Final answer:
Institutions are expected to estimate the loss on a group of loans based on conditions that existed at the balance sheet date according to FAS 5, and not project changes after that date.
Loan loss provisioning relies on historical and current risk assessments, and a significant increase in actual defaults can drastically affect a bank's asset values and net worth.
Step-by-step explanation:
According to FAS 5, now known as ASC 450-20 for Contingencies, when estimating the amount of loss on a group of loans with similar risk characteristics at the balance sheet date, institutions are expected to consider the conditions that existed at the balance sheet date.
Therefore, projections or forecasts of changes in facts and circumstances after the balance sheet date are generally not incorporated into the estimation process.
It is critical to rely on the information up to the balance sheet date because it reflects a point in time measurement of expected losses on loans.
Loan loss provisioning, however, can be complex, as the value of a bank's loans—an asset on the balance sheet—is based on both historical default rates and the bank's assessment of current risks.
A well-run bank assumes that a percentage of loans will not be repaid and will use these assumptions in calculating their yearly expenses.
If the actual number of loan defaults significantly exceeds expected numbers, which can occur during events like a recession, it can dramatically reduce the value of the bank's assets, potentially leading to a negative net worth situation.
For example, if unexpected defaults reduce Safe and Secure Bank's loans from $5 million to $3 million, the bank's assets decline, indicating a shift in its financial stability and revealing the importance of accurate risk assessment and contingency planning.