STATEMENT BY THE ACCOUNTING STANDARDS BOARD (ASB)

Transcription

1 STATEMENT BY THE ACCOUNTING STANDARDS BOARD (ASB) The ASB has approved the British Bankers' Association (BBA) and Irish Bankers' Federation (IBF) for the purpose of issuing recognised Statements of Recommended Accounting Practice (SORPs). This arrangement requires the BBA and IBF to follow the ASB's code of practice for the production and issuing of SORPs. The code of practice provides the framework to be followed by the BBA and IBF for the development of SORPs, but does not entail a detailed examination of the proposed SORP by the ASB. However, a review of limited scope is performed. On the basis of its review, the ASB has concluded that the SORP has been developed in accordance with the ASB's code of practice and does not appear to contain any fundamental points of principle that are unacceptable in the context of current accounting practice or to conflict with any existing or currently contemplated accounting standards. November 1997

2 2 EXPLANATORY FOREWORD This SORP is issued jointly by the British Bankers' Association (BBA) and the Irish Bankers' Federation (IBF). It sets out recommendations on the accounting treatment and disclosure of advances in the accounts of banks. Although its recommendations are not mandatory, banks are encouraged to follow them and to state in their financial statements that they have done so. They are also encouraged to disclose any departure from the recommendations and the reason for it. The provisions need not be applied to immaterial items. The provisions of this SORP have been arrived at after consideration of Statements of Standard Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs) and other applicable laws and regulations currently in force. Regard must be paid to applicable accounting standards, laws and regulations since SORPs cannot override these requirements. The recommendations in the SORP are also subject to the overriding requirement that accounts must present a true and fair view. SORPs issued by the BBA and IBF are recommendations addressed by the two associations to their own members and, as such, are intended to apply to the entity accounts of banks incorporated in the United Kingdom or the Republic of Ireland and to the consolidated accounts of British and Irish banking groups. However, although they are intended to be authoritative and persuasive, it is recognised that it is not compulsory to disclose the fact or nature of any departure from recommended practice. Other SORPs published by the BBA and IBF cover accounting for securities, derivatives, contingent liabilities & commitments and segmental reporting. November 1997

3 3 STATEMENT OF RECOMMENDED PRACTICE ON ADVANCES PART 1: COMMENTARY Paragraphs Introduction 1-3 Scope 4-5 Recognition and valuation general considerations 6-10 Specific provisions General provisions Write-offs Dealing portfolios 21 Netting Sales, purchases and exchanges of advances Interest Fees and expenses Disclosure PART 2: DEFINITIONS OF TERMS USED IN PART 3 51 PART 3: RECOMMENDED ACCOUNTING PRACTICE Scope 52 Balance sheet recognition and valuation Income recognition Disclosure Implementation 77 PART 4: NOTE ON LEGAL REQUIREMENTS 78-84

4 4 STATEMENT OF RECOMMENDED PRACTICE ON ADVANCES PART 1 COMMENTARY Introduction 1. The original SORP on Advances, published in September 1992, served to narrow the differences in the accounting treatment of the various types of bank lending and to establish minimum industry-wide disclosure requirements. The SORP also drew together the fundamental principles to be considered in respect of management judgements relating to the valuation of advances. 2. In reviewing the SORP, five years on, the BBA and IBF have concluded that the broad thrust of the principles and guidance established in 1992 remain valid. The opportunity has been taken, however, to clarify practice and to update the SORP to reflect market developments and changes in financial reporting requirements, most notably FRS 5 'Reporting the Substance of Transactions'. FRS 5 is extremely relevant to aspects of this SORP and, where necessary, must be consulted. 3. No attempt has been made to predict the outcome of the ASB's deliberations on financial instruments, impairment and discounting. In the event that these result in changes to the financial reporting regime, consideration will be given to whether the SORP requires further amendment. Scope 4. This SORP covers loans, overdrafts and other methods of extending credit to borrowers. These are described throughout as 'advances'. In such cases, the claims on the borrowers derive from agreements to lend money; they are to be distinguished from claims resulting from purchasing or subscribing for securities, which are covered by the separate SORP on accounting for securities. 5. Finance leases are in substance a means of extending credit to borrowers and are usually included in the balance sheets of banks under advances. They are within the scope of this SORP. However, the SORP does not discuss the question of how the amounts due under a leasing contract are to be allocated between capital and interest; this matter is covered by SSAP21 'Accounting for leases and hire purchase contracts'. Further guidance on lessor accounting is being developed by the Finance and Leasing Association. Also included under advances in the balance sheet, and within the scope of the SORP, are assets acquired in substitution for advances, but only where such assets are held solely with a view to the orderly realisation of the advance. The SORP does not cover credit derivatives or acceptances, letters of credit, performance bonds or other off-balance-sheet items. General guidance on accounting for derivatives can be found in the BBA's SORP on Derivatives and the other items are all covered by the BBA's SORP on Contingent Liabilities and Commitments.

5 5 6. FRS 26 (IAS 39) Financial Instruments: Measurement sets out detailed requirements for the measurement of financial instruments. FRS 26 applies to listed entities for accounting periods commencing on or after 1 January 2005, and to entities adopting the fair value accounting rules of the Companies Act 1985, for accounting periods commencing on or after 1 January Early adoption and voluntary adoption by other entities, including banks, is permitted. Where an entity applies FRS 26 to its financial statements, it is exempted from the scope of this SORP. Recognition and valuation general considerations 7. Advances, net of amounts written off, should be recorded in the balance sheet on the basis of the cost of the amount of the advance outstanding, less suspended interest debited to the customer's account, specific and general provisions. 8. In the usual case, where the advance is held by the bank which originally made it, the cost will be the amount lent to the borrower. On occasion, however, advances are acquired in a secondary market or by way of exchange for other advances or other assets; their cost may then differ from the amount of the original advance. 9. The balance sheet valuation of advances should reflect any diminution of their ultimate realisable amount below their cost. In order to ensure that deterioration in value is properly reflected in the period in which it takes place, advances should be reviewed at every reporting date and, where necessary, four separate adjustments made: for suspended interest debited to the customer's account, specific provisions, general provisions and write-offs. The latter three are described in paragraphs 11 to 20 below; interest is covered in paragraphs 34 to 40. Although specific and general provisions are computed separately, they are in effect components of the same provision. In total the specific and general components of a bank's provisions for bad and doubtful advances should represent the aggregate amount by which the bank considers it necessary to write down its impaired advances in order to state them at their expected ultimate net realisable value. 10. The methods for calculating the level of impairment inherent in a portfolio and, consequently, the appropriate provision are constantly evolving and are becoming increasingly sophisticated, with greater use of statistical and other modelling techniques. Such methods are compatible with the accounting framework established by this SORP. 11. The review should be based on the state of affairs ruling at the balance sheet date. Events that occur after the balance sheet date should be taken into account only in so far as they shed further light on the position at the balance sheet date. Material 'non-adjusting' post balance sheet events should be separately disclosed in accordance with the requirements of SSAP17 'Accounting for post balance sheet events'. Specific provisions 12. A loan is impaired when, based on current information and events, the bank considers that the creditworthiness of a borrower has undergone a deterioration such that it no longer expects to recover the advance in full. In these circumstances, it is

6 6 necessary to consider whether a specific provision should be made against the advance. Such advances are described in this SORP as 'impaired'. A provision is generally only needed when the position deteriorates to an extent not foreseen when the advance was made, ie when recovery of the outstanding amount in terms of principal and interest due but unpaid at the balance sheet date, is no longer likely. Although it is often an event of default that serves as trigger, a provision should be considered whenever the information available to the bank suggests that the advance has become impaired. 13. When an advance has been identified as being impaired, the amount of the specific provision should be the bank's estimate of the amount (if any) needed to reduce the carrying value to the expected ultimate net realisable value. Where a borrower is already in liquidation or receivership, the bank may have reasonably accurate information on which to base its estimate. In other circumstances, the bank must exercise its judgement, taking into account all relevant information, such as the borrower's financial condition and the net realisable value of any security held. 14. The carrying value arrived at in this way may well exceed the amount at which the advance could be sold on a secondary market. This is acceptable if, as is usually the case, the bank intends to hold the advance until it is recovered. If, however, the bank intends to dispose of the advance before it is recovered, provision should be made to reduce the carrying value to the net amount estimated to be realisable on disposal. 15. The deterioration in creditworthiness that prompts a specific provision may be the result of factors extraneous to the borrower, such as, for example, economic and political factors in the borrower's country of residence. An otherwise sound borrower may be prevented from meeting the obligations concerned, for example, because of difficulty in obtaining the necessary foreign currency. In such cases, a provision is made where necessary to reflect ordinary commercial risk attaching to the advance, then a further provision is applied to the remaining net value to reflect country risk. (The subject of cross-border exposures is discussed in paragraph 48 below.) 16. In a portfolio of consumer advances and other portfolios of homogenous advances it is possible specifically to identify most impaired advances from the fact that payments are in arrears, but it is usually not practicable to investigate the circumstances of the individual borrowers to the extent needed to value each impaired advance individually. In such cases, the required specific provision can be calculated on a portfolio basis. General provisions 17. Experience shows that portfolios of advances often contain advances which are in fact impaired at the balance sheet date, but which will not be specifically identified as such until some time in the future. There will not usually be sufficient information to hand at the review of advances to be certain that all impaired advances have been identified. To cover the impaired advances which will only be identified as such in the future, a general provision should be made.

7 7 18. It is emphasised that the general provision relates to impairment already existing in the advances portfolio at the balance sheet date. It does not relate to advances which at the balance sheet date are subject to no more than normal credit risk, but which in the nature of things may become impaired in the future. 19. Assessment of the appropriate level of general provision is the responsibility of the directors and is inevitably subjective. Past experience will provide some guide, but current economic and other factors affecting the business climate should be taken into account. Because the incidence of losses might vary from one category of advance to another, the main categories, for example public sector lending, industrial and commercial lending and consumer lending, should be considered separately. It may be necessary to analyse the portfolio further and to examine, for example, whether some sectors of industry and commerce are likely to have been affected more than others. As explained in paragraph 8, specific and general provisions together represent the amount by which a bank considers that it needs to write down its loan portfolio in order to reflect bad and doubtful debts. It follows that the approach a bank adopts towards identifying specific provisions, eg in terms of the period and amount of interest arrears permitted before the advance is classified as impaired, will have a bearing on the level of general provisions. Write-offs 20. When an advance has been identified as impaired and subjected to a specific provision, that provision may subsequently be increased or decreased to reflect changes in the prospects for recovery. If the prospects do not improve, a point will come when it may be concluded that there is no realistic prospect of recovery. When that point is reached, the amount of the advance which is considered to be beyond prospect of recovery should be written off. Sometimes an advance is beyond realistic prospect of recovery as soon as it is identified as impaired, in which case a provision and a write-off are made simultaneously. 21. As in the case of provisioning, the timing and extent of write-offs involves a large element of subjective judgement. Nevertheless, a write-off will often be prompted by a specific event, such as the inception of insolvency proceedings or other formal recovery action, which makes it possible to establish that some or all of the advance is beyond realistic prospect of recovery. In any event, the position of impaired advances should be reviewed regularly at least annually with a view to irrecoverable advances being written off in a prompt and orderly manner. A write-off does not preclude the bank from maintaining memorandum records of the full amounts due from the borrower for as long as it finds it worthwhile to do so. Dealing portfolios 22. Where a bank maintains a dealing portfolio of advances for the purpose of trading on a secondary market, the approach to their valuation is different. Such advances should in principle be carried at their secondary market value. Since the markets in question are often thin, a prudent approach to the assessment of 'fair value' should be adopted; similar considerations can apply to the valuation of securities positions and are discussed in the separate SORP on accounting for securities. Under Schedule 9 of the Companies Act 1985 the adoption of this policy

8 8 requires a 'true and fair override' and the disclosures required by the act and UITF abstract 7 will have to be made (see paragraph 81 below). Netting 23. A borrowing customer may maintain several accounts with a bank, some in debit and others in credit, perhaps at different branches of the bank. The separate accounts are often maintained purely for the administrative convenience of the parties concerned. FRS 5 'Reporting the Substance of Transactions' determines that debit and credit balances should be aggregated into a single net item where and only where they do not constitute separate assets and liabilities. This depends on all of the following conditions of paragraph 29 of FRS 5 being met: (a) The reporting entity and another party owe each other determinable monetary amounts, denominated either in the same currency, or in different but freely convertible currencies. For this purpose a freely convertible currency is one for which quoted exchange rates are available in an active market that can rapidly absorb the amount to be offset without significantly affecting the exchange rate; (b) The reporting entity has the ability to insist on a net settlement. In determining this, any right to insist on a net settlement that is contingent should be taken into account only if the reporting entity is able to enforce net settlement in all situations of default by the other party; and (c) The reporting entity's ability to insist on a net settlement is assured beyond doubt. It is essential that there is no possibility that the entity could be required to transfer economic benefits to another party whilst being unable to enforce its own access to economic benefits. For this to be the case it is necessary that the debit balance matures no later than the credit balance. It is also necessary that the reporting entity's ability to insist on a net settlement would survive the insolvency of the other party." 24. It follows from the conditions of FRS 5 that netting should not be applied if there are circumstances outside the bank's control which may impede the enforcement of its legal rights; for example, restrictions on capital movements may impede the setoff of a deposit in one country against an advance in another. 25. In the consolidated accounts of a banking group, however, netting can be applied between advances extended by one company in the group and deposits held in another, provided the requisite conditions are met. Sales, purchases and exchanges of advances 26. Advances are normally extended under agreements made between particular borrowers and lenders and so cannot literally be 'sold'. However, there are a number of ways of achieving the same effect as a sale. These include novation (where the original loan agreement with the seller is replaced by a new one between the borrower and the buyer), assignment (where the seller assigns his rights under the agreement to the buyer), and participation (where the buyer provides the seller with non-recourse back-to-back refinancing).

9 9 27. The accounting treatment of such arrangements is determined by the principles governing the substance of a transaction, as established by FRS 5, rather than the legal technique adopted. Under FRS 5 one of four possible accounting treatments will apply: (1) Where a transaction involving a previously recognised asset results in no significant change in the bank's rights or other access to benefits relating to that asset, or its exposure to the risks inherent in those benefits, the entire asset should continue to be recognised. (2) Where a transaction involving a previously recognised asset transfers to others all significant rights or other access to benefits relating to that asset, and all significant exposure to the risks inherent in those benefits, the entire asset should cease to be recognised. (3) In 'special cases', where there is significant change in the entity's rights to benefits and exposure to risks, but not such that the asset should cease to be recognised, the description or monetary amount relating to an asset should, where necessary, be changed and a liability recognised for any obligations to transfer benefits that are assumed. These cases arise in respect of: transfers of only part of the item in question; transfers of all of the item for only part of its life; and transfers of all of the item for all of its life but where the entity retains some significant right to benefits or exposure to risk. (4) Where a transaction is in substance a ring fenced financing of a previously recognised asset, the finance should be shown deducted from the gross amount of the item it finances on the face of the balance sheet within a single caption. This 'linked presentation' should also be used where an item that is financed in such a way has not been previously recognised as an asset but the conditions given in FRS 5 for such presentation have been met. 28. The following notes may assist in determining which of the four accounting treatments set out above should be adopted and give guidance on profit and loss account recognition: In (1) above, where the conditions for treating the transaction as a sale are not met, the advance should be retained in the balance sheet, the amount received recorded as a deposit, and no gain or loss recognised. Under (2) above, if the sale proceeds, including any fees involved, are greater or less than the amount of the advance, the difference should be taken to the profit and loss account. If the selling bank continues to administer the advance, any fees receivable for this service should be brought into profit as they accrue. In the special cases referred to in (3) above, FRS 5 determines that, where the amount of any resulting gain or loss is uncertain, full provision should be made for any probable loss but recognition of any gain, to the extent that it is in doubt, should be deferred. In addition, where the uncertainty could have a material effect on the financial statements, this fact should be disclosed in the notes.

10 10 The linked presentation, ie (4) above, may in particular be appropriate in the case of securitisations. Under such transactions, a portfolio of advances is sold to a vehicle company which finances the purchase by issuing appropriate securities. In determining whether a linked presentation should be adopted, the conditions given in paragraphs of FRS 5 must be met and the detailed applications notes consulted. 29. Where an advance is syndicated among a number of banks, it is common for the disbursement and repayment to be routed through one bank in the syndicate. Each bank should record only the share of the advance that it has funded: the lead bank merely acts as an agent and the amounts should not be grossed up in its accounts. In some syndicates, the risk is distributed between the members in different proportions from the funding. In these circumstances, it is a statutory requirement that only the amount funded be shown as an advance; any additional amount for which the bank is at risk must be shown in the balance sheet in the memorandum items required by the statutory format. 30. Sometimes banks buy and sell impaired advances; for example, in recent years a secondary market has grown up in problem country debt. Advances acquired by purchase or exchange should initially be recorded at cost. Where an advance is sold for less than its carrying value, it should be written down to the sale proceeds, any provision held against it being applied for that purpose. The difference between the sale proceeds and the former carrying value will then be charged to the profit and loss account. Where an impaired advance acquired by way of purchase or exchange is subsequently recovered, or sold for more than its cost, the surplus over cost should be treated as a profit on disposal and should not be reflected in the charge to the profit and loss account for provisions or in the provisions table in the notes to the accounts. 31. Where advances are exchanged for other advances ('debt-for-debt swaps'), the cost of the advances acquired should be taken to be the net book value of the advances disposed of. (A renegotiation of the terms of an advance, for example of the maturity or the collateral, is not an exchange of one advance for another, even where the advance is formally replaced by a different debt instrument.) The provisions made against the advances disposed of should be updated immediately in light of the terms of the disposal. 32. Provisions should be made against advances acquired (whether by 'debt-for-debt swaps' or otherwise) if it becomes necessary to reduce their carrying value below their cost. The cost and the amounts originally lent should be disclosed where the difference between them is material. This will avoid misleading comparisons between the levels of provisioning of banks which have acquired advances by way of purchase or exchange and those which have not. 33. Where a bank exchanges advances for assets which are not themselves advances, it is necessary to consider the appropriate accounting treatment both for the advances disposed of and for the assets acquired. 'Debt-for-equity swaps' are one example of such an exchange. Another would be the foreclosure of a mortgage, where the bank obtains an unfettered title to the property held as security. (Foreclosure should be contrasted with the more usual procedure of exercising a

11 11 mortgagee's right of sale, which is not an exchange of one asset for another: the bank's asset remains the advance, and the sale proceeds are a recovery of all or part of the advance.) 34. The treatment of such exchanges depends on the bank's intentions for the assets acquired. The assets received in exchange may be intended for employment in the bank's business: for example, securities may be taken into the bank's securities portfolios, while property may be occupied for the purposes of the business. Where this is the case, the advance should be treated as sold; the accounting treatment for the assets acquired should normally follow that of similar assets held by the bank and is outside the scope of this SORP. Often, however, the bank holds the assets only with a view to achieving an orderly realisation; their acquisition is merely a step in the process of recovering the advance. In these cases, the assets should be recorded as advances in the balance sheet and disclosed separately. Such assets should initially be recorded at their cost, which is the carrying value of the advance at the date of disposal, the provision having been duly updated. If subsequently the estimated amount realisable is less than this initial value, the valuation should be reduced accordingly and the adjustment reflected in the provisions account. Income received from such assets should be treated in the profit and loss account as interest. Interest 35. The general rule is that interest earned on advances should be brought into the profit and loss account as it accrues, provided that its collectibility is not subject to significant doubt. Doubtful interest should be excluded from the profit and loss account. 36. The identification of the point at which the collectibility of the interest is doubtful is a matter of judgement. Some banks may wish to use the fact that interest is overdue by some given period as a convenient starting point for making that identification. However, the fact that interest is overdue by some arbitrary period should not lead automatically to interest being considered doubtful. 37. There are two categories of unpaid interest which may become doubtful. First, there is interest which is not yet due but which has been accrued; secondly, there is interest which has become due and has been debited to the borrower's account but which has not in fact been paid. So far as the first category is concerned, as soon as the interest is identified as doubtful it should not be credited to the profit and loss account, but should instead be credited to an interest suspense account. Further, any accrued interest receivable but not yet due which has already been credited to the profit and loss account should, where practicable, be reversed and credited to the suspense account. For the second category, once interest is identified as doubtful amounts debited to the borrower should not be credited to the profit and loss account, but should be credited instead to the suspense account. Unpaid interest already debited to the borrower and credited to the profit and loss account in the same financial year should, where practicable, be transferred from the profit and loss account to the suspense account to the extent that it has become doubtful; unpaid interest debited in earlier years should not be transferred, but should be provided against to the extent necessary. The balance on the suspense account

12 12 should be netted in the balance sheet against the accrued interest receivable or, as the case may be, the amounts due from the borrowers. 38. Where interest has been identified as doubtful and suspended in accordance with paragraph 36, amounts may subsequently be received for the credit of the account. Unless there is an express agreement with the customer to the contrary, payments made by the customer or on his behalf should be appropriated first to reduce the outstanding interest, with a corresponding transfer from the suspense account to the profit and loss account, and then to reduce the outstanding principal (including interest debited in earlier years and consequently not suspended). On the other hand, amounts received from the realisation of security should normally be treated first as a recovery of principal. 39. The crediting of interest to the suspense account should cease when there is no longer any realistic prospect of recovering it, and the accumulated balance on the account should be written out of the books once it is beyond realistic prospect of recovery. The judgements and principles involved are the same as those set out in paragraph 20 in respect of write-offs of principal. 40. For most advances there will be an interest payment profile and it will be clear whether or not interest has been paid. However, for some advances, particularly overdrafts, the situation is more complex as interest, once applied to a borrower's account, loses its identity as interest. In the case of such accounts, interest may not be identified as doubtful until a specific provision in respect of the account is determined to be necessary. For the reasons given above, interest charged to such an account up to the point at which interest is identified as doubtful need not be reversed, but can instead be taken into account when determining the required specific provision. 41. Where a bank acquires an unimpaired advance originally made by a third party, it may pay a premium or receive a discount to reflect the fact that the interest payable is out of line with current market conditions. Such premiums or discounts should be taken into the profit and loss account on a level yield basis over the remaining life of the advance and treated as interest. To comply with the statutory rule that prevents advances being carried in the balance sheet at an amount greater than cost, the amounts taken to the profit and loss account in respect of the amortisation of discounts should be treated in the balance sheet as adjustments to accrued interest and not as adjustments to the carrying value of the advances. Fees and expenses 42. Banks often charge borrowers a fee when an advance is arranged (or rearranged). Usually the fee is payable at the inception of the advance. Its accounting treatment should reflect the nature of the fee. In principle, if it represents no more than payment for the service provided in setting up the advance, then it is appropriate to bring it into profit as soon as it is receivable. To the extent that a fee represents reimbursement of the costs of providing a continuing service to the borrower, that part of the fee, together with a reasonable profit margin, should be spread over the life of the advance on the basis of the work done. If, however, a fee amounts in substance to an additional interest charge it should be spread on a level

13 13 yield basis. The terms and conditions of the advance should be examined to determine the period of amortisation. In practice, in either of these circumstances it may be acceptable on materiality grounds to spread the fee either on a straight-line basis or pro rata to the amount outstanding. Similarly, front-end expenses should be deferred and charged to profit on a level yield basis when they are expected to be recovered out of the interest margin rather than by way of a fee and included in the calculation of any profit or loss on sale. 43. Costs can also arise in respect of incentives provided to the customer, for example in the form of 'cashback or cash gift' schemes and discounted interest rates paid under certain mortgage schemes. Such incentives can be deferred and charged as an adjustment to interest income only if the bank has the right under the terms of the scheme to recover amounts involved from the customer in the event of early redemption and it is its policy and normal practice to exercise such a right. Amortisation over the early redemption period matches the cost of the incentive with the benefit derived as once the early redemption period has expired the incentive is no longer repayable by the customer. Deferral should cease and unamortised costs charged to the profit and loss account if the related loan is redeemed, sold or becomes impaired. Where such incentives are not amortised they should be charged to the profit and loss account as they arise. Disclosure 44. The legal requirements concerning the accounting treatment of advances and the related disclosures are described in Part 4. The latter include the analysis of advances by maturity. The analysis is to be given by remaining maturity; where an advance is repayable in instalments, each instalment is to be treated as a separate advance. 45. The statement of the accounting policies adopted should provide clear explanations of the policy on at least the following matters concerning advances: specific provisions; general provisions; write-offs; interest recognition; and the treatment of fees and expenses, including whether any incentives relating to mortgages or other advances have been written off or amortised. 46. Where advances are material to a bank's operations additional disclosures are needed to provide information about the quality of the lending and its profitability and about the composition of the portfolio. To meet the first of these needs, disclosure should be made of the total amount, before and after provisions, of all nonperforming advances, including advances on which interest is being accrued but placed in suspense and advances on which interest is not being accrued. There should also be separate disclosure of the levels of specific and general provisions and of movements during the period. The analysis provided should include the charge or credit to the profit and loss account, the effect of exchange rate movements, the effect of changes in the composition of the banking group, amounts applied in writing off advances and recoveries of amounts previously written off. 47. So far as information about the composition of the portfolio is concerned, it is considered that it is information on concentrations of credit risk, rather than a complete analysis by segment, which should be provided. ('Credit risk' is the risk of

14 14 loss due to counterparty failure.) Concentrations may arise in respect of industrial sectors or geographical areas, especially problem countries: these are discussed below. There may also be concentrations in respect of particular types of lending; domestic mortgages and 'leveraged buy outs' are two examples. Disclosure should therefore be made of all significant concentrations of credit risk necessary to give users of accounts a proper appreciation of the bank's risk profile. The disclosure in respect of a concentration of credit risk should be based on the relevant advances gross of provisions. In addition, banks are encouraged to give further information regarding the total exposure to the relevant counterparties. Such 'exposure' should be taken to be the maximum amount that could be lost as a direct result of the failure of the relevant counterparties, without taking credit for the value of any security held. This should include not only the full amounts of advances to the counterparties, but also potential losses arising from other assets whose value depends on the maintenance of the financial soundness of the counterparties, from commitments to lend or to acquire such assets, and from contingent liabilities. Where an advance is guaranteed by a third party, the exposure may be treated as an exposure to the guarantor if it is clear that the creditworthiness of the guarantor is superior to that of the borrower. Industry exposure 48. Each bank will normally have its own system for monitoring large exposures to particular industrial sectors, defining the sectors in a manner appropriate to the pattern of the bank's business. For some industries, it is necessary to monitor the exposure on a worldwide basis, while for others a country-by-country approach is more appropriate; the global basis should be used where creditworthiness is affected by global economic factors, as may be the case in the oil and shipping industries for example. Disclosure should be made of gross advances to the bank's chosen sectors where they are significant in terms of total assets. Cross-border exposure 49. One type of concentration is cross-border exposure to counterparties in problem countries. These are countries where government external debt is often in arrears, or subject to moratoria or rescheduling (or where there is a significant risk that this might occur), while private sector borrowers may be barred from access to the foreign currency they need to service their debts. If significant in terms of total assets, disclosure should be made of the aggregate amount of provisionable advances (or exposures) to problem countries, that is advances after deducting commercial risk provisions and the related country risk provisions (the distinction between provisions for country risk and provisions for commercial risk is explained in paragraph 14) Interest margin 50. Banks are encouraged to disclose the net interest margin earned. This should be calculated by reference to net interest income and average total interest-earning assets. Banks are also encouraged to discuss year-on-year movements in net interest margin. These disclosures are considered appropriate for inclusion in the Operating and Financial Review.

15 15 Incentives 51. The impact of mortgage incentives on the results of the period and the balance sheet should be disclosed. Where mortgage incentives have been amortised, the disclosure should include the amount that would have been charged to the profit and loss account in the accounting period in question if the incentives had been written off as incurred. PART 2 DEFINITION OF TERMS USED IN PART The terms listed below are used in Part 3 with the meanings ascribed to them. 'Advance' means an amount provided to a borrower under an agreement to lend money, or another asset having the same essential attributes. 'Country risk' means risk attaching to the generality of borrowers in a country by reason of political and economic factors in that country. 'Fair value' is the amount at which an advance could be exchanged in an arm's length transaction between informed and willing parties, other than a forced or liquidation sale. 'Impaired', in relation to an advance or portfolio of advances, means that, based on current information and events, the creditworthiness of the borrower or borrowers has undergone a deterioration such that the advance or portfolio of advances is no longer expected to be recovered in full.

16 16 STATEMENT OF RECOMMENDED PRACTICE ON ADVANCES PART 3 RECOMMENDED ACCOUNTING PRACTICE Scope 53. This statement sets out the recommended accounting practice for advances, and applies to the entity accounts of banks and to the consolidated accounts of banking groups. The recommendations of the statement need not be applied to immaterial items. 54. The statement also applies to other assets where they are acquired in substitution for advances and are held only with a view to the orderly realisation of the advance. Such assets should be recorded as advances in the balance sheet. However, where assets acquired in substitution for advances are assimilated within the bank's portfolio of similar assets, their accounting treatment should normally follow that of the assets in question and is outside the scope of this statement. 55. This statement does not apply to financial statements for which the bank has applied FRS 26 (IAS 39) Financial Instruments: Measurement. Balance sheet recognition and valuation 56. Subject to paragraph 58 below, advances, net of amounts written off, should be recorded in the balance sheet at cost, less suspended interest debited to the customer's account, specific and general provisions. 57. Advances should be written off to the extent that it appears that there is no realistic prospect of recovery. 58. Provisions should be made to write down impaired advances and should comprise the following two components: (a) specific provisions to be made in respect of impaired advances which have been identified as such. The amount of the provision should be the amount (if any) needed to reduce the carrying value of the advance to its expected ultimate net realisable value. However, where the bank intends to dispose of the advance, the carrying value should be reduced to the net amount expected to be realised by the chosen method of disposal; and (b) a general provision to be made in respect of impaired advances which have not yet been specifically identified, but which are known from experience to be present. The level of the general provision should take account of past experience and current economic conditions and other relevant factors affecting the various categories of advances in the portfolio. 57. When advances are acquired in exchange for other advances their cost should be taken to be the carrying value of the advances disposed of, as assessed at the date of disposal. Subsequent adjustments for provisions and amounts written off should be made in the usual way. The same treatment should be applied to assets

17 17 other than advances which are acquired in exchange for advances and which are held only with a view to the orderly realisation of the advance. 59. Advances held in a dealing portfolio for the purpose of trading on a secondary market should be carried at fair value. The accounting policy, the reasons for it and its effect should be disclosed. 60. Advances should be shown in the balance sheet net of claims on the bank where and only where the offset criteria in paragraph 29 of FRS 5 'Reporting the Substance of Transactions' are met. 61. Advances which a bank has disposed of, in whole or in part, whether by novation, assignment or participation, should be excluded from its balance sheet if all significant rights or other access to benefits relating to the advance and all significant exposure to the risks inherent in those benefits have been transferred. In other cases, the advances should remain on the balance sheet the special case arrangements or the linked presentation, as determined under paragraphs 23 and FRS 5 respectively, adopted if the relevant conditions are met. Income recognition 62. Unless there is significant doubt as to whether it can be collected, interest from advances should be brought into the profit and loss account as it accrues. 63. Both accrued interest which is not yet due and interest which is due but has not been paid should be excluded from the profit and loss account from the time when it is identified as doubtful. It should be credited to a suspense account, which should be netted in the balance sheet against accrued interest receivable or, as the case may be, the amount debited to the borrower. Any such interest already credited to the profit and loss account during the same accounting period should, wherever practicable, be reversed and placed in the suspense account. The same applies to accrued interest receivable but not yet due which has been credited to the profit and loss account in earlier years; on the other hand, interest due but unpaid which has been debited to the borrower and credited to the profit and loss account in previous accounting periods should not be reversed, but provision should be made against it if necessary. To the extent that there is no longer any realistic prospect of recovering it, the interest should be written off and the balance on the suspense account written out of the books. Unless the agreement with the customer provides otherwise, amounts paid in for the credit of an account should be appropriated first to suspended interest and then to principal (including interest debited to the borrower in earlier years and therefore not suspended). 64. Premiums and discounts on unimpaired advances acquired which result from differences in interest rates should be brought into the profit and loss account as interest over the life of the advance on a level yield basis. 65. Fee income relating to advances should be brought into profit as follows: (a) front-end fees charged to cover the costs of a continuing service to the borrower, spread over the life of the advance on the basis of the work done;

18 18 (b) front-end fees charged in lieu of interest, on a level yield basis over the life of the advance; and (c) other fees, when they are receivable. 66. Where costs incurred in arranging an advance are recovered through the interest margin rather than by charging a front-end fee, those costs should be deferred and charged over the life of the advance on a level yield basis. 67. Customer incentives can be deferred only if the bank has the right to recover the incentive in the event of early redemption and it is its policy and normal practice to exercise such a right. The early redemption penalty period should be taken as the amortisation period. Where such incentives are not amortised, they should be charged to the profit and loss account as they arise. 68. Where advances are netted against claims on the bank in accordance with paragraph 59, the corresponding interest items should be netted in the profit and loss account. 69. Where a bank accounts for an advance in accordance with the first sentence of paragraph 60, the difference between the consideration received and the carrying value of the advance, including any fees paid or received in connection with the transaction, should be dealt with as follows: (a) if the consideration is less than the carrying value, by making a specific provision to cover the deficiency and immediately writing off the advance against this and any earlier provisions held in respect of the advance; or (b) if the consideration is greater than the carrying value, by reversing any provision or amount written off to the extent that it is no longer needed and taking any excess over original cost to the profit and loss account as a profit on disposal. 70. Fees receivable for servicing advances which have been sold should be brought into the profit and loss account as they are earned. Disclosure 71. A clear statement should be given of the accounting policies adopted for advances, which should include the following matters: specific provisions, general provisions, write-offs, interest recognition and the treatment of fees and expenses, including whether any incentives relating to mortgages or other advances have been written off or amortised. 72. An analysis of advances by remaining maturity should be given in the notes to the accounts in accordance with the statutory requirements (see paragraph 83). 73. The following disclosures should be made in the notes to the accounts in relation to both specific and general provisions: (a) the balance at the beginning of the period;

19 19 (b) the charge or credit to the profit and loss account for the period; (c) adjustments due to exchange rate movements; (d) adjustments due to changes in the composition of the banking group; (e) amounts applied in writing off advances; (f) credits in respect of the recovery of advances previously written off; (g) any other movements; and (h) the balance at the end of the period. 74. The total amount, before and after provisions, of all non-performing advances should be disclosed. Assets obtained in exchange for advances, but held only with a view to achieving an orderly realisation, should be disclosed separately. 75. Where a bank has acquired impaired advances by purchase or by exchange and, as a result, the level of its provisions is materially lower than it would have been if the bank had made those advances itself, the total cost of the advances so acquired should be disclosed together with the total amount due from the relevant borrowers. 76. Disclosure should be made of all concentrations of credit or country risk which are significant in terms of total assets. 77. The impact of mortgage incentives on the results of the period and the balance sheet should be disclosed. Where mortgage incentives have been amortised, the disclosure should include the amount that would have been charged to the profit and loss account in the accounting period in question if the incentives had been written off as incurred. Implementation 78. This SORP supersedes the 1992 Advances SORP. Banks are encouraged to apply the SORP in respect of the first accounting period beginning on or after 23 December 1997 or sooner if possible.

20 20 PART 4 NOTE ON LEGAL REQUIREMENTS 79. Banks incorporated in the United Kingdom are required to prepare their accounts according to section 255 and Schedule 9 of the Companies Act 1985, as amended by the Companies Act 1985 (Bank Accounts) Regulations They are also subject to the general requirements of the act, financial reporting standards issued by the Accounting Standards Board (and statements of accounting practice issued by their predecessor, the Accounting Standards Committee) and abstracts issued by the Urgent Issues Task Force. 80. Schedule 9 requires advances to be shown under two of its prescribed balance sheet captions, 'loans and advances to banks' and 'loans and advances to customers' (which means all loans and advances other than those to banks). Advances to affiliates and to undertakings in which the bank has a participating interest must be shown separately, as must advances which represent subordinated claims. 81. The Schedule requires advances to be carried in the balance sheet at the lower of cost and net realisable value. This is on the assumption that advances are not fixed assets, that is to say they are not held for 'continuing use' in the bank's business. Advances are not normally 'used' in the business, but there may be exceptions, in which case the valuation rule is cost less provision for diminution in value that is expected to be permanent. However, it is in the nature of credit losses that, when they occur, they are expected to be permanent, so the distinction appears to be academic. 82. Paragraph 58 above recommends that advances held in a dealing portfolio for the purpose of trading on a secondary market should be carried at fair value. It is considered that in these circumstances, which by their nature are exceptional and outside the ordinary course of bank lending activities, the statutory basis of valuation should be overridden in order to show a true and fair view. The small minority of banks which maintain such dealing advances should instead value them consistently with other dealing assets. It is emphasised in paragraph 21 that the assessment of fair value for this purpose will need to be prudent, particularly when the market is thin. There must be reasonable certainty that the value is one that could have been realised at the balance sheet date to enable the profits so generated to be treated as realised. To comply with sections 226(5), 227(6) and paragraph 22 of Schedule 9 of the Companies Act 1985, as outlined by UITF abstract 7 on true and fair override disclosures, the notes to the accounts should explain particulars of the departure from the statutory rules, the reasons for it and its effect. 83. Schedule 9 prohibits set-off between asset and liability items (and between income and expenditure items). This prohibition does not, however, preclude netting as described in paragraphs 22 to 24 of this SORP, where the netting is applied in order to determine the amount of an asset or liability the claim on or amount due to a customer not to offset an asset against a (different) liability. The commentary explains fully the additional requirements of FRS Paragraph 61 of the Schedule requires an analysis of advances to be given, by remaining maturity, into four maturity bands: up to three months, over three months