessment that the quality of 

its loan portfolio has improved. 

Facts: 

Bank A has been in existence for five years. Although it has had profitable quarters from time 

to time, it has never shown positive annual income. Its cumulative losses exceed $2,000,000. 

In the latest fiscal year, its best year ever, the bank lost $150,000. The bank's total assets have 

been growing steadily, and management believes it will reduce costs and begin earning positive 

operating income in the coming year. 

Management estimates the bank will show taxable income of $200,000 next year. 

Management bases its estimate on several factors, including an improved loan portfolio and a 

higher net interest margin, which it believes will result from decreases in market interest rates. 

 

Question 9: (September 2001)

How should Bank A account for its deferred tax assets? 

Staff Response: 

Bank A should record a valuation allowance for the full amount of its deferred tax assets. The 

lack of a strong earnings history raises doubt that the bank can generate sufficient positive 

income to recover its deferred tax assets, although positive operating income is not a 

prerequisite for recording a deferred tax asset. 

The recent history of operating losses provides objective evidence of the bank's inability to 

generate profits. Such evidence should be given more weight than less quantifiable data that 
98

depend on subjective data (i.e., future interest rate forecasts). 

Facts: 

Bank A has a net unrealized holding gain on available-for-sale debt securities of $1,000,000. 

Its composite tax rate is 40 percent, so it has recorded a $400,000 deferred tax liability relating 

to the unrealized gain. The bank also has gross deferred tax assets of $4,000,000 and other 

deferred tax liabilities of $300,000. Taxes paid for the current year and prior three years that 

could potentially be recovered through loss carrybacks total $2,000,000. Its Tier 1 capital 

before deducting disallowed deferred tax assets is $5,000,000. The bank does not have 

servicing assets or purchased credit card relationships. Bank A has a strong record of earnings 

and expects continued profitability in the future. Therefore, it has not recorded a valuation 

allowance. 

Question 10: (September 2001)

Net unrealized holding gains and losses on available-for-sale securities (SFAS 115 gains and 

losses) are excluded from regulatory capital. When calculating the deferred tax limitation, 

should Bank A also exclude from this calculation the tax effect of gains and losses on availablefor-sales securities? 

Staff Response:

For regulatory capital purposes, the OCC allows banks to establish their own policy on the 

inclusion of gains and losses on available-for-sales securities in their computation of the 

deferred tax limitation. However, the bank must apply consistently the method that it chooses. 

The decision on how to treat the SFAS 115 tax effects will affect a bank's regulatory capital 

levels and its leverage and risk-based capital ratios. The following example, based on the 

previous facts, displays the potential affect on Bank A's regulatory capital. 
99

Scenario 1 Scenario 2 

Eliminate SFAS 115 

Tax Effects 

Include SFAS 115 

Tax Effects 

Gross Deferred Tax Asset $4,000,000 $4,000,000 

Carryback Potential 2,000,000 2,000,000 

Deferred Tax Liability 300,000 700,000 

Net Deferred Tax Assets 

Dependent upon Future 

Taxable Income 1,700,000 1,300,000 

10% of Tier 1 Capital 

 (before deductions)* 500,000 

 

 500,000 

Amount Disallowed 1,200,000 800,000 

Tier 1 Capital $3,800,000 $4,200,000 

* For purposes of this example, assume the tax effect of a bank's estimate that one 

year's future taxable income exceeds 10 percent of Tier 1 capital. 

This situation, which included a net unrealized holding gain on the available-for-sale securities, 

resulted in higher regulatory capital under scenario 2. However, if a net unrealized holding 

loss occurred on these securities, scenario 1 would have produced the most favorable 

regulatory capital result. 

Question 11: (September 2001) 

Under the regulatory capital limit, deferred tax assets that depend upon future taxable income 

are limited to the amount of deferred tax assets that could be realized within one year of the 

quarter-end report date. Does the one-year limit on projections of future taxable income also 

apply when assessing the need for a valuation allowance under SFAS 109? 

Staff Response:

No. The one-year limit applies only when determining the amount of deferred tax assets that 

may or may not be included in regulatory capital. The one-year limit does not apply when 

determining the amount of deferred tax assets, net of any valuation allowance, that should be 

reported on the call report. 
100

As noted in question 7, a valuation allowance should be established, when necessary, to 

reduce the amount of deferred tax assets to the amount that is "more likely than not" to be 

realized. SFAS 109 does not specify a time period during which projections of future taxable 

income may be relied upon to support recognition of deferred tax assets. Typically, however, 

the further into the future income projections are made, the less realizable they may be. 

Question 12: (September 2001) 

When determining a bank's carryback potential under SFAS 109 and the regulatory capital 

limit, how should a bank consider taxes paid in prior years at effective rates different than the 

applicable tax rate used to record deferred tax assets? 

Staff Response:

In determining its carryback potential to apply SFAS 109 and the capital limitation, banks 

should consider the actual amount of taxes it could potentially recover through the carryback of 

net operating losses.
101

7B. TAX SHARING ARRANGEMENTS 

Facts:

The bank is a member of a consolidated group subject to a tax sharing agreement with its 

parent holding company. During the current year, the bank incurs a loss that would result in a 

tax benefit on a separate entity basis. However, the consolidated group previously has carried 

back its losses and recovered all available tax refunds from the IRS. 

Question 1:

Should the bank record a tax receivable for the benefit of its current year loss? 

Staff Response: 

Yes. The bank should record the tax benefit for its current year tax loss, and the holding 

company should refund this amount to the bank. The call report Instructions generally require 

that a bank subsidiary compute its taxes on a separate entity basis. Because the bank has NOL 

carryback potential available on a separate entity basis, it should receive the tax benefit of its 

current year loss. 

From a regulatory perspective, a holding company that has the financial capability should be 

required to reimburse the bank. If the holding company cannot do so, the amount of the tax 

benefit should be recorded as a dividend. 

The call report Instructions prohibit the adoption of a tax sharing agreement that results in a 

significant difference from what would have occurred on a separate entity basis. In this case, 

the bank would have received a tax refund if it had filed a separate return. Therefore, it 

should record the tax benefit of its current year loss and receive this amount from its parent. 

Facts:

The bank is a subsidiary of a holding company that files a consolidated return. In accordance 

with the tax sharing agreement, the subsidiary banks calculate and remit their estimated taxes 

to the parent holding company quarterly. 

Question 2: (September 2001) 

May a subsidiary bank remit estimated tax payments to its parent holding company during 

periods when the consolidated group does not have, or expect to have, a current tax liability?
102

Staff Response: 

Yes. Although the Interagency Policy Statement, "Statement on Income Tax Allocation in a 

Holding Company Structure," prohibits banks from paying their deferred tax liability to the 

holding company, it was not intended to restrict the payment of a bank's current tax liability. 

The call report Instructions allow a bank to remit the amount of current taxes that would have 

been calculated on a separate entity basis. However, the tax sharing agreement between the 

subsidiary bank and the holding company must contain a provision to reimburse the bank when 

it incurs taxable losses that it could carryback on a separate entity basis. 

Such remittances may be made quarterly, if the bank would have been required to make such 

payments on a separate entity basis. This is appropriate even if the parent has no consolidated 

tax liability. 

Facts:

The bank is a subsidiary of a holding company that files a consolidated return. The 

consolidated group incurs a loss in the current year and carries it back to prior years, resulting 

in a refund of substantially all taxes previously paid to the IRS. Under the tax sharing 

agreement, the subsidiary banks that produced the loss will receive a pro rata share of the total 

tax refund from the IRS. However, some subsidiaries filing as separate entities would be 

entitled to additional tax refunds. 

Question 3:

How should the bank subsidiaries record the tax benefit of their individual losses? 

Staff Response: 

The call report Instructions require that individual bank subsidiaries compute and record the 

tax benefit of a loss as separate entities. Additionally, they should receive that benefit as if 

they had filed for a refund as separate entities. 

The pro rata allocation of the tax benefit received from the IRS understates the tax benefit due 

the subsidiaries on a separate entity basis. From a regulatory perspective, a holding company 

that has the financial capability should be required to reimburse the amount due on a separate 

entity basis. If the holding company does not have the financial capability, the amount should 

be recorded as a dividend. 

Facts:

The bank is a member of a consolidated group subject to a tax sharing agreement. During the 

current year, the bank incurs a taxable loss which it can carry back as a separate entity. 

However, a mortgage banking subsidiary of the bank is profitable for the year. 
103

Question 4:

Should the mortgage banking subsidiary be included with the bank in determining its income 

tax expense/benefit as a separate company? 

Staff Response: 

As previously noted, the call report Instructions require that a bank compute its taxes as a 

separate entity. However, at the bank level, the reporting entity includes its mortgage banking 

subsidiary and any other subsidiaries that the bank may own. Payment of taxes to and refunds 

from the holding company would be based on the consolidated tax position of the bank and its 

subsidiaries. The mortgage banking subsidiary would pay taxes to the bank, not to the holding 

company. This applies the separate entity concept to each subsidiary level. 
104

7C. MARGINAL INCOME TAX RATES 

Facts:

The bank is a subsidiary of a holding company that files a consolidated return. Because of 

their common ownership, the affiliated companies are entitled to only one surtax exemption. 

Current IRS regulations permit the arbitrary allocation of the surtax exemption to any member 

of a group under common control, even if a consolidated return is not filed. As a result, the 

holding company, which was operating at a loss, allocated the entire surtax exemption to itself. 

Question 1:

For regulatory purposes, what is the proper allocation of the surtax exemption among 

subsidiaries when determining the amount of tax payments to be forwarded to the holding 

company? 

Staff Response: 

The one surtax exemption should be allocated among the affiliates in an equitable and 

consistent manner. Additionally, the surtax exemption should be allocated to profitable 

entities, since it is used only to compute the tax liability. 

A bank subsidiary of a holding company that files a consolidated return must report as current 

taxes and pay to its parent holding company the amount that would otherwise be due had it 

filed a tax return as a separate entity. Accordingly, the amount of the subsidiary's current tax 

liability should include the allocation of the available surtax exemption. This accounting 

treatment is set forth in the call report Instructions. 

Question 2:

Would the answer to question 1 be different if it was the only subsidiary of a one bank holding 

company? 

Staff Response: 

No. The bank should receive an allocated portion of the consolidated group's surtax 

exemption in accordance with the call report Instructions regardless of the number of 

subsidiaries involved. 

Facts:

Assume the marginal tax rate for corporate taxable income over $10 million is 35 percent. 

Under this rate structure, a consolidated group could have taxable income in excess of $10 
105

million that would be taxed at 35 percent, and the taxable income of the banks within the 

consolidated group, measured on a separate entity basis, may be taxed at a 34 percent rate, 

because their taxable income is less than $10 million. 

Question 3:

What rate should the bank use to compute its income tax expense as a separate entity? 

Staff Response:

The bank may use an income tax rate of 35 percent. The call report instructions require that a 

bank's income tax expense be computed on a separate entity basis. However, those 

instructions also allow adjustments to allocate additional amounts among the subsidiary banks, 

provided the allocation is equitable and applied consistently. An adjustment for the 

consolidated groups' incremental tax rate, properly applied, would satisfy that requirement. 
106

TOPIC 8: CAPITAL 

8A. CAPITAL TREATMENT FOR ASSET SALES AND SECURITIZATIONS 

The Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance 

Corporation, the Federal Reserve Board (Board), and the Office of Thrift Supervision 

published a final rule on the Capital Treatment of Recourse, Direct Credit Substitutes 

and Residual Interests in Asset Securitizations in November of 2001 (the recourse rule). 

The recourse rule became effective on January 1, 2002, and has generated several 

questions from the industry regarding proper implementation and application. Questions 

3 through 11, taken from OCC Bulletin 2002-22, provide interpretive guidance on various 

issues raised by the recourse rule. Questions 12 through 20, taken from OCC Bulletin 

2002-20, provide guidance on implicit recourse in assets securitizations. Please refer to 

the recourse rule and these bulletins for additional information. 

Question 1: (September 2001) 

How are pro rata loss sharing agreements treated for risk-based capital purposes? 

Staff Response: 

Certain transactions limit the seller's risk, on a pro rata basis, to a fixed percentage of any 

losses that might be incurred. Assuming there are no other provisions resulting in uneven 

retention of risk, either directly or indirectly, by the seller, risk-based capital is held only 

against the percentage of principal for which the seller is at risk. 

For example, assume $100,000 of assets are sold with a provision requiring the seller and 

buyer to share proportionately in losses incurred on a 10 percent and 90 percent basis, 

respectively. The seller is not liable for any other retention of risk. Capital need not be held 

against the $90,000 of assets. Risk-based capital would be held only against the remaining 

$10,000.

Facts: 

A bank securitized credit card receivables through a master trust. Sometime thereafter, the 

loans in the trust began to experience adverse performance because of credit quality problems. 

To correct that problem, the bank will purchase receivables from the trust to facilitate their sale 

to an independent third party. The purchased receivables will include both performing and 

delinquent accounts. The trust will be paid par value for the receivables. The bank will 

immediately sell all of the purchased receivables for an amount equal to or greater than par 

value to a third party. The sale to the third party will be agreed upon prior to removing the 

assets from the trust. Consequently, the bank will not be exposed to any risk of loss. 
107

Question 2: (September 2001) 

Must the bank hold risk-based capital against the assets in this securitization? 

Staff Response: 

No, the bank need not hold risk-based capital against the assets remaining in the trust. This 

transaction may assist the bank in returning the trust to a healthy financial condition. The 

bank, however, is not exposed to any risk of loss since it will sell the loans to a third party 

buyer for a price that at least equals the amount it paid for those loans. 

Question 3: (June 2003)

Are spread accounts that function as credit enhancements “credit-enhancing interest-only 

strips” and, therefore, subject to the concentration limit? 

Staff Response: 

The recourse rule defines “credit-enhancing interest-only strip” as “an on-balance sheet asset 

that, in form or in substance, (i) represents the contractual right to receive some or all of the 

interest due on the transferred assets; and (ii) exposes the banking organization to credit risk 

that exceeds its pro rata claim on the underlying assets whether through subordination 

provisions or other credit enhancing techniques.” The preamble to the recourse rule elaborates 

on this definition. “In determining whether a particular interest cash flow functions as a creditenhancing I/O strip, the Agencies will look to the economic substance of the transaction, and 

will reserve the right to identify other cash flows or spread-related assets as credit-enhancing 

I/O strips on a case-by-case basis.” 

A spread account is an on-balance sheet asset that functions as a credit enhancement and that 

can represent an interest in expected interest and fee cash flows derived from assets a bank has 

sold into a securitization. In those cases, the spread account is considered to be a “creditenhancing interest-only strip” and is subject to the concentration limit. However, any portion 

of a spread account that represents an interest in cash that has already been collected and is 

held by the trustee is a “residual interest” subject to dollar-for-dollar capital, but not a credit 

enhancing interest-only strip subject to the concentration limit. 

For example, assume that a bank books a single spread account asset that is derived from two 

separate cash flow streams: 

(1) a receivable from the securitization trust that represents cash that has already accumulated in 

the spread account. In accordance with the securitization documents, the cash will be returned to 

the bank at some date in the future after having been reduced by the amounts used to reimburse 

investors for credit losses. Based on the date when the cash is expected to be paid out to the 

bank, the present value of this asset is currently estimated to be $3. 
108

(2) a projection of future cash flows that are expected to accumulate in the spread account. 

In accordance with the securitization documents, the cash, to the extent collected, will also be 

returned to the bank at some date in the future after having been reduced by amounts used to 

reimburse investors for credit losses. Based on the date when the cash is expected to be paid out 

to the bank, the present value of this asset is currently estimated to be $2. 

Both components of the spread account are considered to be residual interests under the current 

capital standards because both represent on-balance sheet assets subject to more than their pro 

rata share of losses on the underlying portfolio of sold assets. However, the $2 asset that 

represents the bank's retained interest in future cash flows exposes the organization to a greater 

degree of risk because the $2 asset presents additional uncertainty as to whether it will ever be 

collected. This additional uncertainty associated with the recognition of future subordinated 

excess cash flows results in the $2 asset being treated as a credit-enhancing interest-only strip, a 

subset of residual interests. 

Under the recourse rule, the face amount of all of the bank's credit-enhancing interest-only strips 

is first subject to a 25 percent of Tier 1 capital concentration limit. Any portion of this face 

amount that exceeds 25 percent of Tier 1 capital is deducted from Tier 1 capital. This limit will 

affect both a bank’s risk-based and leverage capital ratios. The remaining face amount of the 

bank's credit-enhancing interest-only strips, as well as the face amount of the spread account 

receivable for cash already held in the trust, is subject to the dollar-for-dollar capital requirement 

established for residual interests, which affects only the risk-based capital ratios.

Question 4: (June 2003) 

How are instruments that are derived from a securitization and assigned separate ratings for 

principal and interest (split/partially-rated instruments) treated in the recourse rule? 

Staff Response: 

The recourse rule does not specifically address the treatment of split/partially-rated 

instruments. However, in its discussion of the ratings-based approach, the preamble to the 

recourse rule indicates that the ratings-based approach “provides a way for the agencies to use 

determinations of credit quality . . . to differentiate the regulatory capital treatment for loss 

positions representing different gradations of risk.” The rule contemplated treating each 

“position” in its entirety. Thus, for those banks that hold split/partially-rated instruments, the 

OCC will apply to the entire instrument the risk weight that corresponds to the lowest 

component rating. For example, a purchased subordinated security where the principal 

component is rated BBB, but the interest component is rated B, will be subject to the gross-up 

treatment accorded to direct credit substitutes rated B or lower as set forth in the recourse rule. 

Similarly, if a portion of an instrument is unrated, the entire position will be treated as if it is 

unrated. In addition to this regulatory capital treatment, the OCC may also, as appropriate, 

adversely classify and require write-downs for other than temporary impairment on unrated 

and below investment grade securities, including split/partially-rated securities. The OCC also 
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reminds banks that the OCC may “override the use of certain ratings or the ratings on 

certain instruments, either on a case-by-case basis or through broader supervisory policy, if 

necessary or appropriate to address the risk that an instrument poses to banks. See 66 Fed. 

Reg. 59614 and 59625. 

Question 5: (June 2003) 

Do corporate bonds or other securities not related in any way to a securitization or structured 

finance program qualify for the ratings-based approach? 

Staff Response: 

No. Only mortgage- and asset-backed securities, recourse obligations, direct credit substitutes, 

and residual interests (except credit-enhancing interest-only strips) retained, assumed, or issued 

in connection with a securitization or structured finance program, as defined in the recourse 

rule, qualify for the ratings-based approach. “Securitization” is defined as “the pooling and 

repackaging by a special purpose entity of assets or other credit exposures that can be sold to 

investors.” A “structured finance program” is defined as “a program where receivable 

interests and asset-backed securities issued by multiple participants are purchased by a special 

purpose entity that repackages those exposures into securities that can be sold to investors.” 

Corporate debt instruments, municipal bonds and other securities that are not related to a 

securitization or structured finance program do not meet these definitions and, thus, do not 

qualify for the ratings-based approach. 

Question 6: (June 2003) 

Concerning the repurchase of assets pursuant to a clean-up call, the preamble to the recourse 

rule states that a “banking organization should repurchase the loans at the lower of their 

estimated fair value or their par value plus accrued interest.” May the bank determine an 

aggregate fair value for all repurchased assets or should each repurchased loan be individually 

evaluated? 

Staff Response: 

Banks that repurchase assets as a result of the exercise of a clean-up call may do so based on 

the aggregate fair value of all repurchased assets. The OCC did not intend for each individual 

loan remaining in the pool at the time a clean-up call is exercised to be individually evaluated 

to determine its fair value. Rather, the overall repurchase price should reflect the aggregate 

fair value of the assets being repurchased so that the bank is not overpaying for the assets and, 

in so doing, providing credit support to the trust investors. The OCC will review the terms and 

conditions relating to the repurchase arrangements in clean-up calls to ensure that transactions 

are done at the lower of fair value or par value plus accrued interest. Banks should be able to 

support their fair value estimates. Should the OCC conclude that a bank has repurchased assets 
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at a price that exceeds the lower of these two amounts, the clean-up call provisions in a 

bank's future securitizations may be treated as recourse obligations or direct credit substitutes. 

Question 7: (June 2003)

The recourse rule states that “clean-up calls that are 10 percent or less of the original pool 

balance and that are exercisable at the option of the [bank]” are not recourse or direct credit 

substitutes. May this treatment also apply to clean-up calls written with reference to less than 

10 percent of the outstanding principal amount of securities? 

Staff Response: 

Yes. The OCC will not require recourse or direct credit substitute treatment for clean-up calls 

written with reference to 10 percent of the outstanding principal amount of the securities. The 

purpose of treating large clean-up calls as recourse or direct credit substitutes is to ensure that 

banks are not able to provide credit support to the trust investors by repaying their investment 

when the credit quality of the pool is deteriorating without holding capital against the exposure. 

 A clean-up call based on 10 percent of outstanding securities would not defeat 

the purpose of the rule and, oftentimes, may be a more conservative benchmark than 10 

percent of the pool balance. 

Question 8: (June 2003)

Does the mere existence of a clean-up call in a securitization trigger treatment as a recourse 

obligation or direct credit substitute or must the clean-up call be exercised in order to trigger 

this treatment? 

Staff Response: 

The recourse rule includes clean-up calls as an example of both a “recourse” arrangement and 

a “direct credit substitute.” The rule focuses on the arrangement itself, and not the exercise of 

the call. Thus, the existence, not the exercise, of a clean-up call that does not meet the 

requirements laid out in the final rule will trigger treatment as a recourse obligation or a direct 

credit substitute. A clean-up call can function as a credit enhancement because its existence 

provides the opportunity for a banking organization (as servicer or as an affiliate of the 

servicer) to provide credit support to investors by taking an action that is within the contractual 

terms of the securitization documents. 

Question 9: (June 2003) 

Does the recourse rule change the risk weight/conversion factor for performance standby 

letters of credit? 
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Staff Response: 

No. “Performance standby letters of credit,” as defined in the OCC’s risk-based capital 

standards, generally do not meet the definition of a direct credit substitute. Therefore, they are 

not covered under the recourse rule and will still be converted at 50 percent and generally risk 

weighted at 100 percent. 

Question 10: (June 2003) 

 

The recourse rule states that for an internal credit risk rating system for an asset-backed 

commercial paper program to be adequate, “an internal audit procedure should periodically 

verify that internal risk ratings are assigned in accordance with the banking organization’s 

established criteria.” Does the internal audit procedure have to be performed by the internal 

audit department or can it be performed by another independent entity within the bank? 

Staff Response: 

The recourse rule does not require the internal audit of the internal credit risk rating system to 

be performed by the internal audit department. Any group within the organization that is 

qualified to audit the system and independent of both the group that makes the decision to 

extend credit to the asset-backed commercial paper program and the groups that develop and 

maintain the internal credit risk rating system may perform the internal audit of the system. 

Question 11: (June 2003)

How is the capital treatment described in the Synthetic Collateralized Loan Obligations 

guidance published by the OCC and the Board in November 1999 affected by the recourse 

rule? 

Staff Response: 

The preamble to the recourse rule addresses the modification of the treatment of credit 

derivative transactions outlined in the November 1999 guidance. “With the issuance of this 

final rule, the agencies reaffirm the validity of the structural and risk-management 

requirements of the December 1999 guidance on synthetic securitizations issued by the OCC 

and the Board, while modifying the risk-based capital treatment detailed therein with the 

treatment presented in this final rule.” The following detailed information will clarify the riskbased capital treatment appropriate to the credit derivative transactions presented in the 

November 1999 guidance. 

The guidance on synthetic collateralized loan obligations discussed the risk-based capital 

treatment of three specific types of synthetic securitization transactions, subject to the 

sponsoring bank’s compliance with minimum risk management requirements. The objective of 

these capital interpretations was to recognize the effective transference of the economic risk of 
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loss in these synthetic securitization transactions. As discussed more fully below, the riskbased capital treatment of the first two structures described in the November 1999 guidance 

remains largely unchanged. The qualification requirements for the second structure (Bistrotype transactions) have been modified to eliminate the restriction on the size of the retained 

first loss position. The recourse rule has the greatest effect on the risk-based capital treatment 

of the third structure. As indicated in the preamble to the recourse rule, the risk management 

requirements contained in the joint guidance are still in force. 

In the first structure the sponsoring bank, through a synthetic collateralized loan obligation 

(CLO), hedges the entire notional amount of a reference asset portfolio. The credit protection 

is obtained through the issuance of credit-linked notes (CLNs), the proceeds of which fully 

collateralize a portfolio of the bank’s loans. The zero risk-weight on the cash-collateralized 

loans is not affected by the recourse rule. 

In structure 2 (Bistro-type) transactions, the sponsoring bank hedges a portion of the reference 

portfolio and retains a high quality senior risk position that absorbs only those credit losses in 

excess of the junior loss positions. There is no change in the capital treatment for this type of 

transaction under the recourse rule: dollar-for-dollar capital on the retained first loss piece and 

a 20 percent risk weight on the retained senior piece if it is senior to AAA-rated CLNs. (If 

the bank can obtain a rating of BB or better on the first position loss, and the first position loss 

is not a credit-enhancing interest-only strip then the bank may be able to apply a more 

favorable risk weight to the first position loss.) The recourse rule expressly permits “inferred” 

ratings. To obtain that capital treatment, it is no longer necessary to limit the retained first loss 

piece to “a small cash reserve, sufficient to cover expected losses” as specified in the guidance. 

A bank entering into a structure 2-type transaction still must satisfy the risk management 

conditions contained in the annex of the guidance in order to receive the risk-based capital 

treatment described above. 

In a structure 3 transaction, the sponsoring bank retains a subordinated position that absorbs first 

losses in a reference portfolio. The guidance identified three distinguishing features of a 

structure 3-type transaction: (1) the sponsoring bank retains a first loss position greater than 

expected loss, (2) an intermediary OECD bank establishes a special purpose entity (SPE) to 

issue the AAA-rated CLNs, and (3) the sponsoring bank purchased protection on both the 

second loss and the senior positions from the intermediary bank. Under the guidance, the 

capital treatment was the larger of two alternative approaches: (1) dollar-for-dollar capital on 

the retained first loss piece or (2) application of the risk weight of the underlying exposures to 

the face amount of the first loss piece, plus zero percent risk weight on the collateralized 

mezzanine position, and plus 20 percent risk weight on the retained senior position protected 

by a credit derivative from the intermediary bank. The final rule changes this capital 

treatment. 

Under the recourse rule, a sponsoring bank entering into a structure 3-type transaction would 

hold dollar-for-dollar capital on the retained first loss piece. The senior loss position would 

receive a 20 percent risk weight when protected by a credit derivative from an OECD bank or 
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from certain qualifying securities firms. The mezzanine, second-loss position that is 

collateralized by U.S. Treasury securities would continue to receive a zero percent risk weight. 

This interpretation, particularly the lifting of the restriction on the size of the retained first loss 

piece on structure 2 transactions, removes the main structural distinction between structure 2 

and structure 3 transactions. (The other structural difference, the issuance of the CLNs by an 

SPE established by an intermediary bank, does not affect the credit protection obtained by the 

sponsoring bank.) In both structures, the second loss position is collateralized by U.S. 

Treasury securities. Thus, a sponsoring bank’s credit risk exposure for the first and second 

loss positions is virtually identical whether it employs structure 2, and forms an SPE directly to 

issue the CLNs, or structure 3, and purchases credit protection from an intermediary that 

forms the SPE to issue the CLNs. If the sponsoring bank satisfies all of the risk management 

conditions contained in the annex of the guidance, a structure 3 transaction may be classified as 

a structure 2 transaction and qualify for the risk-based capital treatment for such transactions. 

In other words, the sponsoring bank no longer is required to purchase protection on the senior 

loss position in order to assign a 20 percent risk weight to that position. Rather, it can assign a 

20 percent risk weight based on the inferred rating of the subordinate credit linked notes. 

However, if the sponsoring bank does not meet the risk management conditions, it must 

purchase credit protection from an OECD bank or securities firm that qualifies for a 20 percent 

risk weight, before assigning a 20 percent risk weight to the retained senior position. If the 

sponsoring bank decides to use an intermediary that is not an OECD bank or a securities firm 

that qualifies for a 20 percent risk weight, the sponsoring bank must assign a 100 percent risk 

weight to the senior position. 

Additionally, because the zero percent risk weight on the second loss position is due to the 

U.S. Treasury securities collateral, not the type of intermediary that establishes the SPV, the 

sponsoring bank could use a non-depository institution as an intermediary. However, because 

synthetic transactions expose banks to risk other than credit risk, the intermediary should be of 

high quality, e.g., at least investment grade. 

Facts: 

A bank originates and services credit card receivables throughout the country. The bank 

decides to divest those credit card accounts of customers who reside in specific 

geographic areas where the bank lacks a significant market presence. To achieve the 

maximum sales price, the sale must include both the credit card relationships and the 

receivables. Because many of the credit card receivables are securitized through a master 

trust structure, the bank needs to remove the receivables from the trust. The affected 

receivables are not experiencing any unusual performance problems. In that respect, the 

chargeoff and delinquency ratios for the receivables to be removed from the trust are 

substantially similar to those for the trust as a whole. 

The bank enters into a contract to sell the specified credit card accounts before the 

receivables are removed from the trust. The terms of the transaction are arm’s-length, 
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wherein the bank will sell the receivables at market value. The bank separately agrees to 

purchase the receivables from the trust at this same price. Therefore, no loss is incurred 

as a result of removing the receivables from the trust. The bank will only remove 

receivables from the trust that are due from customers located in the geographic areas 

where the bank lacks a significant market presence, and it will remove all such 

receivables from the trust. 

Question 12: (June 2003)

Does the removal of these receivables from the trust constitute implicit recourse for 

regulatory capital purposes? 

Staff Response: 

No, the transaction does not constitute implicit recourse. Supporting factors for this 

conclusion are: 

• The bank’s earnings and capital are not exposed to actual or potential risk of loss 

as a result of removing the receivables from the trust. 

• There is no indication that the receivables are removed from the trust due to 

performance concerns. 

• The bank is removing the receivables from the trust for a legitimate business 

purpose other than to systematically improve the quality of the trust’s assets. The 

legitimate business purpose is evidenced by the bank’s pre-arranged, arm’s-length 

sale agreement that facilitates exiting the business in identified geographic 

locations. 

Supervisors should review the terms and conditions of the transaction to ensure that the 

market value of the receivables is documented and well supported before concluding that 

this transaction does not represent implicit recourse. Supervisors should also ensure that 

the selling bank has not provided the purchaser with any guarantees or credit 

enhancements on the sold receivables. 

Facts:

After the establishment of a master trust for a pool of credit card receivables, the 

receivables in the trust begin to experience adverse performance. A combination of 

lower-than-expected yields and higher-than-anticipated chargeoffs on the pool causes 

spreads to compress significantly (although not to zero). The bank’s internally generated 

forecasts indicate that spreads will likely become negative in the near future. 

Management takes action to support the trust by purchasing the low-quality (delinquent) 
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receivables from the trust at par although their market value is less than par. The 

receivables purchased from the trust represent approximately one-third of the trust’s total 

receivables. This action improves the overall performance of the trust and avoids a 

potential early amortization event. 

Question 13: (June 2003)

Does the purchase of low-quality receivables from a trust at par constitute implicit 

recourse for regulatory capital purposes? 

Staff Response: 

Yes, this activity constitutes implicit recourse because the purchase of low quality 

receivables at an above-market price exposes the bank’s earnings and capital to potential 

future losses from assets that had previously been sold. Accordingly, the bank is 

required to hold risk-based capital for the remaining assets in the trust as if they were 

retained on the balance sheet, as well as for the assets that were repurchased. 

Facts:

Months after the issuance of credit card asset-backed securities, chargeoffs and 

delinquencies on the underlying pool of receivables rise dramatically. A rating agency 

places the securities on “watch” for a potential rating downgrade, causing the bank to 

negotiate additional credit support for the securitized assets. The securitization 

documents require the bank to transfer new receivables to the securitization trust at par 

value. However, to maintain the rating on the securities, the bank begins to sell 

replacement receivables into the trust at a discount from par value. 

Question 14: (June 2003)

Does this action constitute implicit recourse for regulatory capital purposes? 

Staff Response: 

Yes, the sale of receivables to the trust at a discount constitutes implicit recourse. The 

sale of assets at a discount from the price specified in the securitization documents, par 

value in this example, exposes earnings and capital to future losses. The bank must hold 

regulatory capital against the outstanding assets in the trust. 

Facts:

A bank established a credit card master trust. The receivables from the accounts placed 

in the trust were, on average, of lesser quality than the receivables from accounts retained 

on the bank’s balance sheet. Under the criteria for selecting the receivables to be 
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transferred to the master trust, the bank was prevented from including the betterperforming affinity accounts in the initial pool of accounts because the affinity 

relationship contract was expiring. The bank and the affinity client subsequently revised 

the terms of their contract, enabling the affinity accounts to meet the selection criteria and 

be included in future securitization transactions. Later, rising charge-offs within the pool 

of receivables held by the trust caused spread compression in the trust. To improve the 

performance of the assets in the trust, the bank began to include the better-performing 

and now eligible receivables from the affinity accounts among the receivables sold to the 

trust. This action improves the trust’s performance, including spread levels and chargeoff ratios. However, the replacement assets were sold at par in accordance with the 

terms of the trust agreement, so no current or future charge to the bank's earnings or 

capital will result from these asset sales. This action also results in the performance of 

the trust’s assets closely tracking the performance of the credit card receivables that 

remain on the bank’s balance sheet. 

Question 15: (June 2003)

Do these actions constitute implicit recourse for regulatory capital purposes? 

Staff Response: 

No, these actions do not constitute implicit recourse. The bank did not incur any 

additional risk to earnings or capital after the affinity accounts met the selection criteria 

for replacement assets and the associated receivables were among the receivables sold to 

the trust. The replacement assets were sold at par in accordance with the terms of the 

trust agreement, so no future charge to earnings or capital will result from these asset 

sales. The sale of replacement assets into a master trust structure is part of normal trust 

management. 

In this example, the credit card receivables that remain on the bank's balance sheet closely 

track the performance of the trust's assets. Nevertheless, supervisors should ascertain whether 

a securitizing bank sells disproportionately higher quality assets into securitizations while 

retaining comparatively lower-quality assets on its books and, if so, consider the effect of this 

practice on the organization's capital adequacy. 

Facts:

A bank establishes a credit card master trust comprised of receivables from accounts that 

were generally of lower quality than the receivables retained on the bank’s balance sheet. 

The difference in the two portfolios is primarily due to logistical and operational 

problems that prevent the banking organization from including certain better-quality 

affinity accounts in the initial pool from which accounts were selected for securitization. 

Rising charge offs and other factors later result in margin compression on the assets in 

the master trust, which causes some concern in the market regarding the stability of the 
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outstanding asset-backed securities. A rating agency places several securities on its watch 

list for a potential rating downgrade. In response to the margin compression as part of 

the bank’s contractual obligations, spread accounts are increased for all classes by 

trapping excess spread in conformance with the terms and conditions of the securitization 

documents. 

To stabilize the quality of the receivables in the master trust as well as to preclude a 

downgrade, the bank takes several actions beyond their contractual obligations: 

• Affinity accounts are added to the pool of receivables eligible for inclusion in the 

trust. This change results in improved overall trust performance. However, these 

receivables are sold to the trust at par value, consistent with the terms of the 

securitization documents, so no current or future charge to the bank's earnings or 

capital will result from these asset sales. 

• The charge-off policy for cardholders who have filed for bankruptcy is changed 

from criteria that were more conservative than industry standards and the FFIEC 

Uniform Retail Credit Classification and Account Management Policy to criteria 

that conform to these standards and the agencies’ policy. 

• Charged-off receivables held by the trust are sold to a third party. The funds 

generated by this sale, effectively accelerating the recovery on these receivables, 

improves the trust’s spread performance. 

Question 16: (June 2003)

Do these actions constitute implicit recourse for regulatory capital purposes? 

Staff Response: 

No, the actions do not constitute implicit recourse. None of the noncontractual actions 

(above) results in a loss, or exposes the bank’s earnings or capital to the risk of loss. 

Because of the margin compression, the organization is obligated to increase the spread 

accounts in conformance with the terms and conditions of the securitization documents. To 

the extent this results in an increase in the value of the subordinated spread accounts 

(residual interests) on the bank’s balance sheet, the organization will hold additional capital 

on a dollar-for-dollar basis for the additional credit risk retained by the bank. In contrast, if 

the bank increased the spread accounts beyond its contractual obligation under the 

securitization documents in order to provide additional protection to investors, this action 

would be considered a form of implicit recourse. 
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With respect to the other actions the bank took: 

• Because the additions of receivables from the new affinity accounts are made at 

par value in accordance with the securitization documents, as they are with other 

additions to credit card trusts, they do not affect the banking organization’s 

earnings or capital. 

• The trust’s policy on the timing of chargeoffs on accounts of cardholders who 

have filed for bankruptcy was changed to meet the less stringent standards of the 

industry and those required under the agencies’ policy in order to, at least 

temporarily, improve trust performance. Nonetheless, this change does not affect 

the bank’s earnings or capital. 

• In accordance with the securitization documents, proceeds from recoveries on 

charged-off accounts are the property of the trust. These and other proceeds 

continue to be paid out in accordance with the pooling and servicing agreement. 

No impact on the bank’s earnings or capital resulted. 

Facts: 

A bank’s credit card master trust is experiencing problems due to deteriorating credit 

quality. A nonbank subsidiary of the bank holding company, i.e., an affiliate of the 

bank, provides financial support in the form of cash contributions to the trust. 

Question 17: (June 2003)

Does the nonbank affiliate’s support constitute implicit recourse by the bank for regulatory 

capital purposes? Is the bank required to hold risk-based capital against the remaining 

assets in the trust? 

Staff Response: 

No. Support provided to the trust by a nonbank affiliate does not represent implicit recourse 

for the bank. Because the bank did not provide the support, its earnings and capital were not 

exposed to potential risk of loss. The bank is not required to hold additional risk-based capital 

for the assets held by the trust. 

However, these facts and circumstances would result in implicit recourse at the bank holding 

company level. 
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Facts: 

In performing the role of servicer for its securitization, a bank is authorized under its 

pooling and servicing agreement to modify loan repayment terms when it appears that 

this action will improve the likelihood of repayment on the loan. These actions are part 

of the bank’s process of working with customers who are delinquent or otherwise 

experiencing temporary financial difficulties. All of the modifications are consistent with 

the bank’s internal loan policy. However, in modifying the loan terms, the contractual 

maturity of some loans may be extended beyond the final maturity date of the most junior 

class of securities sold to investors. When this occurs, the bank repurchases these loans 

from the securitization trust at par. 

Question 18: (June 2003)

Does the modification of terms and repurchase of loans held by the trust constitute 

implicit recourse for regulatory capital purposes? 

Staff Response: 

Yes. The combination of the loan term modification for securitized assets and subsequent 

repurchase constitutes implicit recourse. While the modification of loan terms is permitted 

under the pooling and servicing agreement, the repurchase of loans with extended maturities at 

par exposes the bank’s earnings and capital to potential risk of loss. 

Facts: 

A wholly-owned subsidiary of a bank originates and services a portfolio of home equity loans. 

After liquidation of the collateral for a defaulted loan, the subsidiary makes the trust whole in 

terms of principal and interest if the proceeds from the collateral are not sufficient. However, 

there is no contractual commitment that requires the subsidiary to support the pool in this 

manner. The payments made to the trust to cover deficient balances on the defaulted loans are 

not recoverable under the terms of the pooling and servicing agreement. 

Question 19: (June 2003)

Does the subsidiary’s action constitute implicit recourse to the bank for regulatory capital 

purposes? 

Staff Response: 

Yes, this action is considered implicit recourse because it adversely affects the bank’s 

earnings and capital since the banking organization absorbs losses on the loans resulting 

from the actions taken by its subsidiary. Further, no mechanism exists to provide for, 

and ensure that, the subsidiary will be reimbursed for the payments made to the trust. In 
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addition, supervisors will consider any servicer advance a credit enhancement if the 

servicer is not entitled to full reimbursement or the reimbursement is subordinate to other 

claims. A servicer advance will also be considered a form of credit enhancement if, for 

any one loan, nonreimbursable advances are not contractually limited to an insignificant 

amount of the loan’s outstanding balance. 

Facts: 

A bank sponsoring a securitization arranges for an unrelated third party to provide a first-loss 

credit enhancement, such as a financial standby letter of credit (L/C), that will cover losses up 

to the first 10 percent of the securitized assets. The bank agrees to pay a fixed amount as an 

annual premium for this credit enhancement. The third party initially covers actual losses that 

occur in the underlying asset pool in accordance with its contractual commitment under the 

L/C. Later, the selling bank agrees, not only to pay the credit enhancer the annual premium 

on the credit enhancement, but also to reimburse the credit enhancer for the losses it absorbed 

during the preceding year. This reimbursement for actual losses was not originally provided 

for in the contractual arrangement between the bank and the credit enhancement provider. 

Question 20: (June 2003)

Does the selling bank’s reimbursement of the credit enhancement provider’s losses constitute 

implicit recourse? 

Staff Response: 

Yes, the bank’s subsequent reimbursement of losses sustained by the credit enhancement 

provider goes beyond the contractual obligations of the bank and, therefore, constitutes implicit 

recourse. Furthermore, the OCC would consider any requirement contained in the original 

credit-enhancement contract that obligates the bank to reimburse the credit-enhancement 

provider for its losses to be a recourse arrangement. 
121

8B. SALES OF STOCK 

Facts:

A bank has a stock offering and finances its sale by issuing unsecured loans to the purchasers 

of the shares. Those loans are for the exact amount as the stock purchases. The 

documentation indicates that the loans are for "investment purposes," but does not state that the 

intention of the investment is to purchase the bank's own stock. 

Question 1:

Should the notes received in exchange for the bank’s capital stock be classified as an asset or as 

a deduction from stockholders' equity? 

Staff Response:

Notes received in exchange for capital stock should be classified as a deduction from 

stockholders' equity. Those notes should not be recorded as an asset, and the bank's capital 

should not be increased as a result of this sale of stock. 

Generally accepted accounting principles require the offsetting of stock loans against capital. 

This requirement has been formalized with a consensus of the FASB Emerging Issues Task 

Force in Issue No. 85-1. The consensus requires that stock loans be recorded as a reduction of 

stockholders' equity, except when the loan is secured by irrevocable letters of credit or other 

liquid assets. Examples of other liquid assets would be a certificate of deposit or U.S. 

Treasury security. Furthermore, there must be substantial evidence of the ability and intent to 

pay the loan within a reasonably short period of time (usually 90 days or less). 

Whether or not these loans are actually secured by bank stock does not alter the conclusion. 

This accounting is also applied to unsecured loans whenever the facts demonstrate that the 

borrowed funds are used to purchase bank stock. 
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8C. QUASI-REORGANIZATIONS 

Question 1:

What is a quasi-reorganization? 

Staff Response:

A quasi-reorganization is an accounting procedure whereby a bank, without undergoing a legal 

reorganization, revalues its existing assets and liabilities and reorganizes its equity capital. 

This allows for removal of a cumulative deficit in undivided profits. Chapter 7A of 

Accounting Research Bulletin No. 43, issued by the American Institute of Certified Public 

Accountants, describes a quasi-reorganization. It is based on the concept that an entity that has 

previously suffered losses, but has corrected its problems, should be allowed to present its 

financial statements on a "fresh start" basis. 

Under generally accepted accounting principles, an entity undergoing a quasi-reorganization 

must revalue all its assets and liabilities to their current fair value. The effective date of the 

readjustment of values should be as near as possible to the date on which the shareholders gave 

their approval to the reorganization. The tax benefits of loss carryforwards arising before the 

quasi-reorganization should be added to capital surplus when realized. 

Question 2: (September 2001) 

As part of the revaluation of its assets and liabilities to their current fair values, can the bank 

record a core deposit intangible for the intangible value of its own deposit base? 

Staff Response:

No. As noted in question 1, a quasi-reorganization requires the entity to present its existing 

assets and liabilities at current fair value, on a “fresh start” basis. This “fresh start” allows the 

entity accounting treatment similar to that of a new or start-up company. However, the use of 

fair value has created the misconception that a quasi-reorganization should be recorded in a 

manner similar to a business combination accounted for as a purchase. This is not the case. In 

a quasi-reorganization, the existing assets and liabilities are recorded as fair value. New 

intangible assets should not be recorded. Intangible assets from previous business 

combinations may be carried forward, but should be reviewed for impairment. 

 

Question 3: (September 2001) 

Can total capital increase as a result of the quasi-reorganization process and the revaluing of 

the bank’s net assets? 
123

Staff Response:

No. Although the individual elements that make up equity capital may increase or decrease, 

generally accepted accounting principles do not permit an increase in total capital, because of a 

quasi-reorganization. This is based upon the historic cost model and the conservative concept 

in accounting that generally precludes recognition of gains until realized. 

Question 4:

12 USC 56 does not allow the payment of dividends by banks that have an accumulated deficit 

in undivided profits. How does the fact that the bank has entered into a quasi-reorganization to 

eliminate the deficit affect the payment of dividends? 

Staff Response:

The elimination of the accumulated deficit in undivided profits through a quasi-reorganization 

applies to the payment of dividends under 12 USC 56 and to financial statement presentation. 

Therefore, in applying 12 USC 56, only the undivided profit amount since the date of the 

quasi-reorganization would be considered. Losses prior to the date of the quasi-reorganization 

are ignored. However, prudent judgment should be employed nevertheless in determining the 

appropriateness of dividend payments, because of the bank's financial condition and anticipated 

future financial needs. 
124

TOPIC 9: INCOME AND EXPENSE RECOGNITION 

9A. ACCOUNTING FOR ASSET SALES AND SECURITIZATIONS 

 

Facts:

Bank A originates $1,000,000 of mortgage loans that will yield 8.5 percent interest income. 

The bank transfers (sells) the principal plus the right to receive interest at 6.5 percent to 

another entity for par ($1,000,000). The bank will continue to service the loans. The contract 

states that the bank will receive a servicing fee of one percent, paid from the interest income 

not sold. The remaining interest income not sold (previously considered excess servicing 

under SFAS 65) is considered to be an interest-only (IO) strip under SFAS 140. At the date of 

transfer, the fair value of the loans (with a yield of 8.5 percent), including servicing, is 

$1,100,000. The fair value of the servicing is $44,000 and of the IO strip is $56,000. The 

fair value of the principal and interest sold is its sales price of $1,000,000. Assume the 

transaction meets the requirements of SFAS 140 for a sale of the portion transferred. 

Question 1: (September 2001) 

How should this sale of assets be accounted for? 

Staff Response:

This sale of assets is accounted for in accordance with SFAS 140. Accordingly, Bank A 

should allocate the previous carrying amount between the assets sold (the loans) and the assets 

retained (i.e., servicing asset and IO strip) based on their relative fair value at the date of 

transfer. Cost would be allocated as follows: 

Fair Value (FV) % of Total FV Allocated Carrying Amount 

Assets sold $1,000,000 91% $ 910,000 

Servicing asset 44,000 4% 40,000 

IO strip 56,000 5% 50,000

 Total Fair Value $1,100,000 100% $1,000,000 

The bank would record a gain of $90,000 (sales price of $1,000,000 less allocated carrying 

amount of $910,000). The retained assets (servicing asset and IO strip) would be recorded at 

their allocated carrying amount of $90,000. 

Question 2: (September 2001) 

How should the servicing asset be accounted for on an on going basis? 
125

Staff Response:

The servicing asset should be amortized in proportion to and over the period of the net 

servicing income. However, it should be evaluated and measured for impairment, based on 

current fair value, on a regular (at least quarterly) basis. 

Question 3: (September 2001) 

How should the IO strip be accounted for on an on going basis? 

Staff Response:

SFAS 140 requires that the IO strip, and any other asset that can be contractually prepaid or 

otherwise settled in a manner that the holder would not recover substantially all of its recorded 

investment, be accounted for similar to an investment in debt securities classified as availablefor-sale or trading under SFAS 115. Accordingly, it would be recorded at fair value. In the 

above example, the IO strip would be written up to $56,000 immediately after the sales 

transaction. 

In addition, the IO strip would be assessed for impairment consistent with the guidance in 

FASB Emerging Issues Task Force Consensus No. 99-20. See question 7 for additional 

information. 

Question 4: (September 2001) 

Assume the same facts as in question 1 except that the loan being sold is an SBA loan and only 

its guaranteed portion is being sold. Would the accounting be the same? 

Staff Response:

Yes, the bank would account for this sale and allocate the carrying amount of the SBA loan in 

the same manner. However, when allocating cost between the guaranteed and unguaranteed 

portions of an SBA loan, the two portions have substantially different risks and require 

different rates of return. Accordingly, the fair value of the two portions normally would be 

substantially different. 

Facts:

Bank A securitized $150 million of its credit card loans. The transaction was accounted for as 

a sale. The next year the bank sold a portion of the underlying credit card account 

relationships to a third party (other than the buyer of the loans) for cash. These account 

relationships were sold at a premium of $25 million. At that time, these credit card loans had 

a material amount of loan balances still outstanding. 
126

Question 5: (September 2001)

How should the sale of the account relationships be accounted for? 

Staff Response:

Bank A should recognize the $25 million premium on the sale of the account relationships. 

Essentially, this transaction is similar to the sale of the mortgage servicing rights on loans 

owned by other parties. Under FASB Emerging Issues Task Force Consensus No. 85-13, a 

gain can be recognized if the rights are sold outright for cash. This transaction is not covered 

by SFAS 140 because the account relationships do not meet the definition of a financial asset. 

Facts:

A bank originates, funds, and services credit card accounts. The bank enters into a transaction 

whereby it will sell the future gross income stream (i.e., interest income and late fees) from its 

existing credit card balances. However, it will continue to own and make advances to the 

credit card customers. Any income received on new credit card advances accrue to the bank. 

The bank will also continue to service the accounts for a monthly fee. Further, the bank may 

cancel the sales transaction through payment of a lump sum amount to the purchaser. 

Question 6: (September 2001)

Should this transaction be accounted for as a sale? 

Staff Response:

No. The proceeds from the sale of the future income stream on the credit card accounts should 

be accounted for as a borrowing. Therefore, the proceeds are recorded as a liability and 

amortized using the interest method over the estimated life of the accounts. This conclusion is 

based on FASB Emerging Issues Task Force Consensus No. 88-18. Under that consensus, the 

sales proceeds may be classified as either debt (a borrowing) or deferred income (sale) 

depending on the specific facts and circumstances. In this respect, the consensus set forth six 

criteria for determining whether the sales proceeds should be classified as debt or deferred 

income. If the transaction meets any of those criteria, the sales proceeds generally would be 

reported as debt. This transaction meets two of the six criteria for debt classification. First, 

the bank has a significant continuing involvement in the generation of cash flows, since it will 

continue to service and fund the credit card receivables. Additionally, the transaction is 

cancelable by the bank through payment of a lump sum amount. 

Question 7: (September 2001) 

How does one determine whether a fair market value adjustment to an IO strip represents 

permanent impairment? 
127

Staff Response:

Institutions should follow the guidance in FASB Emerging Issues Task Force Consensus No. 

99-20 to determine whether an adjustment should be made to the recorded value of an IO strip 

to recognize impairment. The impairment test in EITF 99-20 involves two triggers: 

• There is a decline in the fair value of the IO strip below the investor's carrying amount, 

and 

• There is a decrease in the estimated future cash flows associated with the IO strip. 

If the fair value is less than the amortized cost and the estimated cash flows have decreased 

since the last estimate of fair value was made, then the security must be written down to its 

new fair value by taking a charge through earnings. 

Facts: 

Under SFAS 140, servicing assets purchased and all servicing liabilities are initially measured 

at fair value. Servicing assets retained from a sale or securitization are initially valued based 

on the relative fair value of all the assets sold and retained. 

Specifically, the Statement notes that a servicing asset results when the benefits of (revenues 

from) servicing are expected to provide more than adequate compensation" to the servicer. If 

the benefits of servicing are not expected to compensate a servicer adequately for performing 

the servicing, the contract results in a liability. 

Question 8: (September 2001) 

For purposes of this determination, how is “adequate compensation” defined in SFAS 140? 

Staff Response:

SFAS 140 defines “adequate compensation” as “the amount of benefits of servicing that would 

fairly compensate a substitute servicer should one be required, which includes the profit that 

would be demanded in the marketplace.” The FASB's Implementation Guide for Statement 

140 adds that “Adequate compensation is the amount of contractually specified servicing fees 

and other benefits of servicing that are demanded by the marketplace to perform the specific 

type of servicing. Adequate compensation is determined by the marketplace; it does not vary 

according to the specific costs of the servicer.” 

It is important to note that this definition is consistent with the Statement's emphasis on fair 

value. Specifically, the recorded value of a servicing contract is based on the marketplace. 

Accordingly, a servicing asset is based on the servicing revenue an institution expects to 

receive relative to the compensation a third party would require and is not based on an 
128

institution's own cost of servicing. As a result, an inefficient servicer incurring losses may 

not be required to record a servicing liability, if the servicing income is sufficient to 

compensate fairly a substitute (third party) servicer. 

Facts:

A bank originates a SBA loan and sells the guaranteed portion. It receives a premium on this 

sale. The sale includes a provision that requires the seller to refund any premium received if 

the borrower fails to make any of the first three payments. This transaction qualifies for sales 

treatment under SFAS 140. On this particular loan the bank is unable to estimate either the 

likelihood of the borrower failing to make one of the first three payments, or the fair value of 

this recourse obligation. 

Question 9: (September 2001) 

How should the bank account for the recourse obligation? 

Staff Response:

Normally the bank would record a liability for the fair value of the recourse obligation. 

However, in this situation the bank is unable to estimate the amount of the liability. Appendix 

A of SFAS 140 covers situations when an entity is unable to estimate the amount of the fair 

value of the liability. It requires that any gain be deferred until the recourse period has expired. 

This will require that gain recognition be deferred for three months. 

Facts: 

A bank forms a $1 billion pool of receivables from credit card accounts and transfers the 

receivables to a trust. The bank then sells undivided participation interests in the trust's 

receivables or in the trust and retains the remaining undivided participation interest in the 

receivables or in the trust. During a specified reinvestment period (i.e., 48 months), the trust 

will purchase additional credit card receivables generated by the selected accounts. During the 

revolving period, the investors' dollar investment remains constant, because principal 

payments, allocated to the investors' interest are reinvested in additional credit card 

receivables. The up front transaction expenses of $5,000,000 consist of legal fees, accounting 

fees, rating agency fees, and underwriting fees. 

Question 10: (September 2003)

 

How should the bank account for the up-front transaction expenses of the securitization? 
129

Staff Response: 

The transaction costs relating to the sale of the receivables may be recognized over the fiveyear revolving period, in a rational and systematic manner unless the transaction results in a 

loss. 

According to SFAS 140, transaction costs for a past sale are not an asset and thus are part of 

the gain or loss on sale. Accordingly, transaction expenses for securitizations of term loans are 

expensed as incurred. However, EITF 88-22 indicates that in a securitization of revolving 

assets, such as a credit card securitization, some of the transaction costs incurred at inception 

of the securitization relate to future sales that will occur during the reinvestment period. These 

transaction costs are equivalent to prepaid expenses, and may be treated as an asset and 

amortized into earnings in a rational and systematic manner. 

 
130

9B. CREDIT CARD AFFINITY AGREEMENTS 

Facts: 

In 200x, Bank A entered into a 12-year contract with an affinity group for the exclusive right 

to offer credit cards to the group’s members in return for a nonrefundable payment to the 

group of $50 million per year. The affinity group has a stable membership, and therefore, the 

number of credit card customers is expected to remain relatively constant. Further, the 

services performed by the parties are constant throughout the life of the contract. 

The contract also contains a royalty calculation provision that uses an escalating scale that 

bears no relationship to the expected earnings from the credit card portfolio or services 

performed under the contract. Under this escalating scale, the royalty provision provides for a 

$10 million amount in the first year and in excess of $100 million in the final year of the 

contract. While the excess of the annual payment over the royalty amount is not refundable, it 

may be used to offset future royalties. The bank proposes to record expense of $10 million the 

first year and include the $40 million amount difference as a prepaid expense (other asset) on 

its balance sheet. 

Question 1: (June 2003) 

Is it appropriate for Bank A to capitalize $40 million of the $50 million payment related to this 

affinity agreement as a prepaid asset because of the royalty calculation provision? 

Staff Response: 

No. Generally accepted accounting principles require that the expense be determined in a 

systematic and rational manner to the periods in which the payments are expected to provide 

benefit. In this situation, the benefits of the relationship and the services of the affinity group 

are being provided consistently throughout the contract period. Further, the royalty calculation 

provision in the contract is not related to the expected earnings on the portfolio or the services 

performed by the affinity group. 

Accordingly, an accounting method that recognizes expense on a periodic basis relative to the 

benefits received should be used. In this case, the periodic payments from the bank to the 

affinity group are the best measurement of that benefit. This accounting is consistent with 

FASB Statement of Accounting Concepts No. 5. SFAS 13 also provides guidance. This 

standard requires that leases with accelerated payment structures be accounted for by 

recognizing income or expense on a straight-line basis or another income recognition method 

that provides a systematic pattern consistent with the benefits derived. 
131

9C. ORGANIZATION COSTS 

Question 1: (June 2003) 

What are start-up activities and organization costs? 

Staff Response: 

Start-up activities are defined broadly as those one-time activities related to opening a new 

facility, introducing a new product or service, conducting business in a new territory, 

conducting business with a new class of customer, or commencing a new operation. Start-up 

activities include activities related to organizing a new entity, such as a new bank, that are 

commonly referred to as organization costs. 

Organization costs for a bank are the direct costs incurred to incorporate and charter the bank. 

Such costs include, but are not limited to, professional (e.g., legal, accounting, and consulting) 

fees and printing costs directly related to the chartering or incorporation process, filing fees 

paid to chartering authorities, and the cost of economic impact studies. 

Question 2: (June 2003) 

What is the accounting for start-up activities, including organization costs? 

Staff Response: 

Costs of start-up activities, including organization costs, should be expensed as incurred. Costs 

of acquiring or constructing premises and fixed assets and getting them ready for their intended 

use are capitalized as fixed assets. However, the costs of using such assets that are allocated to 

start-up activities (e.g., depreciation of computers) are considered start-up costs. For a new 

bank, pre-opening expenses such as salaries and employee benefits, rent, depreciation, 

supplies, directors' fees, training, travel, postage, and telephone, are considered start-up costs. 

Guidance on the accounting and reporting for the costs of start-up activities, including 

organization costs, is set forth in AICPA Statement of Position 98-5 and the Call Report 

Instructions. 

Question 3:

How should a bank account for the organizational costs of forming a bank holding company? 

Staff Response:

Although bank holding company fees and other related costs are sometimes paid by the bank, 

they are the holding company’s organizational costs. Accordingly, any unreimbursed costs 
132

paid on behalf of the holding company should be recorded as a cash dividend paid by the 

bank to the holding company. Similarly, if the bank holding company application is 

unsuccessful or abandoned, the costs are the responsibility of the organizers. Therefore, 

unreimbursed amounts should be recorded as a dividend. 
133

TOPIC 10: PURCHASE ACCOUNTING AND CORPORATE REORGANIZATIONS 

 

10A. ACCOUNTING FOR ACQUISITIONS 

Facts: 

Bank A acquires Bank B in a transaction accounted for under the purchase method in 

accordance with generally accepted accounting principles. 

Question 1: 

When is it appropriate for Bank A (purchasing bank) to adjust the allowance for loan and lease 

losses of an acquired bank (Bank B) to reflect a different estimate of collectibility? 

Staff Response:

This question arises when Bank A assigns its acquisition cost to the acquired assets of Bank B. 

Typically, no adjustment is allowed. Additions to the allowance are made generally through 

provisions for loan and lease losses, not as purchase accounting adjustments. Therefore, 

except as discussed later, purchase accounting adjustments reflecting different estimates of 

collectibility generally are considered inappropriate. 

Estimation of probable loan and lease losses involves judgment. Although banks

managements may differ in their systematic approaches to this evaluation, their collectibility 

estimates of Bank B's loan portfolio should not vary materially. Therefore, a purchase 

accounting adjustment to reflect a different estimate of collectibility is inappropriate. 

A purchase accounting adjustment may be appropriate only when Bank A has demonstrably 

different plans than Bank B for the ultimate recovery of the acquired loans. For example, 

Bank A may plan to sell certain loans intended by Bank B to be held to maturity. Such loans 

would be reported as assets held for sale and valued at the lower of cost or market value. 

The staff does not suggest that acquired loans be recorded at an amount that reflects an 

unreasonable estimate of collectibility. If Bank B's financial statements as of the acquisition 

date are not stated fairly because of an unreasonable allowance for loan losses, Bank B's 

preacquisition financial statements should be restated to reflect an appropriate allowance. 

This response is consistent with guidance issued by the Securities and Exchange Commission in 

Staff Accounting Bulletin No. 61. 
134

Facts: 

Bank A acquires Bank B in a purchase transaction. Bank A incurs costs to terminate Bank B's 

unfavorable data processing contracts and to make its data processing system compatible with 

Bank A's system. 

Question 2: (December 2001) 

Should those costs be capitalized by Bank A in the acquisition? 

Staff Response: 

Costs incurred to terminate Bank B's unfavorable contracts, including data processing 

contracts, should be capitalized at the time of acquisition. This includes the cost to make Bank 

B's data processing system compatible with Bank A. However, costs incurred by the acquiring 

institution to modify, convert, or terminate its own data processing system are not considered 

in the cost of acquisition and must be expensed as incurred in accordance with FASB Technical 

Bulletin 85-5. 

SFAS 141, while amending portions of the technical bulletin, retains the provision that permits 

only direct costs of an acquisition to be capitalized in the acquisition cost. Further, those direct 

costs must be "out of pocket" or incremental costs and not internal costs related to the 

acquisition. 

Facts: 

Bank A acquires Bank B from the FDIC in a total asset purchase and assumption transaction. 

Bank A submits a negative bid of $5 million (i.e., the FDIC pays Bank A $5 million to acquire 

Bank B). 

Question 3:

How should this acquisition be accounted for? 

Staff Response: 

The acquisition should be accounted for as a purchase business combination. Accordingly, the 

assets received and liabilities assumed are recorded at their fair market value. The assistance 

received from the FDIC as a negative bid (i.e., the $5 million) represents an acquired asset. 

Any difference between the fair value of the assets acquired and liabilities assumed would be 

either goodwill (if liabilities exceed assets) or negative goodwill (if assets exceed liabilities). 
135

Facts: 

Acquisitions generally are made through a bid process. Prior to submitting a bid, the acquirer 

(Bank A) will estimate the fair value of the assets and liabilities being acquired. However, 

those estimates may be performed quickly and may differ from the actual fair values of specific 

assets determined in a more detailed analysis following the acquisition. 

Question 4: (December 2001) 

Is it appropriate, in recording the acquisition, for Bank A (the acquirer) to revise the estimated 

values assigned to the assets and liabilities of Bank B based on the fair values determined in the 

more detailed analysis? 

Staff Response: 

Yes, not only is it appropriate, it is required. The values assigned during the due diligence 

process are only estimates and must be refined. Therefore, after completing the acquisition, 

Bank A must determine the fair values of the acquired assets and liabilities. This process 

should be completed as soon as possible after the acquisition. The bank must make a good 

faith effort to record all purchase accounting adjustments by the next call report due date. 

However, SFAS 141 permits preacquisition contingencies of purchased enterprises to be 

adjusted during an "allocation period." This allocation period is provided so that a 

contingency, such as an unresolved litigation matter, can be included as a purchase accounting 

adjustment when the amount becomes known. It should not be used to apply "hindsight" to the 

process of determining fair market value, so relatively few adjustments should occur. This 

period should usually not exceed one year. 

Question 5: (December 2001)

How should the excess of acquired net assets over cost (negative goodwill) be recorded? 

Staff Response: 

Negative goodwill should be recorded by taking a pro rata reduction in the amounts that 

otherwise would have been assigned to the acquired assets. However, the following assets 

should not be included in the allocation: (a) certain financial assets, (b) assets to be disposed of 

by sale, (c) deferred tax assets, (d) prepaid assets relating to pension and other post retirement 

plans, and (e) other current assets. Accordingly, the negative goodwill principally will reduce 

the cost basis of long term fixed assets. Once these assets have been reduced to zero, any 

remaining amount of negative goodwill is recognized as an extraordinary gain in the period 
136

that the business combination is completed. 

Question 6: 

Should the fair value of the loan portfolio be determined on a loan-by-loan basis or may it be 

determined for the entire loan portfolio? 

Staff Response: 

Determination of the fair value of the loan portfolio should be made on a loan-by-loan basis. It 

should consider both interest rate and credit risk. Additionally, any allowance for loan and 

lease losses included in the acquisition should be considered in the analysis. An exception to 

this requirement is made for groups of homogeneous consumer loans. The fair value of those 

loans may be determined on an aggregate basis. However, any fair value discount should be 

applied to all the loans in the pool on a pro rata basis. In this way each individual loan can be 

accounted for subsequently. 

Question 7: 

May Bank A record an allowance for loan and lease losses for the acquired loans in the 

purchase price allocation? 

Staff Response: 

Yes. However, the amount of the allowance is limited to the amount that existed on Bank B's 

books at the time of its closure. In addition, the allowance should be recorded on a "clean" 

loan portfolio basis. This is because individual loans are recorded at fair value, including a 

discount for credit risk (i.e., uncollectibility).

Facts: 

Bank A acquires a loan in a business combination. At the time of the acquisition, relevant 

credit information is reviewed and the loan is recorded at fair value. However, the loan 

subsequently becomes uncollectible and is charged off. 

Question 8: 

How should this subsequent charge off be recorded? 

Staff Response: 

The charge off should be recorded against the allowance for loan and lease losses. If needed, a 

provision for loan loss should be recorded to restore Bank A's allowance to an adequate level. 

Generally it is not appropriate to revise the fair value assigned to the loan at acquisition. This 
137

is because all relevant credit information was available for estimating the loan's fair value 

at the date of acquisition. Only when that information is not available and subsequently 

becomes available may a change to the purchase price allocation be made in the allocation 

period. Otherwise, subsequent loan activity is reflected in the appropriate subsequent period's 

financial statements. 

Facts: 

A bank that acquires a thrift institution's deposits may decide to switch insurance funds from 

the Savings Association Insurance Fund (SAIF) to the Bank Insurance Fund (BIF). FIRREA 

imposes an exit fee and an entrance fee on such insurance conversions.

Question 9: 

How should an acquiring bank account for an obligation to pay exit and entrance fees? 

Staff Response:

The acquiring bank should record a liability when it incurs an obligation to pay exit and 

entrance fees. Such costs may be capitalized in the acquisition cost of the thrift and amortized 

over the period benefited. Since those costs are included in the acquisition of the thrift, 

capitalization is allowed only when the decision to switch funds is elected at acquisition time. 

Facts: 

Bank A acquires Bank B in a transaction accounted for under the purchase method in 

accordance with generally accepted accounting principles. 

Question 10: (December 2001)

In accordance with 12 USC 60(b), how should the retained net income amounts be determined 

when computing dividend limitations? 

Staff Response: 

One of the combining entities in a purchase transaction is viewed as surviving the transaction 

and is considered the acquiring entity. The other combining entity no longer continues to be 

formally recognized and its net assets are considered to be purchased by the acquiring entity. 

For accounting purposes, the transaction is a purchase of net assets by the acquiring bank. In 

addition to recording these assets at fair value, the capital accounts of the acquired entity 

are eliminated. Operations of the acquired entity are included only in the income statement 

from the date of acquisition. 

Accordingly, only the acquiring bank's retained net income (net income less dividends paid in 
138

each year) are used when computing the dividend limitations of 12 USC 60(b). Therefore, 

the prior two years of retained net income plus current year net income of only the acquiring 

bank are included in the calculation. Operations of the acquired bank would be included from 

the date of acquisition. 

Facts: 

Bank A acquires Bank B in a transaction accounted for under the purchase method in 

accordance with generally accepted accounting principles. In addition to the amount paid at 

the time of the acquisition, the agreements provide for additional payments by Bank A to the 

former owners of Bank B, based upon the occurrence of certain future events. 

Question 11: (September 2002) 

Should any portion of the contingent consideration be included in the purchase price at the date 

of acquisition? 

Staff Response: 

Consistent with SFAS 141, any portion of the contingent consideration that is determinable at 

the date of acquisition should be included in the cost of acquiring the entity and recorded at the 

date of acquisition. Consideration that is dependent upon the outcome of future events or 

contingencies would generally not be recorded at the date of acquisition. It would be recorded 

when the future event or contingency becomes determinable. 

Question 12: (September 2002) 

In a business combination effected through the exchange of equity interests, is the surviving 

legal entity necessarily the acquiring entity for accounting purposes? 

Staff Response: 

SFAS 141 notes that the application of the purchase method requires identification of the 

acquiring entity and establishes criteria for making that determination. In that context, the 

entity that issues the equity interests is generally also the acquiring entity for accounting 

purposes. However, this is not always the case. In certain circumstances, the entity that is 

acquired for accounting purposes will issue the equity interests and be the surviving charter. 

These transactions are commonly referred to as reverse acquisitions. 

Generally, the acquiring bank for accounting purposes is the larger entity, however, all of the 

facts and circumstances must be considered in making this determination. 

Question 13: (September 2002) 
139

In addition to the relative size of the combining banks, what other factors should be 

considered in determining the surviving entity for accounting purposes? 

Staff Response: 

The following factors should be considered in determining the surviving entity for accounting 

purposes: 

• The relative ownership percentage and voting rights of the shareholders of each entity 

in the combined entity. 

• The composition of the governing body (i.e., board of directors) or senior 

management. 

• The existence of a large minority interest that will have significant voting influence 

over the combined entity. 

Facts: 

Bank A is the legal survivor in a business combination with Bank B. However, prior to the 

merger, Bank A has $150 million in assets and Bank B has $220 million in assets. After the 

merger, Bank A's former shareholders will own 40 percent of the outstanding stock, and Bank 

B's former shareholders will own 60 percent of the outstanding stock of the combined entity. 

Further, former Bank B shareholders will have four members on the board of directors and 

former Bank A shareholders will have three members on the board. 

 

Question 14: (September 2002) 

 

For accounting purposes, which bank is the acquiring bank? 

Staff Response: 

Bank B is the acquiring bank. This determination is based on the relative size of the 

combining banks, as well as the resulting shareholder ownership and board membership 

percentages. In this situation, the determination is relatively clear-cut because Bank B 

provided approximately 60 percent of the assets, and its former owners received approximately 

60 percent of the security interests and board membership. In practice, the determination will 

not always be this clear. 

Question 15: (September 2002) 

How is this transaction accounted for? 

Staff Response: 

Since Bank B is the acquiring bank for accounting purposes, its financial statements will be 
140

carried forward at historical cost. Further, for dividend limitation purposes under 12 USC 

56 and 60(b), the retained net income of Bank B will be used. Bank A is accounted for as the 

acquired bank and its assets (including intangible assets) and liabilities are recorded at fair 

market value. The purchase price for the acquisition is the fair market value of the shares of 

stock owned by former Bank A shareholders. Goodwill is recorded for the difference between 

the purchase price and the fair value of the net assets acquired. 
141

10B. INTANGIBLE ASSETS 

Question 1: (December 2001) 

In July 2001, the Financial Accounting Standards Board issued Statements of Financial 

Accounting Standards No. 141, Business Combinations (SFAS 141), and No. 142, Goodwill 

and Other Intangible Assets (SFAS 142). In general, how do these statements change the 

accounting for business combinations? 

Staff Response: 

These statements significantly change the accounting for business combinations, goodwill, and 

intangible assets (in these statements the term "intangible assets" refers to all intangibles other 

than goodwill). SFAS 141 eliminates the pooling-of-interests method of accounting for 

business combinations, except for certain combinations initiated prior to July 1, 2001. The 

statement further clarifies the criteria for recognizing intangible assets separately from 

goodwill. 

Under SFAS 142, goodwill and indefinite-lived intangible assets are no longer amortized, but 

are reviewed at least annually for impairment. Other intangible assets (i.e., core deposit 

intangibles, purchased credit card relationships, etc.) that are not deemed to have an indefinite 

life will continue to be amortized over their useful lives. The amortization provisions of SFAS 

142 are effective immediately for goodwill and intangible assets acquired after June 30, 2001. 

For intangibles acquired prior to July 1, 2001, banks must adopt SFAS 142 for the year 

beginning January 1, 2002 and will continue to amortize these intangibles in accordance with 

prior accounting requirements during the transition period to January 1, 2002. 

Question 2: (December 2001)

How should intangible assets (other than goodwill and indefinite-lived intangible assets) be 

amortized? 

Staff Response: 

Intangible assets that have a finite life (i.e., core deposit intangibles, purchased credit card 

relationships, etc.) should be amortized over their estimated useful lives using a method that 

reflects the pattern in which the economic benefit of the asset is consumed. This will generally 

result in the use of an accelerated method of amortization. If a usage pattern cannot be 

determined, institutions should use the straight-line method. 

Generally, core deposit intangibles and purchased credit card relationships should be amortized 

over a period of no more than 10 years. However, in unusual circumstances, a longer 

amortization period may be justified. 
142

Facts:

Bank A acquires Bank B in a purchase transaction. Bank B is combined into Bank A. 

Intangible assets (core deposit intangibles and goodwill, etc.) resulting from the acquisition are 

recorded on the Statement of Condition of Bank A. Subsequently, Bank C acquires Bank A in 

a purchase transaction, and Bank A is combined into Bank C. 

Question 3:

Can the intangible assets, resulting from the first acquisition, be included on the Statement of 

Condition for Bank C? 

Staff Response:

No. The acquisition of Bank A by Bank C is recorded at the fair market value of Bank A's 

assets and liabilities on that acquisition date. This includes any identifiable intangible assets, 

such as core deposit intangibles, and unidentifiable intangible assets (goodwill). The intangible 

assets resulting from the first acquisition (Bank B by Bank A) are no longer relevant, because 

the second acquisition creates a new basis of accounting for Bank A's assets and liabilities. 

Accordingly, the intangible assets recorded on the financial statements of Bank C, after the 

acquisition of Bank A, result only from that acquisition. 

Question 4: (December 2001)

Can a bank “sell” goodwill to its parent holding company? 

 

Staff Response: 

No. Goodwill is an unidentifiable intangible asset obtained in the acquisition of an entire entity 

(bank) or group of assets. It cannot be acquired or sold separately. In this respect, SFAS 142 

requires that goodwill be assigned to the reporting units (operating segment or sub-segment) 

that are expected to benefit from it. 

Further, regulatory policy (call report instructions) requires that goodwill created in an 

acquisition by a parent holding company be “pushed-down” and recorded at the bank level. It 

would be inconsistent with this policy to allow the goodwill to be sold to a parent holding 

company or other related party and not be included on the bank’s financial statements. 
143

10C. PUSH-DOWN PURCHASE ACCOUNTING 

Question 1: 

What is "push-down purchase accounting?" 

Staff Response: 

The term "push-down purchase accounting" typically applies when a parent (usually a bank 

holding company) acquires a bank and accounts for the acquisition under the "purchase 

method" of accounting. Following the purchase method, the parent records the acquisition by 

allocating the purchase price to the assets acquired and liabilities assumed based on their fair 

values. Hence, those assets and liabilities are assigned a new basis of accounting. 

The new basis of accounting (both assets and liabilities) is "pushed-down" from the parent to 

the acquired bank. It is reflected on the bank's books. Additionally, the parent's purchase 

price becomes the beginning shareholder's equity amount (capital stock and surplus) of the 

acquired bank. Also, the undivided profits account is adjusted to zero. Hence, push-down 

accounting establishes this new basis of accounting on the books of the acquired subsidiary 

bank. 

Generally accepted accounting principles are concerned primarily with consolidated financial 

statement presentation. They offer only limited guidance for the use of push-down accounting 

for a purchase acquisition. The majority of such guidance is contained in SEC Staff 

Accounting Bulletins. 

Question 2: 

What is the regulatory policy for "push-down" accounting? 

Staff Response:

Push-down accounting is required for financial reporting, if an arms-length purchase 

accounting transaction results in a change in control of at least 95 percent of the voting stock of 

the bank. However, it is not required if the bank has an outstanding issue of publicly traded 

debt or preferred stock. Push-down accounting is also required if the bank's financial 

statements are presented on a push-down basis in reports filed with the Securities and 

Exchange Commission. 

Push-down accounting may also be used after a change in control of at least 80 percent, but 

less than 95 percent. However, approval by the bank's outside accountant and the OCC is 

required in these situations. 
144

Facts:

Holding Company A acquires 75 percent of the stock of Bank B in a tender offer. As a result 

of its newly gained voting control, Holding Company A effects an interim bank merger. The 

assets and liabilities of Bank B are merged into newly formed Bank C, a wholly owned 

subsidiary of the holding company. 

The minority shareholders of Bank B are paid cash for their stock. The holding company now 

owns 100 percent of the acquired bank's net assets. The bank does not have any outstanding 

issues of publicly traded debt or preferred stock. 

Question 3:

Should push-down purchase accounting be applied when the substantial change in control 

resulted from a series of acquisitions? 

Staff Response:

Yes. It is required when a change in control of at least 95 percent of the voting control has 

occurred. This change of control may occur through a single arms-length transaction or a 

series of transactions. 

Push-down accounting may be allowed (if approved) for an 80 percent change of control of the 

voting stock. However, push-down accounting is not allowed unless at least that percent of the 

voting stock is involved. Therefore, in this case, push-down accounting would have been 

required after the interim bank merger (second acquisition transaction). But it would not have 

been allowed after the tender offer (first acquisition transaction), since only 75 percent of the 

bank was acquired. 

Facts:

Purchase acquisitions may involve the issuance of debt securities. The Securities and 

Exchange Commission, in Staff Accounting Bulletin 73 (SAB 73), describes situations when, 

for its filings, parent company acquisition debt must be "pushed-down" to the target entity. 

Those situations include the acquired company assuming the purchaser's debt, the proceeds of 

a securities offering by the acquired company being used to retire the purchaser's debt, or the 

acquired company guaranteeing or pledging its assets as collateral for the purchaser's debt. 

Question 4:

Does the OCC require the push-down of parent company debt to the financial statements of an 

acquired national bank? 
145

Staff Response:

We believe that the circumstances described in SAB 73 would rarely, if ever, occur in the 

acquisition of a national bank. This is because national banks are generally not permitted to 

assume or guarantee the parent company's debt. Nor are national banks permitted to pledge 

their assets as collateral. Therefore, it is unlikely that the parent company's acquisition debt 

would be pushed down to the acquired bank level. 

However, if that circumstance does occur, the debt should be recorded on the financial 

statements of the acquired bank. The offsetting entry would reduce the acquired bank's capital 

accounts. 

 
146

10D. CORPORATE REORGANIZATIONS 

Question 1: (September 2001) 

How should a bank account for transfers of an individual asset or groups of assets between a 

bank and its parent holding company or other related party? 

Staff Response:

The transfer of assets between a bank and a related party generally should be accounted at the 

asset's fair value. This maintains consistency in accounting policy for transactions involving 

affiliated and nonaffiliated institutions. 

For regulatory purposes, each bank reports as a separate legal and accounting entity. 

Therefore, the bank must record, as a separate entity, each transaction based on its economic 

substance. Any resulting profit or loss on the transaction is based on the fair value of the 

assets involved. If a difference between the contract price and the fair value exists, the amount 

is recorded as either a dividend or capital contribution, as appropriate. 

Question 2: (December 2001)

Must a corporate reorganization that involves the combination of two or more affiliated banks 

be accounted for at fair value? 

Staff Response: 

Generally, no. Corporate reorganizations are excluded from the provisions of SFAS 141. 

However, Appendix D to SFAS 141 retains the requirement of AICPA Accounting 

Interpretation No. 39 to APB 16 that a combination between two or more affiliated entities be 

accounted for at historical cost in a manner similar to pooling of interest accounting. 

However, if it involves less than substantially all (90 percent) of the assets of the target bank, 

the reorganization of affiliated banks must be accounted for at fair value (as set forth in 

Question 1), and the banks must recognize gains and losses on the transfer as if they had sold 

the assets to a third party. 

Question 3: (September 2001) 

Are there any exceptions to the fair value requirement for corporate reorganizations that 

involve less than substantially all of the assets of a target entity? 
147

Staff Response: 

There is a limited exception. Sometimes this fair value requirement may discourage affiliate 

combinations that would benefit a holding company and its subsidiary banks significantly. An 

example is a one-time reorganization of a business line, such as credit card operations or 

mortgage servicing, that would permit a holding company to transfer certain banking 

operations to achieve operational efficiencies. Accordingly, as a result of an Ombudsman’s 

decision, the OCC has allowed the transfer of assets at the lower of cost or market value 

(LOCOM). This decision applies, on a case-by-case basis, only to a limited number of cases 

involving the reorganization of a single business line between wholly owned bank subsidiaries 

of a holding company. Further, the bank must be able to demonstrate that the use of LOCOM, 

in those cases, is an acceptable method under GAAP. 

Facts: 

A holding company owns all of the stock of a thrift institution (Institution A). Institution A, in 

turn, owns all of the stock of two other thrift institutions (Institution B and Institution C). The 

holding company desires to convert these three thrift institutions to national banks. It plans to 

transfer the stock of Institution B and Institution C to the parent holding company, so that after 

the transaction the holding company will own all of the stock of the three financial institutions 

(now national banks). 

Question 4: (December 2001) 

How should the bank account for the transfer of stock (of Institutions B and C) from Institution 

A to the parent holding company? 

Staff Response: 

The transfer of stock should be accounted for as a corporate reorganization, which is exempt 

from the general requirements of SFAS 141. Furthermore, since this transfer of assets involves 

all of the target institution’s assets, it is accounted for in accordance with Appendix D of SFAS 

141, at historical cost, similar to a pooling of interest. 

Facts: 

Two national banks owned by the same holding company are merged to form one national 

bank in a corporate reorganization. Under the requirements of Appendix D to SFAS 141, the 

combination is accounted for at historical cost. As a result, the financial statements of the two 

affiliates were combined at historical cost similar to pooling-of-interests treatment. 
148

Question 5: (December 2001) 

In accordance with 12 USC 60(b), how should the retained net income amounts be determined 

when computing dividend limitations? 

Staff Response: 

As the combined national bank's financial statements represent the combination of the financial 

statements of the two banks at historical cost, the retained net income (net income less 

dividends paid in each year) for both entities should be combined when computing the dividend 

limitations of 12 USC 60(b). Therefore, the prior two years of retained net income plus 

current year net income for both banks would be considered in the calculation. 

 
149

10E. RELATED PARTY TRANSFERS (other than reorganizations) 

Facts:

The bank sold a previously charged-off loan to related parties (i.e., members of the board of 

directors and stockholders). The sale price of the loan was its face value of $800,000. An 

appraisal has determined that the fair value of the charged off loan is $100,000. 

Question 1: 

How should the sale of this charged off loan be accounted for? 

Staff Response:

The fair value of the loan ($100,000) is credited to the allowance for loan and lease losses as a 

recovery. The excess of the purchase price over the fair value of the loan ($800,000 - 

$100,000 = $700,000) is considered a capital contribution and is credited to the capital surplus 

account. 

Question 2: 

Assume the same facts as above, except that it is impossible to determine if the charged off 

loan has any value. How should this transaction be accounted for? 

Staff Response:

Inasmuch as it is not possible to determine if the charged off loan has any value, it should be 

assumed the loan has only minimal value. Therefore, the entire proceeds ($800,000) is 

considered to be a capital contribution and is credited to capital surplus. 

Facts: 

The bank sold a previously charged-off loan to related parties, i.e., members of the board of 

directors and stockholders, at its face value of $800,000. It is not possible to determine if the 

charged off loan has any value. Further, because of a lending limit violation, the directors are 

liable legally to purchase the loan at its face value. 

Question 3:

How is this transaction accounted for? 
150

Staff Response:

This transaction is accounted for the same as if the lending limit violation had not existed. 

Therefore, the entire amount ($800,000) is considered to be a capital contribution and is 

credited to capital surplus. 

Facts: 

The bank is a wholly owned subsidiary of a holding company. The bank buys loans at face 

value from unrelated parties introduced to the bank by a loan brokerage company. The loan 

broker is wholly owned by related parties (persons related to the key management personnel of 

the bank). The related parties also own a voting interest in the holding company. As a fee for 

introducing the unrelated parties to the bank, the loan brokerage company receives 20 to 30 

percent of the face amount of the loans from the seller (unrelated party). The loans have 

contractual rates approximating market yields and have demonstrated good repayment 

histories. 

Question 4: (September 2001)

How should the bank record the purchase of the loans? 

Staff Response:

The purchased loans should be recorded at their fair values, which is presumed to be the net 

amount received by the seller (unrelated party). The excess of the purchase price over the fair 

value of the loans should be reported as a dividend. 

In this case, the fee appears to exceed significantly a "normal" fee expected for an arms-length 

transaction for services of the type provided by the loan brokerage company. Further, it 

supports the presumption that the face amount of the loans is not their fair value. Therefore, in 

substance, they represent a dividend, with the fair value of the loans represented by the net 

proceeds received by the seller. 

Facts: 

Bank A maintains escrow balances on deposits for loans serviced by certain mortgage banking 

affiliates of the bank's parent holding company. The bank retains income earned on such 

deposits. 

The mortgage banking affiliates borrow funds from the bank, paying the market rate of 

interest. The interest rate does not recognize the benefit of the escrow funds deposited with the 

bank. Furthermore, no other arrangements exist to compensate the mortgage banking affiliates 

for the loss of the escrow account income. 
151

Question 5: 

How should Bank A account for the earnings from the use of the mortgage escrow balances? 

Staff Response:

Earnings from Bank A's free use of the mortgage escrow balances provided by the mortgage 

banking affiliates should be credited to capital surplus as a contribution rather than recorded as 

income. 

This response presumes that the mortgage banking affiliates can realize the benefit associated 

with the escrow balances. Earnings from escrow deposits provide a significant source of 

income to a mortgage banking operation. This income source is a significant part of the 

inherent value of mortgage servicing rights and a key consideration when servicing is acquired. 

Further, servicers often recognize part of this inherent value by negotiating a reduced interest 

cost on their borrowings as a result of these deposits. 

Differences between the terms that prevail in the marketplace and those entered into by related 

parties is accounted for as a capital transaction (i.e., capital contribution or dividend). This 

policy is based upon the need to maintain consistency in accounting policy for transactions 

between affiliated and nonaffiliated parties. 
152

TOPIC 11: MISCELLANEOUS ACCOUNTING 

11A. ASSET DISPOSITION PLANS 

Facts: 

On January 10, 2002 Bank A proposes to adopt an asset disposition plan that will result in the 

sale or disposition of all non-cash assets of the bank. The bank anticipates that the liquidation 

of the bank's assets will not be sufficient to satisfy all of the bank's liabilities. On the basis of 

a preliminary valuation of the loan portfolio, substantial losses are expected. 

Question 1: (September 2002) 

What is the appropriate accounting for Bank A at December 31, 2001? 

Staff Response: 

The assets and liabilities of the bank at December 31, 2001 should be recorded at fair market 

value. The results of operations for the period ended December 31, 2001 should include a 

charge for the decline in value. This is based on AICPA Statement of Position 93-3 (SOP 93-

3) and FASB Emerging Issues Task Force Consensus No. 88-25 (EITF 88-25). SOP 93-3 

requires that an enterprise not be considered a going concern if liquidation appears imminent. 

EITF 88-25 requires that assets and liabilities of a liquidating bank be recorded at fair market 

value. 

Question 2: (September 2002) 

Does the fact that the decision to liquidate the bank was made 10 days after the year end affect 

the accounting? 

Staff Response: 

The AICPA Auditing Standards establishes two types of subsequent events. A type one event 

provides additional evidence for conditions that existed at the balance sheet date. For a type 

one event, all evidence that becomes available prior to the issuance of the financial statements 

should be considered, and the financial statements should be adjusted for any changes in 

estimates resulting from the use of this evidence. A type two event provides evidence on 

conditions that did not exist at the balance sheet date. These events do not result in 

adjustments to the financial statements. 

The adoption of the asset disposition plan would be a type one event for which inclusion of the 

effects in the December 31, 2001 financial statements would be required. The adoption of an 

asset disposition plan is the culmination of an undercapitalized position that existed prior to 

December 31, 2001.