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EXAMINING ISSUANCE
Comptroller of the Currency
Administrator of National Banks
Type:  Examining Circular
Subject:  Guidelines for Capitalization of Interest on Loans

TO:  Deputy Comptrollers; District Administrators; Division Directors; and
     Examining Personnel

PURPOSE

This issuance describes OCC policies governing the accounting treatment
for capitalization of interest on loans.

POLICY

Capitalization of interest should be based upon the borrower's ability to
discharge the indebtedness in the normal course of business.

BACKGROUND

Capitalized interest on loans is generally defined as uncollected interest
which is added to unpaid principal in accordance with the contractual loan
agreement. Although there are several ways this can occur, two methods
predominate.

One arises when the cash interest payment required from the borrower at
the regular interest payment date is less than the actual rate of interest
charged. The loan contract usually provides for any difference to be added
to the principal amount of the loan and repaid at a later date. Examples
include "negative amortization" home mortgage loans, equipment installment
loans with skip payment provisions and loans having maximum payment
provisions in the initial term offset by larger payments in the latter
term ("capped loans").

The second method involves loans which are renewed at maturity with the
uncollected interest included in the new loan. Such arrangements occur in
connection with real estate construction financing and agricultural
credits.

Although interest is capitalized under the terms of the loan contract and
is added to the note, capitalization of interest for reporting purposes is
appropriate only when the borrower has the ability to repay the debt in
the normal course of business. However, present regulatory and generally
accepted accounting principles do not provide specific guidance as to when
interest capitalization is appropriate. The prevailing practice has
generally relied upon safe and sound lending policies consistent with
prudent credit judgement. The lack of specific guidance and increased
frequency of the practice make the issuance of formal guidance
appropriate.

Loan agreements with borrowers are not affected by these guidelines and
will continue to be based upon the bank's established lending policy.
However, since capitalization of interest may reduce the normal discipline
imposed by payment of full interest charges, it is important that banks
maintain adequate procedures for monitoring and controlling such loans.

PROCEDURES

The appropriateness of interest capitalization for accounting purposes is
based primarily upon the creditworthiness of the borrower. The evaluation
of the creditworthiness of a borrower should be based upon credit quality
factors consistent with those employed in the classification of credits as
identified in Section 215.1 of the Comptroller's Handbook for National
Bank Examiners. In evaluating these credits, the following questions
should be considered in determining whether credit quality is such that
capitalization of interest is appropriate.

o Was interest capitalization anticipated upon approval of the initial
  loan based upon a planned temporary lack of borrower cash flow?

o Is the loan well secured either by (a) collateral in the form of liens
  on or pledges of real or personal property, including securities, that
  have a realizable value sufficient to discharge the debt (including
  capitalized and accrued interest) in full, or (b) by the guaranty of a
  financially responsible party?

o Is repayment of the loan, including capitalized interest, based upon a
  reasonably ascertainable  event in the future?

o Can the borrower obtain funds from sources other than the existing
  creditor at similar rates and terms?

o Is there little or no doubt as to the ultimate collection of all
  principal and interest?

If the answers to the above questions are predominantly affirmative, then
interest capitalization may be acceptable. However, the above questions
are not intended to be the only factors considered in such an analysis. As
mentioned, the key to this determination is credit quality. Reporting of
capitalized interest may be acceptable for credits of sound quality even
though the answers to some of the above questions are negative. Since the
evaluation of credit quality necessarily involves the exercise of prudent
judgment, the examiner should exercise caution in determining whether
reporting of capitalized interest as current income is appropriate. For
example, there is a presumption against capitalization of interest for
loans classified substandard. It is recognized though, that circumstances
may exist whereby such capitalization is appropriate. In no case, however,
should interest capitalization be permitted if the analysis results in the
loan being classified (by the examiner or through a similar internal bank
classification system) as: (1) loss; (2) doubtful; (3) value impaired; or
(4) nonaccrual.

If it is clear upon applying this analysis that interest has been
inappropriately capitalized, the amount should be reversed or charged off
in accordance with the methods permitted in the Instructions -
Consolidated Reports of Condition and Income. Although it may be difficult
to determine when capitalization of interest should cease, it should not
be permitted after it is no longer prudent based upon the criteria
described above.

ORIGINATING OFFICE

Chief National Bank Examiner's Office, Commercial Examinations Division
(202) 874-5490 and Bank Accounting Division (202) 874-5180.


John F. Downey
Chief National Bank Examiner

Date:  May 1, 1985