Accounting for Loan Losses 2



the net loan figure shown on the balance sheet hasn ’ t changed: It ’ s still $ 98 million. The bank ’ s attorney moves quickly to repossess the property. Basic Bank & Trust doesn ’ t want to be in the used - car business; it just wants as much of its money back as possible. A month or so later, a real estate developer offers the bank $ 1.4 million for the property — exactly what the loan officer figured the collateral was worth. The developer gives Basic Bank & Trust a check for $ 1.4 million, and the bank hands over the deed to the property. (See Figure A3.4.) Only now has the size of Basic Bank & Trust ’ s net loan portfolio shrunk, and only by $ 1.4 million — the amount of the loan actually repaid. The other $ 600,000 was reflected earlier by the reduction in the allowance for loan losses. Finally, the $ 1.4 million received is now sitting in the bank ’ s cash account, so total assets haven ’ t changed. The final step comes at the end of the quarter. The bank ’ s managers look over the rest of the loan portfolio and realize the $ 1.4 million balance in the allowance for loan losses account isn ’ t enough; more loans will probably go bad in the future. On the basis of their best estimates of future loan performance, they deem a $ 1.9 million allowance to be appropriate. It ’ s a bit lower than the $ 2 million allowance at the end of the previous accounting period, but the bank now has fewer loans outstanding, and the used - car dealer ’ s loan was one of the riskiest; the remaining portfolio doesn ’ t look quite as risky.

Because the allowance has gone up — at least from where it was after that used - car dealer loan was charged off — this again reduces the value of the bank ’ s net loans. This additional provision of $ 500,000 is what finally shows up on the bank ’ s income statement.
This little drama plays out on the bank ’ s second floor; as a shareholder, all you get to see is what is reflected in the financial statement. Here are some key indicators:
Past - due loans . Between a fully performing loan and a charge - off, the borrower usually falls behind on scheduled interest and principal payments. This value will be reported in the bank ’ s footnotes.
Nonperforming assets . This is the total value of loans that the bank seriously doubts it will be able to collect in full. This isn ’ t a projection of future losses — the full value of a $ 10 million loan might be included in nonperformers, even if that loan is secured with $ 9 million in cash. However, the more nonperforming assets a bank has, the greater the likelihood that the eventual losses will be higher than what has already been charged off.
Allowance for loan losses . How large or small this figure is relative to gross loans will tell you how prepared a bank is for a deterioration in credit quality.