The Search for Clarity in the Accounting for Loan-Loss Reserves: Earnings Management vs. Safety and Soundness

supra note 1, at 8. 7. Steve Burkholder, Accounting: Banks ' Loan Loss Reserves Focus For Rulemakers, SEC StaffAt Conference, BNA BANKING DAILY, Nov. 3, 2000, at d4 [hereinafter Burkholder, Loan Loss Reserves].In a pivotal 1998 speech that launched the SEC's widespread effort to reduce earnings management, commission Chairman Arthur Levitt referred to loan-loss allowances as "cookie jar reserves" used by companies to smooth earnings.Id.Earnings management is "the strategic exercise of managerial discretion in influencing the earnings figure reported to external audiences."Francois Degeorge, Jayendu Patel & Richard Zeckhauser, Earnings Management To Exceed Thresholds, J. oF Bus., Jan. 1999, at 2. Speaking at a November 2, 2000 conference for accountants and bankers in Washington, D.C., Mark Sever, the new chairman of the Accounting Standards Executive Committee (AcSec), commented that loan-losses appeared too "skinny" in years past.Burkholder, supra. 1The SEC argues that banks should not use these accounts as "cookie jar reserves" to be raided in hard times to maintain the appearance of smooth earnings.8 However, the banks and banking regulators, including the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of the Comptroller of Currency, and the Office of Thrift Supervision, strongly support the notion that banks should freely put aside reserves to cushion against bad loans.9 In fact, banking regulators have been encouraging banks to increase reserves to protect themselves from a potential downturn in the U.S. economy."0 They maintain that there should be no requirement for these reserves to be tied to specific problem loans."Banks want to prepare for the unanticipated losses inherent in the loan making business.The banking agencies' desire for safe and sound guarding against bad loans conflicts with the SEC's push for adequate disclosure.13 This Note will briefly recount the history of the loan-loss debate. 1 4 A key focus of this Note is the current debate over a still evolving American Institute of Certified Public Accountants (AICPA) proposal on the recommended accounting for loan-loss reserves.5 This Note will next examine the arguments of the SEC This label was meant to suggest that reserves were insufficient to cover troubled loans.Id. "The concern now is that allowances are too fat," stated Sever, referring to the SEC's allegations of earnings management.Id. 8. Id.See also The Numbers Game, CPA J., Dec 1998, at 16 [speech by Arthur Levitt at the NYU Center For Law and Business (Sept.28, 1998)].9. Bennett, supra note 1, at 8. 10.Carey Gillam & Jaret Seiberg, SunTrust Yields In Tug-of-War With SEC Over Loss Reserves, AM.BANKER, Nov. 16, 1998, at 1. Adding to loan-loss reserve accounts usually involves a debit to a bank's "loan-loss provision" account, which lowers net income, and a credit to the loan assets account, shown as an offset to gross loans and labeled "loan-loss reserve."Viewpoints: Ludwig Sounds False Alarm About Loan-Loss Proposal, AM