Accounting for Loan Losses



As I said earlier, some loans will inevitably go bad — that ’ s the way a banker ’ s cookie will crumble from time to time. The foregoing simplified example doesn ’ t do justice to the actual process of dealing with bad loans. Basic Bank & Trust can ’ t just wait to take the hit when the loan is finally written off; the accounting process begins immediately. This topic may seem a bit complex, but it ’ s very important to understand when analyzing a bank, so let ’ s see if I can simplify it a bit.
Let ’ s say Basic Bank & Trust has $ 100 million of loans outstanding. Management knows that some of these loans won ’ t be repaid in full, but right now it doesn ’ t know for sure which ones or, for that matter, how much it might lose on any particular loan if the borrower defaults. Nevertheless, accounting rules force the bank to make some kind of estimate.
On the basis of what it knows about its borrowers — their current financial condition, the value of the collateral backing up these loans, and historical loan losses, to name just a few factors — Basic Bank & Trust figures that by the time all $ 100 million worth of loans are settled, it will get only $ 98 million of its money back. The $ 2 million difference between these two figures is set aside in an account called the allowance for loan losses . On the asset side of its balance sheet, Basic Bank & Trust will list the gross amount of loans outstanding, the size of the reserve (a negative asset, if you will), and the net figure of $ 98 million. On the income statement, this allowance was reflected by provisions that reduced reported earnings long ago.
Early one morning (about 9 o ’ clock for bankers), the president of Basic Bank & Trust picks up the local paper and discovers that one of his borrowers, a used - car dealer, has just filed for bankruptcy. The bank lent $ 2 million to this clown, and now he ’ s gone belly - up. Spewing coffee over his desk, the president proceeds to call in the officer who made the loan and chew the poor fellow out.
Not all is lost, though. The red - faced loan officer reminds the bank president (who approved the loan in the first place, by the way) that this loan is secured by the land and buildings on the used - car lot. As best he can tell, this collateral is worth $ 1.4 million.
The first accounting step is the charge - off . Because Basic Bank & Trust can ’ t reasonably expect to get its full $ 2 million back, it will write the value of this loan down to the collateral ’ s market value, $ 1.4 million. Only $ 600,000 of the loan will be charged off.
But as in physics, every accounting action has an equal and opposite reaction. Where will this $ 600,000 hit be felt? Not on the income statement — at least not directly, and at least not yet. (See Figure A3.3 .) For the time being, this charge - off shown in Figure A3.3 will be covered by the bank ’ s allowance for loan losses, since this is exactly what the allowance is for. Even though a $ 2 million loan has gone into default,