.,-r.- 1C E u e, {SHIP Na ’Aflw ow LA, u. .D’ ACCQ amNK nsne I AL N%A emu: ERG! DEBT LOSSES £CON‘ FEDS CO thesis entitled COMMERCIAL BANK mm 0? BAD DEBT LOSSES, ITS RELATIONSHIP TO THE ECONOMIC AND ACCOUNTING CONCEPTS 0F moons MEASUREMENT, AND THE EFFECTS OF THE F-ERAL INCOME TAX REQUIREMENTS ‘l‘k presented by 1 JOHN moms BURKE has been accepted towards fulfillment of the requirements for £2— degree in Major professor L 18 R A R Y Michigan State 1% University Ill- "Am“.- 0-169 COMMERCIAL BANK TREATMENT OF BAD DEBT LOSSES, ITS RELATIONSHIP TO THE ECONOMIC AND ACCOUNTING CONCEPTS OF INCOME MEASUREMENT, AND THE EFFECTS OF THE FEDERAL INCOME TAX REQUIREMENTS BY John Thomas Burke AN ABSTRACT Submitted to the School for Advanced Graduate Studies Of Michigan State University of Agriculture and Applied Science in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Economics Year 1958 i” // ,,/(/ / '/" Approvedf f; ’2? - (_k/-L/1/972‘//?¢7“Z%>1’z,/ John Thomas Burke candidate for the degree of Doctor of PhilOSOphy Final examination, Dissertation: Commercial Bank Treatment of Bad Debt Losses, Its Relationship to the Economic and Accounting Concepts of Income Measurement, and the Effects of the Federal Income Tax Requirements. Outline of Studies Major subject: Economics Minor subjects: Accounting, Management Biographical items Born, November 23, 192%, Escanaba, Michigan Undergraduate Studies, Carroll College, l9h6-19H9 Graduate Studies, Michigan State University 19%9-1958 Experience: Assistant Professon Syracuse University, 1957-1958; Assistant Professor, Wisconsin State College, 1956-1957; Instructor, Michigan State University, 1950-1956; Graduate Assistant, Michigan State University, l9H9-l950; U.S. Army l9h3-l9h6. ABSTRACT The requirements of the Federal income tax regulations have historically been the determinant factor in the procedure followed by commercial banks in handling bad debt losses. Before l9k8 no specific procedure had been set forth by the Bureau of Internal Revenue and banks usually followed the procedure of charging off accounts on a current basis when they were deemed uncollectible. December 8, 19%? the Bureau issued a ruling which established a formula that could be used for setting up valuation reserves to provide for the treatment of bad debt losses. A supplemental ruling was issued during 195H'which provided an alternative bad debt formula. These rulings have not been completely accepted by bankers and have been criticized as inadequate and not in conformity with historical bad debt loss experience. This study was undertaken in order to determine the significance and relationship of the bad debt deduction to commercial bank income and to determine the basis for the bad debt deduction that would result in the most accurate measure- ment of income. The amounts and timing of bad debt losses were found to be one of three major influences on bank earnings before income taxes. Therefore, it was considered of utmost import- ance that the most correct amount be used as the deduction to determine annual net income before income taxes. The financial structure and operating results of all insured commercial banks in the'United States were examined. A study was made of 3% commercial banks and the percentage ratios for the two groups were compared with special emphasis on.the relationship of bad debt losses. The study of all in- sured commercial banks revealed the close relationship between _ bad debt charge-offs and the net profits figure after income taxes. Income measurement was considered an accounting prob- lem, which when employed for income measurement by commercial banks, was determined to be in little conflict with the econ- omist's definition. The historical methods employed for bad debt charge-offs, the present methods allowed for tax purposes, and the methods proposed by banking groups were all found to be in conflict 'with proper income dtermination. The problem of faulty in- come determination caused by emphasis on valuation was discov- ered to be a major cause of conflict between the past, present, and proposed bad debt charge-off methods. A recommendation was made that the reserve method be used and that the bad debt experience factor formula for each bank should be computed upon the individual banks' experience. The formula would emphasize income determination rather than asset valuation. It was recommended that the bad debt experience factor formula be based on a shorter period of time than the 20 years now used in order to more closely associate the ex- perience factor with current operations rather than with past experience. COMMERCIAL BANK TREATMENT OF BAD DEBT LOSSES ITS RELATIONSHIP TO THE ECONOMIC AND ACCOUNTING'CONCEPTS OF INCOME MEASUREMENT, AND THE EFFECTS OF THE FEDERAL INCOME TAX.REQUIREMENTS BY John Thomas Burke A THESIS Submitted to the School for Advanced Graduate Studies of Michigan State University of Agriculture and Applied Science in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Economics Year 1958 ’9': (EM ‘5’ :3 CHAPTER I. II. III. TABLE OF CONTENTS mmoDUcTIm.......0.0QO0.0C.C.......C.U....O... Background of the Thesis.................... Purpose of the Study........................ Definition of Terms......................... Source of Data.............................. Importance of the Study..................... Organization of Chapters.................... HISTORY OF THE FEDERAL INCOME TAX TREATMENT OF BAD mTSoocoooooooeocecocoooeeotoooocoooocoo Early History............................... Determination of Werthlessness.............. Agitation for Change in the Reserve Method.. A Change in Bureau of Internal Revenue Policy...................................... Reaction to the New Policy.................. Supplemental Ruling......................... Summary..................................... THE FINANCIAL STRUCTURE, PERIODIC INCOME DETERMINATION, AND THEIR RELATIONSHIP TO THE MVEFORBEDEE...-IOOOOOOOOOOOOOOIOIOOOOI The Financial StructureCCOOQ..OOCOIOOOOQI... Periodic Income Determination............... The Reserve for Bad Debts................... BAD DEBTS ANDBAk‘KLOSSFJS..."OOOOOIOQOIOOOOQOOC Classification of Bank Losses............... Losses before Federal Deposit Insurance..... Losses after Federal Deposit Insurance...... Summary..................................... COMPARISON OF THE DIFFERENCES AND SEEILARITIES OF THE CONCEPT OF ACCOUNTING, ECONOMIC, AND BANK ACCOUNTING MEASUREMENT OF INCOME WITH SPECIAL REFERENCE TO A STUDY OF THIRTY-FOUR INDIVIDUAL BANK PERCENTAGE RATIOS.......................... IntroductionOOOOOOCQOCOOO00000000000000.0000 11 PAGE HOGNNH H H 100 100 CHAPTER Accounti%00000.000.010.0000...0.000.000... The Economic meaning of Income............. Accounting and Economic Income Compared.... Bank Income Determination.................. Summary.................................... VI. SUMMARY, CONCIUSIONS, AND RECOMMENDATIONS..... . 00......CO...OOOOOOOOIOOOJOOOOOOIOC. Conclusions................................ RecommendationSOOOOOOOOI O. .0000. .0 I. 0...... BELIwmm-O...OCOOOOOOIOOICOOOOOOOOOCOOCOOOOOOI0.0... t umDEO0.00'OCQIOIIIOOOOUO0....IIOCIOOCOOCQOOOOOC..... iii PAGE 101 110 119 135 157 137 140 143 146 151 . _ ‘_ ' _'¢ m C‘i'i‘oI‘W'lr’i-fimritaut.bum-D‘G‘OIIAVIOUcOoOOOQdOIC-vvoomkau ‘ TABLE 1. LIST OF TABLES Estimated Losses on Assets of Commercial Banks 1865-1953 for Selected Periods................ Estimated Rates of Loss on Assets of Commercial Banks 1865-1933 for Selected Periods.......... All Charge-offs, All Recoveries, and Total Net Charge-offs on Assets of All Insured Commer- Oial Banks 1934-195500000000000.000.000.001... All Charge—offs, Recoveries Less Profits on Securities Sold, Net Charge-offs, and Per- centages of Net Charge-offs to Total Assets of All Insured Commercial Banks 1934—1955..... Percentage of Net Charge-offs and Recoveries on Loans, Securities and Securities Including Government Securities of Insured Commercial Banks 1954-1955............................... Charge-offs, Additions to Reserves, Transfers from Reserves for Loans and Securities for All Operating Insured Commercial Banks 1948-1955..................................... Amounts of Reserves for Losses on Loans and Securities and Ratios of Reserves to Loans and Securities, Insured Commercial Banks 1948-1955..................................... Comparison 01 the Ratio 01 Losses on Loans and Securities with the Reserves at the end of the Year, Insured Commercial Banks 1948-1955.. Net Charge-offs on Loans, Securities, and Net other Charge-offs as Percentages of Total Current Operating Earnings of All Insured Commercial Banks 1934-1955.................... iv PAGE 66 67 70 72 75 76 79 80 l , . : ' . t — I t .......-..... f - ...... .......-..-.. . .. . .. ....... c . \' o TABLE 10. 11. 12. 15. 14. 15. 16. 17. 18. Net Profits Before and After Income Taxes and Net Charge-offs on Loans and Securities of All Insured Commercial Banks 1954-1955........ Net Charge-offs as Percentages of Net Income Before Income Taxes for All Insured Commer- cial Banks 1954-195500000QOOOOQIOOOIOICOOOIOO. Net Charge-offs as Percentages of Net Income After Taxes for All Insured Commercial Banks 1934-19550001000000IC00OOOCIOOOOOIOOO000...... Dispositions of Current Operating Earnings as Percentages of Current Operating Earnings for All Insured Commercial Banks 1954-1955........ Net Charge-offs on Loans, Securities and Net Other Charge—offs, as Percentages of the Percentages of Total Net Charge-offs of Current Operating Earnings for All Insured Commercial Banks 1934-1955.................... All Charge-offs, All Recoveries, and Total Net Charge-offs on Assets - 54 Commercial Banks in New York State 1953—1955...noose-cocooooooo All Charge—offs, All Recoveries Less Profits on Securities Sold, Net Charge-offs, and Per- centages of Net Charge-offs to Total Assets - 54 Commercial Banks in New York State 1955-1955..................................... Percentages of Net Charge-offs and Recoveries on Loans, Securities, and Securities Including Government Securities - 34 Commercial Banks in New York State 1953-195500¢oooeoacoco-cocoa Net Charge-offs on Loans, Securities, and Net Other Charge-offs as Percentages of Total Current Operating Earnings - 54 Commercial Banks in New Ybrk State 1953-1955............. PAGE 86 87 88 92 97 122 123 124 126 I ~u-g.nu.-n-rn-.I..u.-n...- u..--..--.. ---n-nunno-unuunanununq-n ' - nun-u... ' ‘ - K or...---u.a us..---- 1 1 1 i u 1 1 1 ‘ .u-n...-.-..-. one. 1 : ' . ' . _ ...............-..n- unro--o.---..--- - E I nun-u..-n.--n...¢-u C . a -r--ua---u-u. TABLE 19. 20. 21. 22. 23. 24. 25. 26. PAGE Net Charge-offs as Percentages of Net Income Before Income Taxes - 54 Commercial Banks in New York State 1953-1955000cooe0.0.00.0... 127 Net Charge-offs as Percentages of Net Income After Income Taxes - 54 Commercial Banks in New York State 1955-1955.................. 128 Dispositions of Current Operating Earnings as Percentages of Current Operating Earnings - 54 Commercial Banks in New York State 1953-1955-10000000000loo-locuceooeoooeocan... 129 Net Charge-offs on Loans, Securities, and Net Other Charge-offs, as Percentages of the Percentage of Total Net Charge-offs of Current Operating Earnings - 54 Commercial Banks in New York State 1953-1955............ 129 Reserves for Bad Debts as a Percent of Net Loans and Discounts - 442 Commercial Banks in New York Stateoooooooooeeoucoooco0.0.0.000 15]- Reserves for Bad Debts as a Percent of Net Loans and Discounts, Commercial Banks in Upstate Metropolitan Areas........................... 132 Reserve for Bad Debts as a Percent of Net Loans and Discounts - 442 Commercial Banks in New York State-0000.000.ooooeooo-ooooc-cease-coco 155 Reserve for Bad Debts as a Percent of Net Loans and Discounts in the Commercial Banks in the Towns of the 43 Non-Metropolitan Counties in New York State................................ 134. vi ' .‘ ' ’«E+,K p .5 '--" uliIA~ - j.‘-.: '. ¢ _. 9- ‘5 -qm ._ " '“u u L. L a "swarm "- 1" ”Return .‘x' .54; :‘ ‘8' 3.139" 5‘: I'M," the? “Mi 1'; r '1 L’; r firm" :n M a -W' . :rr VII-bloat...que~4ioev0cuouooo-00a: ." .2».‘ t ‘ d '0"IIIllll'l‘l-Uul-OIIHICOO‘IDIIII LIST OF FIGURES FIGURE PAGE I. Relationship of the Net Profit Percentage Ratios to the Total Net Charge—offs Percentage Ratios........................... 94 II. Relationship of the Net Profit Percentage Ratios to the Total Net Charge-offs Percentage Ratios.'0'...OOIOOIOOOOIOOOOCOOOO 95 III. Current Operating Expenses and Net Income Taxes as Percentages of Total Current operating BaningSOOOOOOCIOOOO0.00.00.00.000 96 APPENDIX DOCUMENT PAGE I. Com.-Mimeograph Coll. No. 6209 R.A. No. 1625 T.S. No. 526, Reserve method of Account— ing for Bad Debts in the Case of Banks......152 II. IR-MimeOgraph No. 54-55 And. No. 20. Reserve Method of Accounting for Bad Debts in the Case of Banks....IOO‘OOOOCOOOOOOOQOOCCCI156 III. First Clarifying Letter on Reserve method.......159 IV. Second Clarifying Letter on Reserve Method......165 vii III-Oill...o.lll.l.lll..". Ill-l-n-nllv-IIIIIJOI CHAPTER I INTRODUCTION Background of the Thesis The methods by which commercial banks have historically handled bad debt losses have been prescribed by law, those which developed from tax court interpretation of the law and the Bureau of Internal Revenue regulations. The provisions of the Federal corporation income tax have usually decided the basis to be used. Until 1947 no specific bad debt pro- cedure was indicated for tax purposes and most commercial banks followed the procedure of charging off accounts on a current basis when deemed to be uncollectible. On December 8, 1947 the Bureau of Internal Revenue issued a ruling which established a formula that could be used for setting up val- uation reserves to provide for the charging-off of losses. In 1954 the l947 ruling was supplemented to provide an alter- native bad debt charge-off formula. The impact of these rulings have largely determined the procedure to be used in setting up the valuation reserves, charges for bad debts, and the timing of each. These rulings and the accounting methods provided have not been completely accepted by bankers. They have been criticized as inadequate and not in conformity with histor- ical bad debt loss experience. Banks are permitted to deduct bad debts based upon a twenty year moving average experience factor for their individual bank or an average of any twenty years after 1928 by creating a valuation reserve which is not to exceed three times the average experience factor for the period selected. It is this reserve ceiling that is most se- verely criticized as an inequitable basis for determining bad debt charges. Purpose of the Study This study was undertaken in order (1) to determine the significance and relationship of the bad debt deduction to commercial bank income, and (2) to determine the basis for the bad debt deduction that will best measure commercial bank income. Specific answers were sought for the following prob- lems: 1. Does the treatment of bad debts have a significant influence on the determination of commercial bank income? 2. What have been historical bad debt losses for commercial banks? 5. What should be the basis for bad debt charges against operations? Definition of Terms Commercial bank. By "commercial bank" is meant a bus— iness organization engaged in business activity of a finan- cial nature but distinguished from other financial institu- tions because it handles checking or other demand deposit accounts.1 However, commercial banks also engage in many other banking activities. Although in the traditional sense the commercial bank should be defined to include only banks that lend money to finance the production, distribution, and sale of goods and other business activities, that is, to make short-term busi- ness loans, for the purpose of this study the definition given was necessary.2 Accounting. The commercial bank as a business entity uses as its method of income determination and balance sheet amounts the art of accounting, defined as: "The art of re- cording, classifying, and summarizing in a significant manner and in terms of money,transactions and events which are. in part at least, of a financial character, and interpreting the _resu1ts thereof."5 1. John E. Horbett, "Banking Structure of the United States." Banking_Studies. Board of Governors of the Federal Reserve System, Washington, D.C.: U.S. Government Printing Office, 1941, pp. 93-94. 2. It is the classification for commercial banks used by the Comptroller of the Currency, the Federal Reserve System, and the Federal Deposit Insurance Corporation, which were the sources of most of the data for this study. 3. Accounting Research Bulletin No. 7, Special Report of the Committee on Terminology. New York American Institute of Accountants, November 1940, p. 81. Income. "The income of an enterprise is the increase in its net assets (assets less liabilities) measured by the ex- "4 This is an accounting defi- cess of revenue over expense. nition of income and was used as the basic definition because of the assumption of accounting as the basis for commercial bank income determination. The definition also includes what is sometimes called net income or net profits. BEEEEEE° "Revenue is the aggregate of values received in exchange for the goods and services of an enterprise."5 It includes the amount of assets received or reductions in liabilities through the sale of enterprise products or serv- ices, the gain from.sales or exchanges of assets not stock in trade, and the gain through advantageous settlement of lia— bilities, but does not include the inflow of assets from sources such as gifts. Empense. EXpenses are costs deducted from.revenue in the determination of enterprise income. Extenses arise through current expenditures of cash, expiration of asset ‘ ‘ —“ 4. Accounting and Reporting Standards for Corporate Finan- cial Statements anddPreceding Statements and Supplements, American Accounting Association, Coln_mbus: The Ohio State University, 1957, p. 14. 5. merton Backer, "Determination and Measurement of Business Income by Accountants," Handbook of} iodern Accounting Theory. NeW'York, Prentice-Hall, Inc., 1955, p. 210. See also American Accounting Association (Accounting and Reporting Standards for Corporate Financial Statements and Preceding Statements and Supplements) loc. cit., p. 15. costs, or the incurrance of liabilities and consist of costs associated with the production of revenue, termed operating costs, and deductions that have no such association called losses. ‘ Bad debts expense. Bad debt losses represent deductions that have a traceable association with the production of rev— enue because the establishment of the receivable asset upon which bad debt losses occur was due to the revenue producing activity of an enterprise. The period in which the asset was established on the books and the period when the loss is finally determined are usually not the same. Because the bad debt deduction should be charged against the period when the asset was established and the revenue recognized, the amount of the bad debt expense deduction for the period must be estimated upon expectations of the losses. The bad debts expense, therefore, is defined as the estimated amount of future uncollectibles deducted from revenue in the measure- ment of income. Reserve for bad debts. When the bad debt charge against operations is made it is not possible to directly write off or down specific assets and an amount equal to the bad debt charge is entered in a special account called a valuation reserve to be deducted from the assets upon which the future bad debts are anticipated. The bad debts reserve may be de— fined as the valuation reserve deducted from the assets upon which future bad debt losses are anticipated. Source of Data Although much data are available on bank losses, little had been done to determine what the relationship of losses have been to commercial bank income and the accounting meth— ods of treating such losses. The Federal Deposit Insurance Corporation published the results of a study on bank losses from 1865 to 1940 in their annual report for 1940.6 Data from that study have been in- cluded in chapter four. The Board of Governors of the Federal Reserve System publish in their Federal Reserve Bulletin each May, figures on losses, charge—offs, and recoveries.7 Aha Russel A. Swaney, Vice President of the Federal Reserve Bank of Chicago stated that their Research Department is unable to locate any other studies on this subject.8 The material 5. Annual Report of the Federal Deposit Insurance Cor oration for the Year Ended Decemper 51, 1940, Federal Deposit In- surance Corporation, Washington, D.C.: U.S. Government Printing Office, August 15, 1941, p. 61. 7. Federal Reserve Bulletin, Board of Governors of the Feder- aI Reserve System, Washington, 3.0.: U.S. Government Printing Office. Member bank earnings for the previous year are discussed in detail with specific references to losses, charge-offs, recoveries, profits, transfers to valuation reserves, and transfers from valuation reserves. 8. Written communication, June 1, 1956. available, therefore, was largely of a reporting nature, showing what the total losses, charge-offs, and recoveries have been as compiled by these sources. Publications and reports of the Board of Governors of the Federal Reserve System and the Federal Reserve Banks, the Federal Deposit Insurance Corporation, and the Treasury Department, Office of the Comptroller of the Currency are the three main sources of financial data pertaining to com- mercial banks. Data are not completely comparable between the three sources for several reasons. The Federal Reserve System reports data for "All commercial banks" and also for "All insured commercial banks" as well as for various other cat- egories. The Federal Deposit Insurance Corporation reparts financial data for "All insured commercial banks" as well as many other classifications, but has not always included the "All commercial banksH category reported by the Federal Reserve System. The Comptroller of the Currency reports data for "All banks" both commercial and mutual banks, and reports such data according to "National banks" and "Banks other than national banks" with further sub-classifications. The data reported by the Federal Reserve System for "All insured commercial banks" and by the Federal Deposit Insurance Corporation for the same classifications are also .l ”(I <.I... 1 not exactly the same. The Federal Deposit Insurance Corpor- ation includes banks in possessions of the United States whereas the Federal Reserve System includes banks only in the United States except for the inclusion of one bank in Alaska. The Federal Deposit Insurance Corporation statistics include the banks in the United States, Alaska, Hawaii, Puerto Rico, and the Virgin Islands. The data available since 1947 have been compiled primar- ily by the Federal Deposit Insurance Corporation (F.D.I.C.) in accordance with an agreement reached between the three groups. This agreement was reported in the 1948 Annual Report of the Comptroller of the Currency.9 9. "In order to avoid duplication of work, an agreement reached by the Comptroller’s Office, the Board of Govern- ors of the Federal Reserve System and the Federal Deposit Insurance Corporation in the early part of 1947 whereby a single tabulation of the assets and liabilities of all operating banks in the United States and possessions would be made semi-annually by the Corporation beginning June 30, 1947, instead of following the practice pursued previously when each of these three Federal bank super- visory agencies tabulated such figures independently. Therefore, the assets and liabilities for all banks for 1948 published by the Comptroller in the current annual report have been supplied by the Corporation. The fig— ures for all banks published in subsequent annual reports will be obtained from the same source. The Comptroller's Office, however, will continue to tabulate the returns of national banks and make them available to the Corporation for inclusion in the all-bank figures." United States Comptroller of the Currency, Eighty-Sixth Annual Report of the Comptroller of the Currency, 1948, Treasury Department, Washinjton, D.C.: U.S. Government Printing Office, 1949, p. 14. Therefore, the data for all insured commercial banks reported by the F.D.I.C. have been used in this study as primary source data in preference to the other two sources because banks outside the United States are included and in preference to the "All commercial banks" classification of the Federal Reserve System because data are available in more detail as well as being original source data since 1947.lo Importance of the Study Many factors influence bank earnings after taxes but four are of particular importance; the interest rates re- ceived on earning assets, the rates of interest paid on de- posits, the amounts and timing of bad debt losses, and the income taxes on bank earnings.11 The first three largely determine the net taxable income and the last factor the net lO. Included in the Federal Deposit Insurance Corporation classification "Insured commercial banks" are commercial banks, savings banks, and trust companies engaged in deposit banking. Annual Report of the Federal Deposit Insurance Corpora— tion For the Year Ended December 51, 1952, Federal De- posit Insurance Corporation, washington, D.C.: U.S. Government Printing Office, August 17, 1953. 11. Professor Robinson mentioned in 1941 the first three factors as having been of particular importance in the previous two decades. R.I. Robinson, "Commercial Bank Operations", Banking Studies, Board of Governors of the Federal Reserve Sys- tem, washington, D.C.: U.S. Government Printing Office, 1941, p. 184. 1'. r - : I ‘ I - I - n . \ . . K . I - u- s I .. ‘ - . n l U ‘ lO income after income taxes. The present Federal income tax normal rate of 50 per cent and the 22 per cent surtax rate for corporate incomes over 25 thousand dollars has become the dominant influence upon the amounts and timing of bad debt losses. Because of the high tax rate bankers take the maximum deduction allowed without regard for income determination or asset valuation. To a commercial bank, just as to other business enter- prises, income determination is of fundamental importance. A large reSponsibility for correct income determination rests upon accounting, which is the basis for the measurement of commercial bank net income. The bad debt deduction is an accounting problem and should be determined in accordance with established accounting principles. To determine the de- duction and, therefore, its effect upon net income according to a tax ruling may operate to distort the net income report- ed unless the tax basis is also in accordance with accounting principles. Because banks are primarily engaged in extending credit and because of the importance of this activity to the econo— my, the bad debt deduction has special significance. It is believed to be of utmost importance in determining what should be the proper accounting as well as income tax treatment of 11 commercial bank bad debts so as to determine the correct in- come before income taxes. Organization of Chapters The history of the treatment of bad debts is presented in Chapter II and in Chapter III the financial structure of commercial banks, bank accounting, and the theory of the re- serve for bad debts are described. In Chapter IV the histor- ical bad debt losses related to assets and income are present- ed. They are analyzed in relation to bank asset valuation and bank income determination. Chapter V compares the differences and similarities of the concepts of bank, economic, and accounting measurement of income together with the Federal income tax influence on bank income measurement so as to in- tegrate the nature of the bad debt problem and to show the reason for the changes that are necessary. A summary of the purpose of this study, findings, conclusions, and recommend- ations is given in Chapter VI. 12 CHAPTER II HISTORY or m FEDERAL moon/m TAX TREAmENT OF BAD DEBTS Early History The individual taxpayer may be concerned with a bad debt loss he may encounter but it is usually of small importance to him. To a business enterprise engaged in credit activity it is of considerable importance, but to a bank whose busi- ness is the sale of credit it is of paramount importance be- cause every transaction may result in a bad debt. For federal tax purposes bad debt deductions by banks are allowed to the extent that the Congress of the United States provides according to law. Before 1921 the deduction allowed WaS for debts ascer- tained to be worthless and charged—off within the taxable year. No provision was made for partially bad debts or for a valuation reserve method. The basis was the so-called "direct charge off." The 1921 Revenue Act Section 254(a)(5) provided a con- siderable enlargement of the concept of the bad debt sect- ion. Bad debts at the discretion of the Commissioner were allowed to be charged off when ascertained to be worthless 15 during the taxable year on when recoverable only in part the debt could be charged off in part. A reasonable addition to a reserve for bad debts, in the discretion of the Commission- er, was also accepted as a basis for bad debt charge-offs. The 1952 Revenue Act was changed to limit the deduction to an amount not in excess of the part charged off within the taxable year. Determination of WOrthlessness The next important change was made in the Revenue Act of 1942. It settled on a retroactive basis the question, what was meant by "ascertainment" of worthlessness. The law was changed from when the taxpayer ascertained a debt to be worthless to when did the deot become worthless. This change was made to include both wholly bad debts as well as par- tially bad debts. Section 113 of the Revenue Act of 1945 reinstated the clause pertaining to partially bad debts according to Treasury interpretation before the Revenue Act of 1942, which allowed the taxpayer to wait and deduct the bad debt loss in a period subsequent to when it was deemed to be partially bad. The 1945 Act, therefore, made a wholly worthless debt deductible in the year it became worthless and charge off not a prerequisite, whereas a debt which (to the satisfaction of the Commissioner,) was recoverable only 14 in part could be deducted only in the year of charge off. The regulations now permit two general methods for treating bad debts: a deduction when the asset becomes worth- less, wholly or partially, or the deduction by the use of a reserve for bad debts, the deduction being based on the add- ition to the reserve. These are the same two methods that were first authorized in 1921 and taxpayers were allowed the option of selecting either method at that time. Banks that chose to select the specific charge—off method are still faced with the problem of determining worth- lessness. The regulation provides for conclusive presumption of worthlessness of assets charged off, partially or wholly, at the direction of the bank examiners. The bank, however, does not have to accept the presumption of worthlessness and may reject it and attempt to establish worthlessness in a later year in which case it would not have the benefit of any presumption by the bank examiner. The acceptance of the bank exannnars presumption of worthlessness has helped banks on the specific charge-off method to solve this problem. Pre- sumption is now conclusive evidence of worthlessness although as late as 1942 the Tax Court in Central National Bank of Richmond vs Commissioner, I.T.C. 244, refused to give effect to a 1939 charge—off directed by a bank examiner, holding that even if the regulation was sound prior to 1942, it was 15 nullified by the changes made by the 1942 Act. Agitation for Change in the Reserve Method Since the end of World War II the American Bankers Association has supported proposals to change the method of determining bad debt losses charged against operations for determination of income for commercial banks. At a series of conferences and conventions in 1946 and 1947 the matter of reserve for bad debts was given considerable attention. At the 1946 convention of the American Bankers Associ— ation in Chicago, the Nebraska Bankers Association brought before the Resolutions Committee a proposal for support of legislation to facilitate the creation of reserves for bad debt losses by banks through the use of the amounts placed in such reserves as deductions in determining Federal Income Tax liability. The matter was referred by the Resolutions Committee to the Committee on Federal Legislation of the Association. The Subcommittee on Taxation of the President of the Citi- zens Fidelity Bank and Trust Company, Louisville, Kentucky, held meetings in washington during December 1946, and Janu- ary and April, 1947, at which time the entire problem was discussed in detail and it was determined that a solution of the problem was possible through administrative action by the Commissioner of Internal Revenue without resorting to the difficult procedure of obtaining legislative action to amend the Internal Revenue Code. Immediately following the April 1947 meeting a formal request was made to the Commiss- ioner for a modification of his present regulations. The Subcommittee on Taxation in its consideration of the problem had the assistance of Mr. E.W. Rossiter, president of the Bank of Hartington, Hartington, Nebraska, and Chairman of the Taxation Committee of the Nebraska Bankers Association, and Mr. Glen T. Gibson, President of the Exchange Bank, Gib— bon, Nebraska, and President of the Nebraska Bankers Associe ation, both of whom attended all of the meetings at which the problem was studied. The Subcommittee also had the benefit of advice from representatives of the three Federal Bank supervisory agencies as well as from.representatives of the State Bank Supervisors Association.1 A Change in Bureau of Internal Revenue Policy Mimeograph Collector No. 6209. A Bureau of Internal Revenue mimeographed letter dated December 8, 1947 was a re- sult of these conferences.2 It set forth a change of policy 1. washipgton Bulletin, American Bankers Association, wash- ington, D.C.: Special Bulletin, December 9, 1947. 2. "Reserve Method of Accounting for Bad Debts in the Case of Banks", Commissioner Mimeograph Coll. No. 6209, R.A. No. 1625, T.S. 526, Treasury Department, Office of Com— missioner of Internal Revenue, Washington, D.C.: In Mim- eograph, December 8, 1947. 16 17 regarding reserves for bad debts or losses and established a procedure that was to apply to 1947 and subsequent taxable years. Banks had until March 15, 1948 to elect to change to the reserve method if they so desired. All that was necess- ary to change was to include a statement accompanying the bank's Federal income tax return stating that it had elected to go on the reserve basis and to explain the computations used in determining the bad debts deduction taken. The Bureau policy set forth in the mimeographed letter approved the use by banks of a twenty year moving average experience factor for the determination of the annual ratio of losses to outstanding loans for taxable years after December 51, 1946. The twenty year moving average included the current year, 1947 and the preceding 19 years, that is, beginning with the year 1928. The twenty year period was assumed to be a long enough period of time to constitute a cycle of good and bad years. The percentage obtained from this ratio, by adding together the ratio for each year and dividing by 20 resulting in a figure considered as the aver- age experience factor, was to be applied to the loans out— standing at the end of the taxable year in order to deter- mine the permissable reserve for a bank changing to the re- serve method in such year and the maximum reserve that could be maintained in future years. A bank could continue 18 to take deductions equal to the current moving average per- centage of actual bad debts times the outstanding loans at the end of the taxable year, or an amount great enough to increase the reserve at the end of the year to the maximum previously mentioned, whichever Was greater. Such continued deductions were allowed only in such amounts that would in- crease the reserve at the end of the taxable year to a total not in excess of three times the moving average loss rate applied to outstanding loans. The ceiling could vary from year to year even if no losses were sustained merely by the change in outstanding loans to which the factor was applied. The Bureau in determining the basis for the change be- ‘lieved the twenty year period as a basis for computing the average annual bad debt loss was fair and sufficiently ac- curate. It was deemed to constitute a representative per- iod in the bank's history and the acceptance of the equiva- lent percentage of outstanding loans Was indicative of the probable annual accruing loss. Mimeograph Collector No. 6209 pointed out that the Tax Court had held the use of the reserve for bad debts to not be inherently inconsistent with a cash basis, where, as in the mimeographed letter, the re- serve Was against the loss only of capital and did not con— tain an element of unreported income.5 It was stated that 5. Special reference was made to the case of; Estate of Maurice S. Saltstein, Deceased, Transferee, etc., 46 B. T.A. 774,777, (1942) Acq. C.B. 1942-1, 14. such a reserve did not materially differ from a depreciation reserve set up on a percentage basis rather than on actual depreciation suffered. The ruling included a reference to the reason for the restriction on the size of the reserve to the effect that the reserve could not be permitted to accums ulate indefinitely because of the possibility that large losses in the future may be concentrated within a relatively short period of time and absorb the greatest probable re- serve. The permission of such a deduction would be sanctioning the deduction of a contingency reserve for losses which were not a taxable deduction and, therefore, the imposition of a reasonable ceiling was considered necessary. The mimeographed letter also contained an example of the application of the rule and specific statements relat- ing to its applications. The following example was given: Example of the application of the foregoing with amount of outstandi loans remaining unchanged at $1,000,000.00 Actual Bad Reserve Debts For at end Year Average Year Deduction of Year Ceiling 1 1. $ 2,000 $ 12,000 $ 10,000 $ 50,000 2 .8 11,500 9,500 8,000 24,000 5 .7 1,000 7,000 14,000 21,000 4 .8 1,000 8,000 21,000 24,000 5 l. 500 9,500 50,000 50,000 19 The moving average percentage was to be computed on loans comparable in their nature and risk involved to those outstanding at the end of the taxable year involved in the computation. Losses not in the nature of bad debts result- ing from ordinary conduct of the present business and gov- ernment insured loans were required to be eliminated from prior year accounts in computing the percentages of past los- ses. A new bank or a bank that did not have sufficient years experience for computing the average was permitted to set up a reserve based on the average experience of similar banks with respect to the same types of loans and preferably in the same location. The reserve could later be subjected to ad- justment when after a period of years the bank's own exper- ience was established. ' Bad debt losses for the 1947 taxable year were to be charged to the reserve. If the losses exceeded the reserve, the allowable deduction in that year could be increased by the excess. The second year of the example taken from mim— eograph 6209, shows that the bad debt loss for the year was $11,500, the current deduction against the reserve $9,500, the $2,000 excess Was also charged against the reserve re- ducing it to $8,000. For two years the total bad debt loss was $13,500, the additions to the reserve $21,500 less the bad debts $13,500 charged against the reserve leaves the 20 21 balance of $8,000 at the end of the second year. The one percent loss experience ratio Was assumed for purpose of the example. By the and of the fifth year the ceiling allowed in the reserve had been reached. The moving average factor of one percent applied to the $1,000,000 equaled $10,000, which was the addition to the reserve, three times $10,000, equal to $30,000, was the amount the reserve had reached at the end of the fifth year. Therefore, the ceiling of $30,000 in the re- serve was the maximum that could be carried for $1,000,000 of loans outstanding with a moving average factor of one percent. Any recoveries that may be made of bad debts charged off against the reserve were to be credited to the reserve and would increase the reserve by the amount credited. Questions raised about the ruling. Questions were im- mediately raised by people engaged in tax work on the use of the reserve method of accounting for bad debts in income taxation of banks. A variety of points raised among the comp- trollers and tax officers of the New Yerk City banks were in- corporated into a letter sent to Fred 8. Martin, Deputy Com- missioner of Internal Revenue, at Washington, by A.G. Quaremba, conference chairman, for the New York Committee on Banking Institutions on Taxation, and vice-president of the National City Bank of New Ybrk, asking for clarification and interpre- tive comment.4 The Deputy Commissioner, E.I. MbLarney, in a letter dat— ed December 29, 1947 answered ten of the specific questions with a statement that, "It is hoped that further answers can be furnished at an early date to other questions raised by you and which are not answered in this letter."5 The questions were set out in question and answer form and were reported exactly as given in a special bulletin dated December 29, 1947 of the American Bankers Association. The American Banker, December 31, 1957 also published a copy of the letter so that it received wide publicity. A second clarifying letter dated January 29, 1948 was issued by E.I. McLarney with answers to five more questions which had been raised.6 The letter again was in question 4. For a complete discussion of this letter see: "Questions Raised by N.Y. Bank Tax Men on Use of Reserves Before Taxes Formula," The American Banker, New Ybrk: American Bankers Association, December 26, 1947. 5. First Clarifying Letter on Reserve Method, by E.I. McLarney, Deputy Commissioner, Treasury Department, Office of Commissioner of Internal Revenue, Washington, D.C.: In Mimeograph, December 29, 1947. 6. Second Clarifying Letter on Reserve Method, by E.I. McLarney, Deputy Commissioner, Treasury Department, Office of Commissioner of Internal Revenue, washington, D.C.: In Mimeograph, January 27, 1948. 22 35 and answer form and actually reversed two of the answers to questions in the first letter. Both letters helped to an- swer specific questions pertaining to the computation of the experience factor and the ceiling permitted but did not al- ter the ruling. Reaction to the New Policy Reaction to the ruling. The ruling seemed to have re- ceived a favorable reaction when it was announced. The Amer- ican Banker stated editorially that the Treasury believed in- formally that the objective of providing a way to cushion bank capital against bad debt losses and the prevention of taxes on interest received but destined to be lost, had been provided.7 It was also stated that, "Reaction at first glance, generally was that the new rules standardizing the Treasury agents administrative policies place the reserve method on a most favorable and equitable basis for banks.8 The Chicago Journal of Commerce stated, "The new ruling was described by officials as a sort of depreciation allowance for banks on their main stock in trade -— loans -- after the fashion of plant depreciation allowances for other business- 7. "Reserve Method Formula Being Studied by Banks," The American Banker, New York: American Bankers Association, December 11, 1947. 8. Loc. cit. 24 as. ‘MacLeanlo claimed the 20-year moving average method used in Mimeograph 6209 was not a completely new idea. It was developed by Arthur Anderson and Company in 1943 and had been adopted throughout the country by a number of bank cli- ents since 1943. He stated that, "Revenue agents who have examined returns of banks using this formula have generally been convinced of its reasonableness and have accepted it, though often after many initial objections and long and pro- tracted explanations.ll However, the reserve method was not adopted by many banks to which it was recommended because the Bureau of In- ternal Revenue in Washington refused to accept the formula. Banks not subject to excess profits taxes felt the struggle to convince the Internal Revenue Agent in charge on the tech- nical staff outweighed the Advantages of the reserve method. The change to the reserve method did in some cases result in substantial bad debt deductions in excess profits tax years 9. "Bank Reserves on Bad Debt Losses", Chicago Journal of Commerce, Chicago: December 11, 1947. 10. Daniel P. MacLean, "Bad Debt Reserves for Banks", The American Banker, New York: American Bankers Association, January 30, 1948. 11. Loc. cit. for banks that did make the change. macLean believed that with the acceptance of the formula, even though limited by the reserve ceiling, it Was safe to assume that most banks would change to the reserve method. Bankers desired more. However, the bankers were not completely convinced that the ruling was all they wanted nor all they had asked. wellslz raised certain questions con— cerning the application of the ruling to the reserve method theory. He asked if the new ruling would give banks a more equitable method for spreading losses over good years and bad years. WOuld taxes be reduced in good years and the rul- ing not contain at the same time other provisions which in application would result in offsetting disadvantages that would nullify the favorable features. Horne13 in an address reviewing the background, provis- ions and interpretations of the ruling clearly indicated the ceiling included was not in accord with the banker's desires. A much greater deduction was desired and also more control 12. Kenneth R. Wells, "Should Banks Adopt the New Reserve Method for Bad Debts", A talk given by Wells at a meet- ing of the Northern Cook County Group of the Illinois Bankers Association, February 2, 1948, Reprinted by the American National Bank and Trust Company of Chicago. 13. Donald Horne, "Reserve Method on Accounting for Bad Debts in the Case of Banks - Its Background, Provisions, and Interpretations," The American Banker, New Yerk: American Bankers Association, February 19, 1948. 25 26 over the deduction. It was claimed the accumulation of amounts of deductions should be much larger than the bad debt estimates of any one year if an adequate cushion was to be provided against deficit years. The banking cycle was stated to cover 20 years or more and with the plus amplitude of the cycle being offset by a period of negative amplitude years which often are severe enough to end the existence of many banks. Horne stated in reference to the above, "Our belief is that additions to a reserve to meet this situation should be allowed as deductions in the discretion of the bank, with- in certain fixed limits, without regard to any estimate of expected bad debts for the taxable year of deduction.l4 In the same address he also indicated the extent to which the deduction and the ceiling should be increased to be adequate and what the original proposal to the Bureau had been. The following proposal from his Speech specifically states the original proposal: Our original proposal, incidentally, was a reserve built up by annual deductible additions, at the discretion of the bank officials, up to 20% of gross income, until a ceiling was reached at 25% of combined capital and surplus. No proof of bad debts would be required. Against this reserve bad debts write-offs would be charged, and to it recoveries would be credited. If, because of re- coveries, the amount of the reserve would exceed the ceiling (25% of the capital funds) such excess would be treated as taxable income and taxed at a 14. Loc. cit. rate of the year or years in which the deductions occurred to which the recoveries constituting the excess relate. Interest from the time of the de- duction added to the tax, would penalize against over—reserving. Agreement of the bank to such treatment would be a condition to the use of the reserve method. Thus the system proposed would be self-checking. Excessive charge-offs would be automatically penalized. The American Banker strongly supported the proposal editorially from time to time.1 Eight days after Mr. Horne's address the American Banker£16 also questioned the adequacy of the ceiling. It was felt the reserve method formula should be more flexible. Also improve- ment was expected in the hope that the elimination of the ceiling requirement or possible increase to an amount which would have approximately the same effect would be made. Supplemental Ruling An alternative method. The moving average began with the year 1928 and included 1947, for the first years deter- mination of the experience factor. As each new year was add- ed to the moving average the beginning year was drOpped. The years after 1947 were years of low loss experience but the years that were being drOpped were soon the years of the ear- ly thirties, when the loss experience was highest, the result 15. Loc. cit. 16. "Is the Ceiling Adequate in the Reserves Before Taxes Formula: and What May be Done About it?", The American Banker, New York: American Bankers Association, February 19, 1948. being to cause a reduction in the allowable experience factor and the ceiling on the reserve. April 8, 1954 the Bureau of Internal Revenue issued a ruling supplemental to Mimeograph 6209.1'7 The ruling in no way was to replace Mimeograph 6209 but offered an‘alterna- tive to the moving average experience factor method of determ- ining additions to the reserve. The ruling provided for a 20-year average after 1927. The years chosen for the compu- tation of the experience factor had to be consecutive and could not be changed once adopted without the permission of the Revenue Bureau. The ruling was not retroactive and be- gan with the first taxable year after December 31, 1953. Reaction to thg new ruling. The American Banker18 com- mented that the view of the banking authorities was that al- though it was not as much as some banks had hoped, it would be helpful. The bankers wanted to use the industry wide average rather than that of their particular bank in comput- ing the 20-year average after 1947. The 20-year average selected constituted a "frozen average" pertaining to the l7. Bureau of Internal Revenue, "Reserve Method of Account- ing for Bad Debts in the Case of Banks", I.R. Mimeograph No. 54-55 and No. 20, Treasury Department, Office of Commissioner of Internal Revenue, Washington, D.C.: In Mimeograph, April 8, 1954. 18. "The Change in Bad Debt Reserves, an Alternative: Old Way Still Usable, The American Banker, New York: American Bankers Association, April 16, 1954. individual banks' past experience.19 The bankers presented a strong argument for the use of the industry wide average rather than the 20-year average of their own experience. The bank that did not suffer losses during the 20-year period chosen was not permitted to take as large a deduction, that is, the ceiling is lower than for the bank that suffered high losses. The bank that suffered the greatest losses in the past, usually 20 to 25 years ago, received the benefit by being able to establish the larger bad debt reserves. The Comptroller of the Currency referred to this same argument in the 1954 Annual Report, "thus the bank that suffered the heaviest losses many yearsago is, in effect, rewarded today by being permitted to establish the largest reserves for bad debts."20 The following quotation from the Comptroller's Report indicates what was considered necessary in order to solve the problem of the bad debt formula and also contains a statement of the suggested rate for annual increases in the reserve: There is need for a bad debt reserve formula, not related to the loss history of the individual bank or groups of banks, but based upon the sound premise that a normal proportion of loss must be 19. Loc. cit. 20. United States Comptroller of the Currency, Ninety— Second Annual Report of the Comptroller of the Currency, Treasury Department, Washington, D.C.: U.S. Government Printing Office, 1949, p. 13. 29 expected in the business of lending and such losses should be regarded as a legitimate business expense against which a reasonable initially tax free re- serve should be established. A suitable and soundly based formula would permit banks to create and main- tain reserves by transfers from gross earnings at a rate of % percent per annum until a suitable ceiling is reached without previous or current loss experi- ence. To accomplish this it is believed that legis— lative action would be necessary.9 An important question was raised concerning the method for determining the percentage bad debt losses to be used as the basis for the "frozen experience factor". Should the bank use a percentage figure obtained by adding the total net losses for the 20-year period or could the bank use an average figure of the debt loss percentage computed for each of the 20 years? The decision on this question was that, since it was not specified which method must be used, either was acceptable but the method used must be consistently fol- lowed.22 fresent status of the bad debt method. The alternative method was incorporated into the Internal Revenue Code and is in effect at the present time° The specific statement of the alternative method is as follows: .01 In lieu of the moving average experience factor provided in paragraph 3 of Mimeograph 6209, 21. Loc. cit. 22. "Bureau Holds any Method Averaging 20 years O.K. But be Consistent”, The American Banker, New York: American Bankers Association, December 23, 1954. 30 51 which is determined on a basis of twenty consecutive years of its own experience after the year 1927. Such average experience factor, representing the percentage of bad debt losses to loans for the peri- od selected, applied to loans outstanding at the close of the taxable year, determines the maximum permissible addition to the reserve for the year.2:5 However, neither Mimeograph 6209 nor the alternative method applied to securities. In the case of securities no specific formula has been set forth, and either the direct 9 charge-off method or the reserve method may be used.”4 No deduction may be allowed merely on account of market fluct- uations, but a reasonable addition to a reserve for bad debts, determined in the light of the facts in each case, may be recognized.25 Summary The efforts of bankers and interested groups have re- sulted in two specific methods by which commercial banks may deduct bad debts on loans in computing the Federal corpora- tion income tax by additions to bad debt reserves. However, they have not been successful in obtaining the deductible allowance to the extent desired. Their objection to the maximum ceiling on the reserve was defended because they 23. I.R. Min. 54-55, Section 4. Alternative Method, Op. cit. 24. P.H. Federal Tax Service, New York: Irentice—Hall, Inc., Paragraph 13,964, 1958. 25. Loc. cit. ()1 N -claimed it was not in accordance with actual experience. When losses did occur they would be so great that the re— serves should be large enough to absorb the losses and such reserves should be created by deductions before Federal in- come taxes inasmuch as bad debt losses are normal business expenses for financial institutions. Objection Was also made to the use of the experience factor based on their own bad debt experience rather than the industry wide average. Their own proposal was to be allowed to take deductions and increase the reserve until it was 25 percent of capital and surplus, the annual deductions at the discretion of the bank officials not to exceed 20 percent of gross income. The Comptroller of the Currency proposed that the formula be based on annual deductions of one—half percent until a suit- able ceiling was reached without the deduction being related to the individual bank's experience. The Treasury Department stated that to allow reserves to be built up without the ceiling on the account would allow additions to what really are contingency reserves to be deductions for Federal corporate income tax purposes. Therefore, at the present time, the disagreement is over the basis for computing the deduction, the amount of the de- duction allowed, and the amount of the reserve permitted. 'Au 0 r» J 55 ‘ CHAPTER III THE FINANCIAL STRUCTURE, PERIODIC INCOME DETERMINATION, AND THEIR RELATIONSHIP TO THE RESERVE FOR BAD DEBTS The Financial Structure Bank accounts. Bank bookkeeping consists of the business transactions being recorded first in journals and then trans— ferred to ledgers for summary. The transactions summarized in the general ledger form the basis for the preparation of the statement of condition, termed the balance sheet, and the statement of periodic operations, usually called the profit and loss statement. Banks use some account classifications that are peculiar to banking institutions because of the nature of their oper- ations. Reports of condition required by supervisory agen— cies have tended to standardize the asset, liability, and proprietorship accounts that are employed. The various accounts that are required may vary according to the nature of these three groups but should be the accounts necessary to properly segregate the groups according to their distinct nature. Commercial bank assets. Commercial bank assets in this study have been divided into five broad classifications. These classifications are: cash assets, including balances with other banks and cash collection items; loans, including 34 discounts; securities, also termed "investments"; bank prem— ises, fixtures, equipment, and real estate; and miscellaneous assets. Cash is a non-income earning asset held as currency for use as till money and as deposits with other banks. Because cash is a non-income earning asset well managed banks keep their funds as fully employed as possible. 1 category of bank assets is the classification The loan that includes the assets most closely of the nature of tradi- tional bank loans, although not exactly comparable in terms of liquidity. Commercial banks do not now, nor have they in the past, limited their loans wholly to the short-term com- mercial loan, but have followed the practice of lending funds for many purposes and are classified according to the pur- pose: as commercial, including open market paper; agricul- tural; loans for purchasing or carrying securities; real estate; other loans to individuals; loans to banks; and other loans. Securities are divided into two main groups; U.S. Gov— ernment obligations and Other securities.2 The U.S. Govern- 1. A "loan" is distinguished from a "discount" by the method by which the interest is computed and collected. Both are included in the loan category. 2. The classification "Investments" is used by the Federal Reserve System to include these two groups, which accord- ing to the Federal Reserve are divided into three groups: U.S. Government obligations, Obligations of States and ‘ment obligations group is further divided into two groups: Direct, which include Treasury bills, Treasury certificates of indebtedness, Treasury notes, and United States non-mar- ketable bonds, (Other bonds maturing in five years or less, Other bonds maturing in five to ten years, Bonds maturing in ten to twenty years, and Bonds maturing after twenty years); and secondly into Guaranteed, which represent Federal Housing Administration debentures. The category termed "Other secur- ities" includes: Obligations of States and subdivisions; Other bonds, notes, and debentures; Federal Reserve bank stock; and other corporate stocks. The "Other securities" group is usually less than five per cent of total securities. Bank premises, furniture and fixtures, and other real estate average less than one per cent of total bank assets with bank premises the largest single category in the class— ification. The "Miscellaneous assets? the last classification men- tioned, are reported in four accounts: Customer's liability on acceptances outstanding, Income accrued but nOt collected, Prepaid expenses, and Other assets.5 political subdivisions, and Other securities. The Federal Deposit Insurance Corporation uses the term "Securities" according to the two groups used above. 5. The classification "Miscellaneous assets" is not reported by the Federal Reserve monthly bulletins. 35 56 Bank liabilities. Bank liabilities are almost entirely time and demand deposits. They are classified by the Federal Deposit Insurance Corporation according to the depositor as well as the total time and demand deposits.4 The deposit liabilities are approximately 98 percent of total liabili- ties and demand deposits are about 75 percent of total de- posits. The remaining liabilities are termed Thiscellaneous" and are less than two percent of the total liabilities. Ownership equity. The difference between the bank assets and bank liabilities represents the ownership equity. The bank ownership equity is divided according to four account classifications: Capital stock, notes and deben- tures; Surplus: Undivided profits: and Reserves. The first classification is almost entirely common stock, which represents the residual ownership equity. The capital notes and debentures are sold to the public as a means of securing capital funds by banks that either cannot legally issue preferred stock or do not wish to do so. Pre- ferred stock is also sold to the public and may consist of both first and second preferred. It is given a preference 4. The Federal Reserve classifies them as "Interbank" and "Other" deposits. "Other deposits" are further divided as "Time" and "Demand” depoSits. over common stock as to dividends and sometimes preference in other rights, such as preference as to assets in the event of liquidation, issuance of future securities with a prior lien on assets or earnings, or to participation in the corporate bank management. The surplus classification includes capital surplus from two sources, paid in capital and capitalized earnings. A paid in surplus of 20 percent of the capital is required of all national banks before they may begin operations under the National Bank Act. The additions to surplus are usually from retained earnings. Undistributed profits is the account classification used to include retained earnings that have not been closed to surplus, that is, they have not been made a part of the permanent capital accounts upon which the legal limits are based. This account represents unrestricted retained earn— ings. From the undistributed profits account special surplus reserves are set up and it is also the account upon which dividend declarations are based. The reserves that are established from this account represent the classification entitled "Reserves". Banks sometimes provide reserves from undistributed profits for undeclared dividends in cases where banks have an established divident policy and may wish to segregate undivided profits before the dividend is declared and paid. 38 A reserve also may be established before the retirement of preferred stock, capital notes, or debentures. When they are actualiy retired the amount set up in the reserve is trans- ferred to the surplus account to replace the preferred stock, capital notes, or debentures as part of legal capital. If they are retired through the use of funds obtained by the sale of capital stock, it is not necessary to provide a re- serve segregation of undistributed profits. Reserves for contingencies is the third type of surplus reserve that may be established. The reserves are set up in order to provide for future possible losses which may in- clude losses on securities, loans, or other real-estate held by the bank. These losses are only contingent and their nature and extent are not known. Therefore, they are es- tablished on an estimated basis.5 These three types of re- serves set up from undistributed profits are accounts which represent retained earnings segregated into special classi- fications. Esrodic Income Determination Income accounts. Income and expense accounts are also dependent upon the diversity and nature of bank operations. 5. The nature of "reserves" is discussed later in this chapter. However, it should be stated that "surplus re- serves" must not be confused with "valuation reserves" that are established before earnings are determined. 39 Income is usually classified as current earnings and desig- nated as either "regular income" or "other income". Classi- 'fied as "regular income" are: interest and dividends from assets owned and earnings derived from stable and constant sources, such as rentals of offices and safe deposit boxes. Earnings derived from bank services rendered, profit from trading activities,and other regularly non-recurrent items constitute what are included in "other income". Although only certain assets are earning assets, they do not produce income in direct relation to their propor- tionare share of the total. There are five sources of cur- rent operating income classified as earnings on: loans, United States Government obligations, other securities, service charges on deposits, and other current earnings.6 Recoveries on securities and loans, profits on secur- ities sold or redeemed, all other recoveries and profits, and transfers from valuation reserves are not considered as part of current earnings. Expense accounts. EXpenses considered to be ordinary and recurring expenses of bank operations are the "current operating expenses". Losses, charge-offs, and transfers to 6. Burton P. Allen, Editor NA BAC Manual, Cleveland: The National Association of Bank Auditors and Comptrollers, 1945. Because these account classifications are used in the NA BAG manual and are in accordance with reports of supervisory agencies, they have been used as the account classifications for this study. 4O valuation reserves are not considered as current operating expenses. Current operating expenses include: salaries and wages, interest on deposits, and other current expenses. The interpretation of bank earnings statements. The bank earnings statement reports current operating earnings less current operating expenses to arrive at net current operating earnings. Recoveries, transfers from reserve accounts are added and losses, charge-offs,and transfers to reserve accounts are deducted to arrive at net profits before income taxes. Federal and state income taxes are deducted leaving net profits after income taxes. Bank statememmamust be recognized as provisional to the extent that future events may change the true nature of the data reported and in the light of this their interpretation should be made. The accounting convention of the "going con- cern" must be assumed to apply to the commercial bank for it is by this convention that a bank assumes its continuity of operations. The continuity of operations must be assumed as the basis for periodic reporting and data reported in the present period and for past periods depends to a substantial extent upon future events. The normal time period of income measurement in bank accounting is one year. But, just as in other enterprises, the overlapping of income determining data creates the prob- lem of the proper timing of allocation of revenues and costs. When adjustments to the records are not made at the end of the accounting period the net income figure may be distort- ed to the extent that the revenues and costs are not properly apportioned. The cash basis has been employed traditionally by banks for income and expense accounting. Adjustments are not made for unrecorded income earned nor unrecorded expenses incurred and for unearned income collected in advance or pre- paid expenses. The merit of this system lies in its simplic- ity and low cost, for which reasons many small banks still prefer to use the cash basis. To some extent the failure to record one type of data is balanced by the failure to record another type, but it could only be an unusual coincidence if they were to balance each other. However, from period to period, the effect of not adjusting the records may be to offset the differences in resulting net income. For example, accrued wages may not be taken into account as an expense of the period but recorded as expense in the period when paid. At the end of the same period in which they were paid wages again may have accrued for which no adjustment is made. To the extent that unpaid wages at the end of each period are equal they would balance each other, the net result being to not distort the total wage expensefor the period. However, adjustments to the accounting data for banks should be made just as for all business enterprises if the best approximation to income is 42‘ to be determined. The accrual method of accounting by the use of adjust- ments more accurately determines enterprise net income when used in accordance with the "generally accepted principles of accounting". Commercial banks, therefore, should also use the accrual system of accounting, if they are to best determine net income.7 The determination of operating and non-operating gains and losses has special significance in bank accounting be- cause recoveries and profits on securities and loans as well as losses and charge-offs on them are treated as non-operat- ing gains and losses and are shown on the income statement after "Net Earnings from Current Operations". However, in adjusting the records for a business enterprise an adjust— ment charging operations for estimated bad debts is employed as a means of properly allocating an expense of the period against such period. The bad debt charge is a proper and nec- essary operating expense even though the extension of credit is incidental to the business transaction. In a comrercial 7. Ibid, pp. 143-147. wherein it is pointed out that many banks even accrue their accounts each day on worksheets so as to know daily their position. However, these accruals are not entered into the general ledger. The daily accrual system is also considered to strengthen and simplify the audit program and a help in forecasting the net earning positions for a period. 45. bags}; wherein credit extension is the main business activity the bad debt losses and the recoveries that may result, pro- mucsing the net bad debt losses, should be considered as a deéixlction to determine net earnings from.current operations. The emphasis on proper net income determination causes soznja of the balance sheet accounts to be stated in amounts thsrt: are the resultants of the allocations and residuals from inczc>me determination. Traditional bank accounting theory cozissiders the balance sheet to be the statement of condition tha.t: shows the financial position of the bank at a given date.8 The assumption of the dollar as a common denominator of rescxrding values, the valuation convention, was accepted for ban}: accounting in accordance with accepted accounting prin- CiIiLes. The cost outlay basis for fixed assets such as bank Prenflses and fixtures is in conformity with this accounting COinvention and bank assets of this type are not adjusted for increases and decreases in market values. The greatest share of assets of this type is represented by the classification ‘Df "Bank premises, furniture and fixtures, and other real eState". The classification was .89 percent of'total assets \ 8. Ibid, p. 22. "This statement of condition is a summary of the assets and liabilities and net worth of a bank. It is a snap—shot of the condition of a bank at a given date." The Manual further states on the same page: "Is the business sound financially? This can be ascertained frmn the balance sheet." 4i December 51, 1955.9 The percentage of these assets to the total being low, the effect of their change in value and the distortion of income that may result from the improper treat— ment of their costs is not significant in its effect on the‘ average for all banks. Recurring depreciation on banking house, furniture and fixtures for 1955 was 1.70 percent of total current operating earnings. An error 25 percent would distort income approximately .4 percent for the year for all insured commercial banks.10 The assumption of the stable unit of measurement for banks in this respect was more valid than for many other types of business organization possess- ing a larger percentage of assets subject to cost apportion— ments over future periods.ll If income and expenses are allocated correctly to the proper periods it should follow that assets, liabilities, and ownership equity accounts would also be stated correctly. 9. Annual Report of the Federal Dgp_sit_ Insurance Corporation for the Year Ended December 51,1955,_Federa1 Deposit Insurance Corporation, Washington, D. C.: U.S. Government Printing Office, 1956, Table 107, pp. 128—129. 11. Harold G. Avery, "The Relative Importance of Fixed Assets," The Accounting Review, Menasha, Wisconsin: American Accounting A53001ation, July 1956, p. 454. Avery shows the median of the percentage of fixed assets for 77 indus- trial firms in 1954 to have been 51. percent of total assets. This study included 17 industrial groups but included no banks. But, when the proper apportionment of an asset cost is charged against income as an expense the residual that remains for the statement of condition represents the unapportioned cost rather than the asset stated in terms of an amount that would indicate its actual market value. However, certain balance sheet assets are not stated in terms of their market value which may indicate liquidation value, but rather, in terms of the unallocated cost in accordance with the "going concern" concept. The finanial condition reported is a going concern condition in anticipation of future operations. The past cost apportionments apply primarily to the fixed asset group and prepaid expenses. They represent estimated cost allo- cations which must be as accurately as possible determined if bank accounting is to measure net income in accordance with proper accounting principles. The bank premises, furn- iture, and fixtures, and other real estate, plus the prepaid expenses percentage of total assets represented less than one percent and, therefore, an error in apportionment of 25 per- cent would affect the asset valuation in terms of the "going concern" concept by less than one-fourth of one per cent.12 From both the going concern viewpoint and the asset valua- lZ. F.D.I.C. Annual Report for 1955, Table 107, pp. 128-129. 4.5 46 tion in terms of market value of the fixed asset group the percentage of the group was very small, although in terms of the dollar amounts the difference between the stated dollar figures for this group may have been large in amount from their actual dollar market value. When the valuation conven- tion is assumed and costs are apportioned on such basis the effect upon net income determination of price level changes would only be considered as significant when asset costs that have been charged against operations resulted in the asset being materially understated or overstated in terms of the current market value. Therefore, it was assumed that asset cost allocations are in accordance with the best accounting procedure and that the differences between the book value of the asset and its market value or replacement cost is due to 15 But even a change in the changes in the price level. price level that would increase the market value or the re- placement cost of the asset by 100 percent over a period of twenty years would not distort annual income by more than five percent of the .89 percent of the total bank assets December 51, 1955. Such amount, equal to .045 percent, would not materially distort reported net income. Because price 15. Banks sometimes have charged amounts to current expenses that should have been charged to fixed asset accounts, thereby causing the fixed asset accounts to be under— stated. 47 level changes affect primarily the enterprise assets that are of a relatively permanent nature and because in commercial banks this asset classification was found to be a very small percentage of total assets, the effect of price level changes on commercial bank net income was very small. The largest share of the bank assets, 76.3 percent of total assets December 51, 1955, were of an interest earning nature.14 A change in the interest rate will change the present value of the assets capitalized at the new interest rate. For example, a downward shift in the rate of interest will cause an interest bearing obligation to have a higher present value than previous to the lower rate just as an up- ward change would cause a shift downward in the present val— ue of the interest bearing asset.15 Accounting does not recognize as income the increased value of the assets in accordance with their market value changes because income is not considered earned until realized, that is, until the assets are disposed of at a gain no income is recognized. However, when the market value has declined below the acqui- sition cost, certain assets are often written down to the market value with a corresponding charge against operations.16 l4. F.D.I.C. Annual Report for 1955, Table 107, pp. 128-129. 15. By a change in the interest rate is meant a change in the rate that would apply to the same asset. 16. Cost is the preferred basis for handling investments but sometimes the market value quotations cannot be ig— nored. The declines may sometimes of necessity be rec— This is the case particularly of business enterprises that have inventories of products for sale. Commercial banks do not have inventories and as the problem of their wasting physical assets are not significant their assets were, as was stated, almost entirely money claims. The fluctuations in the value of the monetary unit did not affect the accounting determination of income even though the real value of the income may have been affected.17 Accounting assumes the use of the monetary unit as the basis of measurement and consid- ers it impractical to measure income in real terms. 18 The bank assets classified as securities were nearly entirely U.S. Government obligations or obligations of other governmental units upon which losses are not expected except on sale or disposal of such assets. Therefore, no problem of balance sheet valuation for this classification of bank assets was encountered. Cash assets are valued in terms of the monetary unit 17' 18. ognized as losses of the perumiin which incurred but not in terms of the change due to the change in the rate of interest but to the actual market value which may be caused by other factors than the rate of in- terest. See also, W.A. Paton and W.A. Paton, Jr., Asset Accounting, New York: The Macmillan Company, 1952, p.159. For a full discussion see, Study Group on Business Income, Changing Concepts of Business Income, Report, New York: The Macmillan Company, 1952, p. 72. The use of a price index may cause certain assets to be stated in terms of more meaningful data but would not cause assets to be valued or income to be measured in real terms. 4? leaving only the classification "Loans and discounts" to have a material effect upon balance sheet valuation and income de- termination. The loans and discounts, the traditional bank earning assets should also be valued in terms of the "going concern" concept because they should be valued according to their future anticipated realization inasmuch as the loans are made with anticipation of collection. The anount loaned should be the valuation of the assets and the amount collect— ed less the amount loaned represents the earnings.19 The loan Values actually may vary from period to period but be- cause the intention is to collect the loan at maturity and in terms of the anticipations of collection at maturity, the proper income determination is to allocate the excess over the amount left to the accounting periods in relationship to the time of the periods. Even if accounting did recognize increases and decreases in the various asset values as income and losses, the net result would give the same income over the total thus period. But, records of this nature would have less practical useful- ness inasmuch as data could not be consistently compared. Consistency as a doctrine of reporting enterprise income 19. A discount is valued at maturity value and the amount of the discount is classified as a deferred credit to in- come to be amortized as an adjustment of the interest earned over the period of the loan. 59 should be adhered to in bank accounting Just as in other enterprises if data are to be compared.20 The Reserve for Bad Debts Reserve accounts. Because these various factors cause accounting data to be provisional in nature and not always determinate in amount, certain accounting techniques have evolved that are used to indicate such indeterminateness. By the use of special accounts that indicate the nature of the asset, liability, or proprietorship accounts subject to such indetermination, accounting attempts to best approxi- mate periodic income and balance sheet residuals. To many of these accounts the term "reserve" has been attached. A clear understanding of the use and meaning of the various reserves is essential in order to realize the differences that exist for it is by the use of the reserve for bad debts that accounting measures the influence of losses and recov- eries on loans for income detemnination and asset valuation. The various kinds of reserves. The term "reserve" is applied to many account classifications that differ greatly from each other. Generally they may be divided into three groups insofar as balance sheet presentation is concerned. 20. In accordance with, "generally accepted principles of accounting." 51 The term also has other meanings when used in banking. Such terms as "primary reserves" and "secondary reserves" are of everyday usage in banking. However, for the purpose of this study only the term "reserve" as used in accounting and not the other uses of the term has been used. There are three general classifications of reserves used in accounting: Reserves applying to assets. Reserves that are actual liabilities. Reserves that represent part of the net worth and are appropriations of surplus. Zglugtion reserves. A practice of long standing is the use of the wordflreserve" for accounts that are offsets against recorded asset values. In the case of certain de— creases in asset values, and especially those that are esti— mated as to amount, it is customary to set up another account called a reserve for the purpose of deducting the balance of such account from the asset account to which it applies in order to determine the assets'estimated book value. Such accounts are often called "valuation" accounts or "valuation reserves" because they determine the book valuation of the asset to which they pertain. Some accountants object strongly to the use of the word "reserve" for these accounts and suggest names such as "allowances" or other terms for the use of the word "reserve".‘2l however, the term is Still 21. W.A. Paton, Advanced Accounting, New York: The Macmillan Company, 1941, p. 598. used very much in this meaning for such as: "reserve for de- preciation," "reserve for depletion," and "reserve far bad debts". Liability reserves. The second general classification, that of a liability, is used when it is necessary to record a liability on the books, but the exact amount is not determine. able. Estimated liability accounts of such nature and also revenues of deferred nature, such as advances by customers are sometimes designated as reserves. The use of the temn "reserve" in such cases is questionable. Surplus reserves. The segregation er setting aside into special accounts certain amounts of surplus is the cre- ation of a surplus reserve. The board of directors of a corporation may deem it desirable to retain earnings in the business for certain purposes. The decision to retain earn- ings under certain account titles merely supplements the decision to retain earnings in the business. Actually the "surplus reserve" is nothing more than a special designation of retained earnings and represents surplus that for some purpose has been restricted and not available as a basis for a dividend declaration. Dividends not being declared, the earnings in the form of an asset could not be paid out of the business. Contingency reserves are usually reserves of this type. Other ggcountingruses. There are a few other uses of 53 the term "reserve” in accounting, although they can be class- ified under the other three general classifications. Accounts I on the books that represent asset values received which do not become a part of net worth or of earnings until certain obli- gations are fulfilled are sometimes termed "reserves of de- ferred application". They are by nature liabilities and now are usually classified as deferred credits to income or un- earned income rather than as liabilities because the obliga- tion is usually payable in service rather thanlnoney. A "secret reserve" is an element of net worth which is either not reported as such or is suppressed. Reserves of this type result from such transactions as charging capital 'expenditures to reserve accounts, the overstatement of de— preciation or the charge for bad debts, understatement of inventories and other transactions that cause understate— ments of assets or overstatements of liabilities. All reserves have credit balances. The three types of reserve accounts have one thing in common, they all have balances that appear on the credit side of the account. Because of their credit balances the natures of the various reserve accounts are sometimes misunderstood. The "valua— tion" or "contra asset" accounts cause the most trouble. Both the "reserve for bad debts" and the "reserve for depre— 54, ciation" are confused by people not familiar math accounting usage. The use of the word "reserve" indicating that same— thing has been set aside may also account for part of the mis= understanding. The distinct nature of each of the three types of reserves must be clearly distinguished. Purpose of the reserve for bad debts. The concept of the valuation reserve has a double purpose inasmuch as it is part of the determination of asset valuation at a moment of time and also through the provision for its changes it causes re- sulting effects upon income determination. The understanding of this dual purpose and effect on accounting data is of par- amount importance for an understanding of the problem. The bad debt reserve is normally considered to be a valuation reserve for current receivables which in a commercial bank are the loans and discounts. However, merchandising enterprises engage in the selling of goods or products and in the course of operations receive promises to pay in exchange for the goods or products. These promises are usually in the form of accounts receivables and are considered valid assets and evidences of a sale. In the course of collection it may result that not all these accounts will prove collectible. The business enterprises from exper- ience know approximately what percentage of their credit sales will result in uncollectible accounts or approximately what percentage of the accounts receivable will prove to be un- collectible. If an operating statement is prepared at a certain time, for example, December 51 for the past year and a balance sheet, the statement of condition at a moment of time, is also prepared December 51, it would be necessary to know for the operating statement what part of the sales will result in non-collection so that such loss can be charged to that period in which the sales were made. However, there is no way of knowing which accounts will prove to be uncollect— ible at that time and thus it is necessary to resort to an estimate. The amount estimated to be uncollectible is usu- ally based upon a percentage of sales or an amount determ- ined by an analysis of the accounts receivable. When it is based on sales an experience factor results which is the basis for determining future charges against income and credits to the reserve. When an account is determined to be uncollectible it is written off by being charged against the reserve for bad debts. The establishment or increase in the reserve for bad debts with the corresponding charge against income is noth- ing more than a bookkeeping entry that is necessary in order to, as much as possible, charge the losses resulting from uncollectible accounts against the income of the period when the accounts were established that may prove to be uncollect- ible. 55 Credit function differs for a bank. merchancising en- terprises use a period of about five years for determining their experience factor based on sales.22 Terms of sales are such that most credit sales are made for short periods of time,,usually not in excess of 50 days. The terms often in- clude provision for a discount for prompt payment within a short period of time. Credit is incidental to the carrying on of trade and is merely a step in the cycle of operations. The commercial bank deals in credit and the extension of credit is its primary function. The credit is extended not as an incidental partof its operations, and not for a short period of time but for months or even years. As a result of the difference in the nature of the credit exten- sion between a bank and a trading or manufacturing enter- prise it becomes necessary to differentiate between methods required for providing for bad debt losses. The merchand- ising operation being concerned with short term credit is able to change with the business cycle up or down, depend- ing upon conditions, because the trading enterprise is able to change its credit policy over a short period of time.25 In periods of general business depression banks incur 22. For a complete discussion of this problem see Daniel P. MacLean, "Bad Debt Reserve for Banks", American Banker, January 50, 1948. 25. Loc. cit. 56 their greatest bad debt losses, which are the result of a build-up over many years of operation. It has been advocated that the bad debt reserve for banks should be built up over a period of time to include the complete cycle of good and bad years.as a basis. MacLeanz4 mentioned twenty years as about a complete business cycle for banks. Advantage of overstating the bad debt charge. It may be good and wise policy for the business firm to set up reserves in good years to provide for losses in bad years, but what type of.reserves should be set up? The reserve for bad debts is supposed to be a valuation reserve and results from a bookkeeping entry. To provide by a bookkeeping entry a spec- ial account against which future losses may be charged may result in an account to absorb the losses but what in effect has been done is to understate an asset and income in one year and in some future year overstate income and perhaps finally adjust the asset to its true value. It will create a tax advantage if deductions can be taken in years of high income rather than in years of low income only if the tax rate on the higher incomes is greater than on the lower in- comes. However, the present corporate tax rate on corpora- tion incomes over twenty-five thousand dollars is the same 24. Ibid,, pp. 17"18. 57 58 for all income. The advantage, therefore, would be to indef- initely avoid payment of income taxes on the overstatement of the reserves. An entry in the records undervaluing an asset and over- stating a charge against income has the effect of reducing the income reported for the period and understating surplus. It is the creation of a secret reserve, that is, if the re- serve for bad debts were overstated, the assets would be understated and the surplus would also be understated. The amount of overstatement of the reserve for bad debts would correspond to the understatement of surplus. The understate— ment of surplus is buried in the reserve for bad debts. It would be of advantage to any firm subject to an income tax to create a reserve in this manner, inasmuch as the'bad debt charges are deductions before the determination of income for tax purposes. Bad debt chgrge is more important to banker. The banker forces a difficult and important problem in determining the bad debt charge. More difficult than the average merchan- dising enterprise because of the credit nature of the banking business. The bad debt loss for a commercial bank may be the difference between reporting a profit or loss for the account- ing period. Therefore, it is of major importance that the bad 59 debt deduction be determined as correctly as possible. The bank's problem is also made more difficult by the nature of banking wherein large losses occur over a short period of time. The year 1954 is an excellent example of such occur- ence and has been well illustrated by the following quotation: In 1954 the greatest losses in the history of national banks were charged off. many of these write-offs had been delayed from earlier years in the hope that uncomfortable situations . could be remedied. The losses on loans of the 5422 national banks in that year amounted to $579,294,000 which was almost e ual to the tgtal net earnings and recoveries of ,584,854,000.“5 égcounting methods for bad debts on loans and discounts. There are three possible basic accounting methods for determr ining the bad debt loss for a period: 1), The direct charge- off, that is, the bad debt charge against income is made at the time the loan is determined to be uncollectible, 2), the establishment or a reserve for bad debts and a charge off equal to an amount based on an analysis of the outstanding loans, and 5), the establishment of a reserve and current bad debt charges, being based upon loans made during the accounting period. The first two methods are in use at the present time, but subject to the tax regulations discussed in Chapter Two. The direct charge-off method does not create problems like those created by the use of the reserve method. 25. H.V. Prochnow and R.A. Foulke, Tractical Bank Credit, Second Edition, New York: Prentice—Hall, Inc., 1950, p. 16. 6O The loans are charged off when determined to be bad and if later are collected, income is credited for the amount of the recovery. However, this method is not in accordance with the accounting principle of matching income and expense, if it is argued that the accounting period in which the loan was made should be charged with the loss and not the period when it‘ becomes bad. This is a sound argument for a merchandising concern because income is recognized when the sale is made but a bank may make a good loan that for a time could earn income and then become bad. Just as the merchant makes a sale, the banker makes a loan with the expectation of col- lection on the due date, but like the merchant the banker also faces non—collection of some debts. The banker assumes risk when he lends the money but if he knew he would not collect he would not make the loan. Therefore, all the loans P, n L20 he makes are good loans, they later turn had. Method to use. The question arises, what period should be charged with the loss? The period when the loan is made or the period when the loan becomes bad. The answer is the former if the loan is considered to be a bad loan from the 26. For a detailed discussion of this statement see, Kenneth R. Wells, "Should Banks adopt the New Reserve Method for Bad Debts?" American National Bank and Trust 00., Chicago: Eebruary 2, 1948. 6L beginning, the latter if a good loan first and then a bad loan. Under this last assumption the direct charge-off meth- od for loans would be as correct as any method that could be devised. However, the matter of recoveries creates another problem. Under the direct charge-off method recoveries are added back in in the year in which they are recovered. But, a recovery of a loan charged off is merely recognition of an error in determining the collectibility of the loan, not in— come of the period when collected. Although it may be un- avoidable, the loan was charged off and later collected. The recovery should be added back to the year in which the loan Was charged off to properly measure income for that period. Under either assumption as to the period in which to charge off bad loans the charge-off and recovery method does not follow the accounting concept of matching cost and income of the same period. The valuation reserve method statistically developed should help to solve both the problems of charge—off and recovery. The bad debt charge for an accounting period is determined by a statistical method and the amount charged against income with the corresponding amount added to a re- serve for bad debts that is set up for this purpose. Any future recoveries would also be added to the reserve rather than taken into income for the period. However, this does 68 not solve the problem of mathhing costs and income unless the assumption is made that the statistical method for providing for current bad deb charges takes into account the recoveries that may be realized on loans written off. 'The problem then resolves itself into one of determination of the proper ” statistical method of computing the bad debt loss and corres— ponding addition to the reserve. Two methods in common use by merchandising enterprises have already been mentioned as possible for banks. One based on an analysis of the receivables and the other based upon an experience factor applied to sales during the accounting I period. Neither of these methods would be entirely satisfact— ory for a commercial bank. The nature of the commercial bank, as stated previously, differs greatly from that of the merch- andising enterprise. Because the size of the bad debt reserve will determine the valuation of the loans on the bank's balance sheet, it can be argued that the proper method would be to analyze the loans and after determining their estimated col— lectibility and value, to increase or decrease the reserve accordingly with a charge or credit to income for the period. In this case it would have to be assumed that if the loans decreased in value during a period a loss resulted and if they increased, that is, regained part of their previous valuation, a gain would be involved. This method would have no relationship to the loans and discounts currently made during the period. It would be a method of determining balance sheet valuation, that is, the estimated value of the loans at a moment of time. There still remains the problem of the proper determination of the charge against income. It is the two—fold purpose of the use of the valuation reserve that causes the difficulty. The valuation of the loans at a moment of time can be handled through eval- uation of them.‘ The determination of the proper charge against income is the primary objective of valuation accounts and when the extent of the Federal income tax upon income is considered it is of also primary importance. Therefore, the bad debt charge should be determined not on the basis of asset valuation but upon an experience factor determined by a statistical determination of past loss exper— ience of commercial banks and future expectations so that the proper charge for income determination can be established. 64 CHAPTER IV BAD DEBTS AND BANK LOSSES Classification of bank losses The Federal Deposit Insurance Corporation and other bank- ing agencies divide bank losses into two general classifica- tions: 1.) losses borne by Operating banks, termed "net charge-offs" and 2.) losses of closed banks. Losses in closed banks are further classified as losses borne by stock-holders or borne by depositors. Losses borne by operating banks for the purpose of this study were further divided as net charge-offs on: 1.) total assets, 2.) loans, 3.) securities, and 4.) other securities. Losses charged off by the operating banks Were absorbed by the banking system as a cost of bank operation even though reported as a non-operating expense on the operating state- ment. The losses borne by the depositors and stockholders were not absorbed by the banking system. The losses borne by the operating banks, the net charge—offs, are often termed "bad debts". Most bank losses result when loans are not col- lected in full or when securities may either be defaulted or decline in value and are disposed of at a loss. Other losses may be incurred on other assets that come into the possession of banks during their normal course of business and also they 65 may suffer losses on banking equipment and premises. Bank losses also may include losses due to theft, embezzlement, and other casualty losses of such nature.1 However, they are not included in the classification of net charge-offs of oper- ating banks. Losses before Federal Deposit Insurance Losses on commercial bank assets were esthnated to equal 12,515 millions of dollars for the 69 year period from 1865 to 1955 before the establishment of Federal deposit insurance. Of this amount 7,725 millions of dollars represented charge- offs in operating banks and 4,587 millions of dollars repre- sented losses in closed banks of which 2,417 millions of dollars were borne by depositors.2 In table I the estimated total losses are Shown before 1921, the period before the 1921 Revenue Act discussed in Chapter II, which provided for the 1. Annual Report of the Federal Deposit Insurance Corporation for the Year Ended December 51, 1940, Federal Deposit In- surance Corporation, Washington, D. 0.: U. 8. Government Printing Office, August 15, 1941, p. 61. 2. Source of data - Ibid., Table 50, p. 62. This data resulted from a study conducted by the Federal Deposit Insurance Corporation that had as one of its purposes the determination of an approximation of the losses that would have been imposed upon an insurance fund similar to that operated by the Corporation. The data of necessity was estimated on the basis of four general methods stated in the published report. 66 use of the reserve method, and for the period from 1921 to 1955. Table I shows that losses for the thirteen year period 1921-1955 were more than three times the losses of the prior fifty-six year period. For the last three years before de- posit insurance, 1951-1955, total net charge-offs were 2,595 millions of dollars, a greater amount than the previous fifty- six year period.5 TABLE I ESTIMATED L(BS'ES ON ASSETS OF 4 COMMERCIAL BANKS 1865-1955 FOR SELEETED PERIGDS (In millions of dollars) In operating In closed banks Total banks (net Borne by Borne by Teriod losses charge-offs) stockholders depositors 1865-1920 5,060 2,482 509 269 1921-1955 9,255 5,244 2,108 1,901 1865-1955 12,515 7,726 2,417 2,170 However, Table 2 shows the rates of total losses on com— mercial bank assets were less than three times as great for 5. Ibid., Table 52, p. 66. 4. Source of data - Ibid., Table 50, p. 62. These estimated losses included for the period 1865-1955 normal depreciation on bank premises and equipment and amortization of premiums. 67 the period 1921-1955 as the period 186541920 and the loss rate on net charge-offs was double the rate fer the same per- iods. For the period 1865-1880 the loss rate for net charge- offs was even higher than for the 1921—1955 period. The loss rates borne by stockholders and by depositors were higher than before 1921 for all periods and over five times for the total 1865—1920 period. The reason for the difference in the rates of losses from the actual amounts of losses was due to the increase in bank assets and deposits during the sixty-nine year period. TABLE 2f 0F COLEERCIAL BANKS 1865-1955 for SEECTE‘D PERIODS5 ESTIMATED RATES OF LOSS ON ASSETS ‘ (Average per year per $100 of deposits in operating banks) In operating In closed banks Total banks (net Borne by Borne by Period losses charge—offs) stockholders depositors 1865—1880 1.45 1.09 .17 .19 1881-1900 1.08 .77 .19 .12 1865-1920 .66 .55 .07 .06 1921-1955 1.67 .95 .58 .54 The Federal Deposit Insurance Corporation was designed to improve the standards of bank operations and by so doing pre- vent the accumulation of losses that could not be absorbed by 5. Source of data - Ibid., Table 51, p. 65. 68 the banking system and to provide insurance for the losses that can not be avoided so that losses would not fall upon de- positors in closed banks.6 Bank losses on assets should be considered as a cost of bank operations inasmuch as a banker must expect that some assets will prove wholly or partially worthless. Since the greatest risk in bank losses exists because some loans may prove to be uncollectible wholly or in part and securities may be defaulted or disposed of at a loss, operating banks should adequately charge these losses off against current operations just as are charged the other costs of banking. When the banks properly charge off the losses against in- come the amounts of the charge-offs affect the net profits figure reported and, therefore, the capital accounts upon which dividend declarations are based. It is only when banks. fail to properly make provision for losses before payhmg div— idends or before income taxes that the losses accumulate and then if the banks suspend operations the accumulated losses will be borne by the stockholders and the depositors in order. Losses after Federal Deposit Insurance gglationship of charge-offs and reserves to assets. After Federal deposit insurance was established a significant 6. Ibid., p. 64. 69 change in commercial bank losses developed. The net charge- offs, except for 1954, never exceeded 158 per cent of total, bank assets in operating banks as shown in Table 5, which shows the total net charge-offs for the 21 year period since 1954.7 In six of the years recoveries actually exceeded gross charge—offs. Table 5 shows that after 1956 gross charge-offs fluctuated around $400 million per year until 1941 when they dropped to less than $500 million. They fluctuated for the war years and through 1947 at this rate until a sig- nificant increase took place in 1948 to almost $500 million and then the rate returned to about $400 million until 1954 when the $555 million represented an increase of over $100 million over 1955 and it was the first time since 1956 that gross charge—offs exceeded the $502 million of that year. The reduction in charge-offs for 1954-1956 was chiefly due to the progressive elimination of assets on which losses had accumu- lated previously.-8 Recoveries were higher for 1955 and 1956 than the follow- ing years until 1945 when they exceeded $500 million for the first time since 1956. The high of 1945 was primarily due to the profits on securities sold or exchanged. The high rate 7. The percentages are not comparable with those of Table 2 because they are based on rate of loss per $100 of deposits. 8. See F.D.I.C. Annual Report for 1940, p. 55. ALL CHARGE~OFFS CHARGE-OFFS 0N ASSETS on ALL IN TABLE 3 70 ALL RECOVERIES AND TOTAL NET §URE6 COMMERCIAL BANKS 1939-1955 (In millions of dollars) Net charge-offs All All Percentage of Year charge-offs recoveries Amount total assets 193% 1,033 292 7H1 1.65 1935 628 M32 196 .38 1936 502 585 3&8 .12a 1 9 09 - 13% 655 £29 126 .22 1939 438 381 57 .09 19ho 386 3H9 37 .05 19h1 33h 32h 10 .01 19h2 271 223 #8 .05 1943 291 353 62a .068 194M 266 362 96a .078 19h5 26% 509 2%8 .16a 1946 283 #09 1268 .09a 19%? 29h 262 32 .02 19MB #86 266 220 .14 1949 379 213 166 .11 1950 367 2H5 122 .07 1951 396 169 227 .13 1952 362 14% 218 .12 1953 RHB 152 296 .15 195% 553 631 78a .048 1955 707 2ho M67 .22 1Percentage of net charge-offs to total assets at December 1 of each year. aIndicates recoveries exceed charge—offs. BSource of data: Annual Reports for the years 1990-1955. Adapted from data obtained from the F.D.I.C. : a I u a n . ') ’fi 71 of recoveries from 1955 to 1936 reflected the recoveries on the unusually large amounts of loans and real estate charged off in the early thirties, recoveries on securities written down to very low levels during the same period, and profits on securities sold during the 1934-36 period of rapidly rising bond prices.10 However, included in the "all recoveries" classification are the amounts for profits on securities sold or exchanged. When these amounts were removed a significant difference Was noted for certain years as indicated in Table 4. In no year during the 22 year period did the recoveries exceed the gross charge-offs When the profits on securities sold or exchanged were not included. Except for the year 1934 the highest annual percentage of net charge-offs on total assets was .53 per cent in 1958. When the net charge-offs were separated between loans and securities a difference in the annual rate fer the two asset groups was noted. In Table 5 the two years 1955 and 1936 illustrate most clearly the difference between the annual rates on the two groups. Securities actually showed net recoveries as against the two years of the highest rates of loan losses for the total 21 year period. After 1956 the rate on securities to securities exceeded the rate on loans 10. Loc. cit. TABLE 4 ALL CHARGE-OFFS RECOVERIES LESS PROFITS 0N SECURITIES SOLD, T CHARGE-OFFS, AND PEBCENTAGES OF NET CHARGE-OFFS T0 TOTAL ASSETS OF lALL INSURED COMMERCIAL BANKS 1934-195511 (In millions of dollars) 72- All recoveries Net emerge-offs1 All less profits Percentage charge- on securities of2 Year offs sold Amount total assets 1934 l 033 277 756 1.68 1935 ’628 404 224 .44 1936 502 317 185 .33 1937 395 192 203 .37 1938 455 156 299 .53 1939 4 8 166 272 .43 1940 ‘ 3 6 171 215 .30 1941 334 179 155 .20 1942 271 157 114 .12 1943 291 250 41 .02 1944 266 232 34 .03 1945 264 242 22 .01 1946 283 200 83 .06 1947 294 162 132 .07 1948 486 206 280 .18 1949 379 140 239 -15 1950 367 155 212 .1 1951 396 112 284 .1 1952 362 110 252 .13 1953 448 113 335 .18 195‘t 553 214 339 -17 1955 707 183 52’+ ~25 1 Not including profits on securities sold. 2 Total assets December 31, of each year. 11 Source of data: Annual Reports for the years 1940-1955. Adapted from data obtained from the F.D.I.C. . l - ._ _ _ I a. . . . . . .. . ..r . - - .'! . . ' ‘ .- I I I -\-- u I I . . I-_— . - . . | - '- 1" I .u . 'I . . u . , . I . i' u I TABLE 5 PERCENTAGE OF NET CHARGE-OFFS AND RECOVERIES ON LOANS, SECURITIES AND SECURITIES INCLUDING GOVERNMENT SECURITIES OF INSURED COMMERCIAL BANKS 1934-195512 (Percentages of assets December 31, of each year) 73 nggggtgggg of Net Charge-offs on: Loans Securities Securities to to to securities including Year loans securities government securities 1934 3.36 3.20 1.15 1935 1.61 2* .2 * 1936 .87 .26* .09* 1937 .31 1.73 .58 1938 0 59 2 o .75 1339 .42 2.17 .66 1 _0 .26 1.69 .50 1941 .16 1.25 .31 1942 .06 .98 .14 1943 .06 .40 .04 1944 .07 28 .02 1945 .04 15 .01 1946 . 01 91 .09 1947 .14 .83 10 1948 . 53 75 .10 1949 .47 29 04 1950 .30 .33 O5 1951 .30 68 12 1952 .20 .70 .13 1953 .18 1.19 .22 1954 .23 .73 .14 1955 .31 1.39 .29 *indicates percentages of net recoveries. 2Source of data: computed from data obtained from the F.D.I.C. Annual Reports for years 1940-1955. " .,V «y -‘ ~ ' rI5$5§7§IW . , ' .‘ "‘7" ”".'. 52;». WW4!” " 7 7, " 7'. . i am, mun?) I (139‘; does ‘30 ,IE sednoaad Men: to ---..._ .._.—.. .——— 7.....- ....__- .u.. — u—-—--*.'I .._..._ _- -— -rv "'1 ' "an. '1 -. 4.29 :--.-.‘....-.-.-- -. ... - mural: . - ..-‘_ - .' f-I' ‘ "I ' . l I _ .£l_ -, . ' .n -_ ' __ . — :- _.' . .5 z n 2 _ ‘ :- ‘- ‘ _ l -_ ------ . .. a... - . n . - . .. . . ..... .......... ..- .- .— I ‘ r r c I 0 A .1 I. . 1 l' ‘ ' i I ' n .. a ' A ._ l . ‘ " g I ' v I . -'\_\-E ' :I-r ~ 0 I ~ 0 i “, __':-[ . . '..I I D a ' ’-_'T.I J r.— r .r o o ' o ‘ i".- ‘ I Q - ' I a I (1-“\l: ' r a C O ‘ I ~ - I - ' ' I I- . -I I '~- I o n I _.. .t . a ' n I o I l . I. . O . l .I‘ l ‘ I . I o a . U ' l _ '. o u I I . - ' I ,. o o t l I I c ‘ a I _ l I C Q I I . g I ' a o v \ _ I - . c . . I ‘ .I- I I l 1 . ..- u u ‘ _ u o - _ . . . - . - . . . . _ _ . - _ — . - - — . I. - - .. . — — I a I I . u ' _. o . J I '- ' r - . r 1 ‘l l l I 74 to loans for every year except 1949, and until 1948, the rate was in nearly every year greatly in excess of the rate on loans to loans. The rate on loans to loans decreased until only .01 per cent was reached in 1946 and then a slight rise took place in 1947 to be followed by the great increase in 1948. The rate then decreased steadily until 1954 when the rate again increased. The rate of losses on securities to securities showed a much greater fluctuation during the 22 years. When govern- ment securities were included in computing the rates of losses they were much lower as shown by Table 5, but did show a de- creasing trend until 1945 and then increased gradually until a high was reached for 1953. I The high rates of charge-offs for 1934 in Tables 3-5 were due to the large amounts of loans and securities charged off at the establishment of deposit insurance and represented the accumulation of prior years operations that had not been Charged off and excess drugs—offs on securities which later resulted in the high security recoveries for 1955 and 1936. The results of changes in the tax rulings can be noted in the data. Mimeograph 6209 of December 7, 1947 was immed- iately reflected in the increase in total charge-offs from $294 million to $486 million, an increase of 65 per cent. The method of reporting charge-offs was changed in 1948 to report separately recoveries and transfers from valuation 75 reserves and also to report separately direct charge-offs and additions to valuation reserves. In Table 6 the charge-offs and recoveries, and transfers to and from valuation reserves are shown. The moving average experience factor according to Mimeograph 6209 started with the year 1948 and included the twenty year period after 1927. Because each year the first year was to be dropped and the last year added, the individual banks experience factor included the years of high bad debt losses, but after the losses for 1953 were added 1934 was the first year included. The next year 1934 was dropped and 1954 added so that for years after 1955 the twenty year moving average experience factor would have resulted in years of low losses being added and the years of the high losses having been eliminated from the experience factor. The change allowed by the supplemental ruling in 195413 was to the advantage of individual banks that had high loss experience in the early years and low losses in the last years of the period. There- fore, the ruling has given a bank that suffered high losses in the past a tax advantage that banks that had low loss experiences do not have. The results of the tax ruling in 1954, which applied to years after 1953, resulted in increases in the additions to 13. Internal Revenue Ruling 54-148, April 8, 1954. TABLE 6 CHARGE-OFFS, ADDITIONS T0 RESERVES,15 TRANSFERS FROM RESERVES FOR LOANS AND SECURITIES FOR ALL EgERATING INSURED COMMERCIAL BANKS 1948-1955 (Amounts in millions of dollars) 76 Additions Transfers Net Losses and to Recov- from charge- Year Charge-offs reserves Total eries reserves Total offs* Lassa 1948 32 279 311 40 49 89 222 1949 29 221 250 23 28 51 199 1950 23 191 214 29 30 59 155 1951 21 204 225 23 28 51 174 1952 24 155 179 22 27 49 130 1953 32 123 164 28 18 46 118 1954 29 22 252 34 58 92 160 1955 28 3O 332 27 51 78 254 Securities 1948 79 41 120 29 24 53 67 1949 39 33 72 16 27 43 29 1950 39 55 94 15 39 54 40 1951 84 32 116 15 12 27 89 1952 98 30 128 11 20 31 97 1953 156 54 210 11 28 39 171 1954 67 126 193 15 61 76 117 1955 221 67 288 21 4O 61 227 *Figures do not include profits on securities losses, charge-offs, etc. 1”Source of data: pp. 134-135. sold or other F.D.I.C. Annual Report for 1955, Table 108, 77 valuation reserves as shown by Table 6. An increase of $91 million for 1954 and an additional $81 million over 1953 for 1955 in the loans figures, whereas the amounts for direct losses and charge-offs remained almost constant over the eight year period. In Table 7 the ratio of reserves to loans and securities are shown since 1948 the first year of Mimeograph 6209. Again there was a difference between the ratios for loans and for securities. The ratios for loans Show an increase for the second year, the same percentage the third year, an increase for 1951 with about the same percentage for 1952 and 1953. The next two years after the 1954 ruling, 1954 and 1955, again show an increase to a new high ratio. The ratio for all securities did not indicate a trend but remained almost constant ending in 1955 on almost the same ratio for the period. The years 1950 and 1951 were the two highest by a small amount. The year 1954 was unusual for securities. It was a period during which great amounts of securities were sold and large profits reported resulting in a decrease in securities held from 1954 to 1955. The ratio for securities not including government secur- ities shows a constant decreasing percentage in every year except 1954. The actual amount of the reserves vary little from year to year and indicate no trend. Therefore, the de- creasing ratio was due to the increase in the amount of the non-government securities held. Over the eight year period the amount of the securities increased by 83.2 per cent, the ratio percentage decreased by 43.3 per cent and the actual reserve increased by 2.6 per cent. A comparison of the losses for the eight year period with the reserves at the end of the years indicates the ade— quacy of the reserves provided. In Table 8 the comparison for both loans and securities has been made. The ratio of reserves to losses showed a steady increase until 1953 and then a small decrease for 1954 and a large decrease for 1955. These ratios indicate the number of times the reserve exceed- ed the actual net charge-offs. Also many banks are still not on the reserve basis and, therefore, the results may be interpreted to include the fact that the ratio of reserves to charge—offs of banks actually on the reserve basis could be much higher. TABLE 7 AMOUNTS OF RESERVESZROR LOSSES ON LOANS AND SECURITIES AND RATIOS OF RESERVES T0 LOANS AND SECURITIES, DISURED COMIIIEROIAL BANKS 1948-195515 (Amounts in millions of dollars) Amount of reserves Ratio of reserves to Year at end of the year loans and securities* All Non-government Secur— insured secur- Loans Securities Loans ities ities only 1948 410 233 .97 .33 2.54 1949 549 238 1.28 .31 2.33 1950 674 250 1.28 .34 2.02 1951 818 254 1.41 .34 1.91 1952 906 243 1.40 .32 1.72 1953 964 235 1.41 .30 1.61 1954 1,072 277 1.50 .33 1.70 1955 1,268 239 1.52 .31 1.44 * Loans and securities at the end of the year. The increase in the percentage of the reserve to net charge-offs Was to a great extent due to the increasing numr ber of banks using the reserve method. The ratios for securities did not indicate a trend and fluctuated greatly from year to year. The ratios for both securities not including government securities and for total securities were approximately the same. 15. 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