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Answer: Reduce ABC's asset values and increase its loan loss reserves.
## Explanation This question involves accounting treatment for impaired loans and making financial statements comparable between banks with different approaches to loan defaults. ### Key Points: - **XYZ Bank**: Already wrote off the loan (removed from assets) - **ABC Bank**: Retained the asset hoping for recovery - **James's belief**: The loan will never be recovered ### Accounting Impact: 1. **Asset Value Reduction**: Since the loan is not recoverable, the asset value on ABC's balance sheet should be reduced to reflect the economic reality. 2. **Loan Loss Reserves**: To make the financial statements comparable and conservative, ABC should increase its loan loss reserves. Loan loss reserves are contra-asset accounts that reduce the carrying value of loans and reflect expected credit losses. ### Why Option D is Correct: - **Reducing asset values** directly addresses the overstatement of assets - **Increasing loan loss reserves** provides a conservative allowance for the expected loss - This combination makes ABC's financial position comparable to XYZ's, which already wrote off the loan ### Why Other Options are Incorrect: - **A**: Only reducing assets doesn't adequately reflect the credit risk through reserves - **B**: Only increasing reserves doesn't properly reduce the overstated asset value - **C**: Reducing both assets and reserves would actually improve the financial position, which is inappropriate for an impaired loan This treatment aligns with accounting standards (IFRS 9/ASC 326) that require recognizing expected credit losses through provisions and adjusting asset carrying values.
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XYZ and ABC Bank each make a loan of $1,000,000 at 4% interest to a technology startup, Innovate, in January of 2022. Unfortunately, Innovate makes only 4 payments. Innovate defaulted and became unlikely to repay its debt. ABC decides to retain the asset in hopes of recovering part of the loan one day while XYZ decides to write off the lost asset. Assume all other items between the banks are the same. James, a financial analyst, is evaluating both banks' financials. He wants to make the firm's financial statements comparable. What would he need to change if he believes that the loan to Innovate will never be recovered?
A
Reduce ABC's asset values only.
B
Increase ABC's loan loss reserves only.
C
Reduce ABC's asset values and its loan loss reserves.
D
Reduce ABC's asset values and increase its loan loss reserves.