In the late 1980s, loan loss reserves established by depository institutions were criticized by regulators as being inadequate to cover losses from bad loans. From 1980 to 1992, approximately 2,700 federally insured depository institutions failed, at a substantial cost to the insurance funds and taxpayers. Bad loans for agriculture, energy, less developed countries, and commercial real estate contributed to the large number of failures. In 1992, the condition and performance of the nation’s depository institutions improved substantially. Commercial banks posted record earnings of $32 billion while savings institutions posted aggregate earnings of $6.7 billion, continuing a positive trend that began in 1991. For 1993, this improvement continued with commercial bank profits of $43.4 billion and savings institution profits of $7 billion. Recently, some depository institutions have been criticized by regulators for maintaining more reserves than they need. The management of a depository institution establishes loan loss reserves through periodic provisions or charges to operating expenses. When a provision for loan losses is recorded by management, loan loss reserves increase by a like amount. Loan loss reserves adjust the institution’s loans receivable to reflect amounts that management estimates will not be recovered. When losses associated with loans or portions of loans are confirmed or determined to be certain, the loans or portions of loans are removed from the books of the institution by writing off the loan against the loan loss reserve. This results in removing amounts from the reserve that are associated with the confirmed losses. Loan loss provisions and reserves are key indicators of loan quality that are included in the financial reports of depository institutions. Depositors, investors, and other financial report users rely on these indicators to make decisions about the financial condition of the institution. Regulators evaluate the adequacy of loan loss reserves during on-site, full scope, safety and soundness examinations. These examinations are conducted periodically to identify problems early and control risk. Regulators also monitor reserves through financial reports received between examinations to track institutions’ financial condition and performance. Because of their importance to various users of financial reports, loan loss provisions and reserves need to accurately reflect specifically identified loss exposures as well as other inherent loss exposures in the institution’s loan portfolio. Authoritative accounting rules for financial reporting are primarily established by the Financial Accounting Standards Board (FASB). These accounting rules are referred to as generally accepted accounting principles (GAAP) and are promulgated through the issuance of statements of financial accounting standards (SFAS) by FASB. The American Institute of Certified Public Accountants (AICPA), through its Accounting Standards Executive Committee (AcSEC), issues accounting guidance on issues not otherwise covered in authoritative literature. The Securities and Exchange Commission (SEC) has statutory authority to set accounting principles, but as a matter of policy it generally relies on FASB and the AICPA to provide leadership in establishing and improving accounting principles. However, SEC frequently issues accounting and disclosure regulations to supplement guidance provided by FASB and the AICPA. We have previously reported the existence of significant problems in measuring and accounting for losses from problem loans and regulatory examinations of loan loss reserves. In our study of 39 banks which failed without warning in 1988 and 1989, we found that asset valuations the Federal Deposit Insurance Corporation prepared after the banks failed increased their loss reserves from $2.1 billion to $9.4 billion. Although we acknowledged that several factors contributed to this difference, such as deterioration in loan values subsequent to failure, we concluded that a significant portion of it was caused by institutions making inadequate estimates of loan losses prior to failure. In our assessment of regulatory examinations, we found that the four federal financial institution regulators—the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS)—did not have a uniform risk-based methodology to judge an institution’s loan loss reserves. Examiners lacked a consistent framework to quantify loan portfolio risks such as real estate exposure, unfavorable economic conditions, and deficient loan policies. Methods for assessing loan loss reserves varied among the regulators and the lack of a generally accepted method made it difficult for the regulators to successfully challenge management’s estimates when the examiners believed reserves were inadequate. Our objectives were to determine whether loan loss reserve methodologies used by insured depository institutions resulted in reserve amounts that were justified by supporting analysis and comparable among institutions and accounting standards provided by FASB and regulatory guidance provided by OCC, FRB, FDIC, and OTS were sufficient to promote fair and consistent financial reporting of loan loss reserves among depository institutions. To determine whether loan loss reserve methodologies used by insured depository institutions resulted in reserve amounts that were justified by supporting analysis and comparable among institutions, we conducted case studies of 12 depository institutions, each with total assets over $1 billion, which we judgmentally selected. They are referred to as Institutions A through L in this report. To include a cross section of depository institutions, we selected institutions supervised by OCC, FRB, FDIC, and OTS that were currently being examined or had been examined during the last 12 months. For geographic diversity, we selected institutions located in California, Maryland, New York, North Carolina, Texas, and Virginia. For each institution, we reviewed all major components of the loan loss reserve methodology, including individual loan assessments, analysis of historical experience, and other means used for reserve allocations. In addition, we reviewed the institution’s overall loan loss assessment, including the criteria and methods used to estimate losses for both commercial and consumer loans. To accomplish our work, we reviewed examination working papers for loan loss reserves and the institution’s loan loss reserve documents, when they were available. We also conducted detailed interviews with the regulatory examiner-in-charge and/or management to discuss the institutions’ loan loss reserving methodologies and the application of accounting rules and regulatory guidance. To determine whether accounting standards and regulatory guidance were sufficient to promote fair and consistent financial reporting, we reviewed all relevant accounting and regulatory guidance for establishing loan loss reserves. This included SFAS No. 5, Accounting for Contingencies; SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings; SFAS No. 114, Accounting by Creditors for Impairment of a Loan; AICPA audit and accounting guides for banks and savings institutions; OCC Banking Circular 201, Allowance for Loan and Lease Losses; FDIC May 1991 Policy Memorandum for Allowance for Loan and Lease Losses; examination manuals for each of the four federal regulators; and the Securities and Exchange Commission’s Financial Reporting Release No. 28, Accounting for Loan Losses by Registrants Engaged in Lending Activities. Each of the four federal depository institution regulators and FASB provided written comments on a draft of this report. These comments are presented and evaluated in chapter 2 and are reprinted in appendixes I through V. Our work was performed between November 1992 and March 1994 in accordance with generally accepted government auditing standards. The 12 depository institutions we reviewed used markedly different methods to establish their loan loss reserves, which resulted in incomparable reserves, and, in most cases, significant portions of their reserves were not justified by supporting analyses. Most of the institutions based large amounts of their reserves on loss history. Historical loss rates provide a valuable basis for estimating future losses and can be appropriately used to establish reserves for nonproblem loans and smaller-balance pools of loans. However, the methods used by the institutions to determine and apply historical loss experience did not consistently identify and measure loan loss exposure, which resulted in incomparable reserve amounts. In addition, historical loss rates were routinely applied to establish reserves for individual problem loans even though individual loan assessments provide the most accurate means to identify and measure loss exposure for such loans. Finally, most of the institutions maintained large supplemental reserves which were not linked to quantitative analyses of loss exposure or other evidence that demonstrated that the amounts were needed to cover likely loan losses. Neither accounting standards nor regulatory guidance provided sufficiently detailed direction about how loan loss reserves should be established to ensure that reserves are clearly justified and comparable among institutions. Given such flexibility, the institutions used widely diverse loan loss estimating methods that resulted in incommensurable reserves and also reserves that may not have reflected the true risk of loss in their loan portfolios. Loan loss reserves that cannot be compared or that misrepresent risks in loan portfolios impede investors, creditors, depositors, regulators, and other users of financial reports from understanding the true financial condition of depository institutions. Such reserving practices also impede early warning of changes in an institution’s financial condition and timely regulatory actions to protect the banking and savings and loan insurance funds. The primary purpose of financial reporting is to provide information to report users which they can utilize in making investment, credit, and similar decisions. Statement of Financial Accounting Concepts (SFAC) No. 2, Qualitative Characteristics of Accounting Information (FASB, May 1980), discusses criteria that are necessary for accounting information to be useful for making business and economic decisions. Reliability and comparability are two of the major criteria discussed in the statement. SFAC No. 2 states that accounting information is reliable to the extent that users can depend on it to reflect the economic conditions or events that it purports to represent. Reliability of accounting information stems from representational faithfulness and verifiability. In other words, to be reliable, accounting information must be verifiable and directly related to the economic resources and obligations of the enterprise, as well as to transactions or events that change those resources or obligations. With regard to comparability, SFAC No. 2 states that information concerning an enterprise gains greatly in usefulness if it can be compared with similar information about other enterprises and with similar information for different periods of time or points in time for the same enterprise.