The issue of whether banks are using their loan loss reserves to manage earnings reached an uncomfortable point for bankers last week when an explanation of the relevant generally accepted accounting principles (GAAP) was posted on the Internet. In fact, it appears banks have loosely interpreted the rules, but the Security and Exchange Commission’s ruling on their accounting behavior may be awhile.

The issue is of particular importance to banks, which were once viewed as very volatile in terms of earnings due to their dependence on interest rates. Banking regulators gave the go-ahead to build up reserves several years ago, providing banks with a cushion when unexpected losses occur. Last fall, the SEC questioned the legitimacy of those cushions, and then backed off when the industry cried unfair.

Last week, Financial Accounting Standards Board posted an article on its Web site interpreting financial accounting statements 114 and 5. While there is still room for a special task force from the American Institute of Certified Public Accountants (AICPA) to clarify how to reserve for possible bad loans and remain within GAAP, the FASB staff’s interpretation provides guidance that industry sources said was not apparent to bankers before. An example is the observation that a loss must be incurred before it can be written down, which sources said is generally not the approach today. Instead, there now is a liberal interpretation of FAS 5, which holds that a loss has occurred once a borrower enters prolonged financial trouble, not when bankruptcy occurs.

"It could have a serious effect on the amount of allowances banks could have. This comes out hours or days before people put out first quarter earnings and file 10Qs," said one source at top-five accounting firm.

A FASB staffer said, however, that "nobody’s particularly arguing it needs to be applied retroactively."

Nevertheless, bankers contacted by Financial Modernization Report were eager to hear from the SEC, which ultimately enforces the accounting. SEC staffers said that the agency was waiting for someone–specifically, a bigfive accounting firm–to ask them for the guidance on when, how and by how much to revise allowances.

But even then it may be awhile before the SEC acts, according to staffers, because Lynn Turner, the chief accountant, has been out of the office, and because the issue is a complex one.

"This is going to take a couple of weeks. I haven’t fully thought this out. Usually those things are treated prospectively, or by cumulative catchup," where a bank recognizes the effect of the change in one line below net income and before cumulative effect on the financials. The staffer added that the possibility of restatement was practically nil. Further, he said, the staff might have to turn around and consult with FASB on the issue and even the top five accounting firms. "We’d really need to understand the extent of the problem before we come up with a solution," he said.

Meanwhile, the AICPA is scheduled to meet April 20 to continue studying implementation issues and work on a proposed statement of position on how to apply GAAP to loan reserves. The proposal must be approved by both FASB and the AICPA’s Accounting Standards Executive Committee.

Pascal Desroches, SEC accounting fellow and member of the task force, said the issue of when a loss is incurred may appear straightforward but, in fact, is complicated. As an example, he cited the differing opinions on a bank allowing for the default of a corporate borrower due to Y2K problems. "Some may say if the borrower hasn’t fixed the bug, then it’s a fair allowance. But some would say whether or not they fix this bug is a future problem; the company hasn’t gone bankrupt, therefore you can’t provide an allowance."

One controller at a major regional bank voiced a popular opinion when he said he hoped FASB’s interpretation merely means regulators are "sensitizing everyone to put more discipline in the process. We’re not going to change the world, but we’re going to control the current situation. We’ll keep an eye on you. You better tighten up your documentation (of the rationale for reserving for loans that have not defaulted yet but are expected to.)"