Accounting for Credit Risk
Overview
When an firm (such as a bank) lends money in the form of a loan, the loan becomes an asset on the balance sheet.
(Typically market at the principal amaount)
However, when there is a risk that the obligor will not pay the full amount of the loan, the value marked on the books may
not be an accurate measure of the value of the asset.
As time progresses, if the credit quality of the obligor declines, there may be a real loss of financial value that
needs to be recognized. The accounting treatment of credit risk is designed to account for these issues.
Loan Impairment
Once it has been determined that a loan has been impaired (that is, not likely to pay back its principal or interest in full),
companies should recognize the loss to their income in the period where the impairment was recognized,
assuming that the size of the loss can be reasonably estimated.
Loan Loss Reserves
When a bank issues a new loan, it will generally create a loan loss reserve account to account for expected credit losses
to the loan. The loan loss account is a contra account, and is sized to account for expected losses.
As an example, when the bank issues a $10 million construction loan, it will debit its loan account and then credit its cash account
by $10 million dollars. If the bank's internal analysis indicates that on average, the bank will lose 1% on construction loans due
to credit losses, it will create a loan loss reserve account, contra to the construction loan accounts, and debit it $100,000. Likewise,
it will credit the construction loan account $100,000. This amount is recognized in the income statement as a loss.
As actual losses occur, adjustments to the loan loss reserve may be necessary. Banks that over reserve will eventually have to
release some of those reserves, thereby creating a profit at the time of release.
The loan loss process can create the oppurtunity to manipulate earnings. As a simple example, a bank could decide to
begin investing in riskier assets, while not increasing their loan loss reverves. This will create additional profits
in the early period of this process, due to the higher coupon rate paid on riskier loans, while keeping expenses low
due to the unrealistic loan loss reserve.
Of course, losses will eventually catch up the bank over time, but bank managers may have collected large bonuses during the
early years and investors will have been hurt by the manipulation.
Debt Security Impairment
When the value of a debt security is materially affected by a credit event or other credit assessment, companies are required
to recognize a loss in value of the security. The method by which this loss is recoreded depends on the treatment of the
asset in question.
- Available for Sale - changes to the value of an asset that are
attributable to credit quality is recognized in income through the other than temporary impairment
(OTTI) account.
- Held to Maturity - credit loss is recognized in income.
Hedge Accounting
It is possible to enter into hedges that are designed to hedge credit exposures. For information about the
accounting treatment of credit hedges, see
hedge accounting
