Your auditors are likely referring to IRS and banking regulations that govern the application of payments when loans are categorized as non-accrual and/or non-performing. The application of payments between principal and interest may differ for tax accounting and regulatory accounting purposes. Most of the BankersOnline posters do not make a distinction between the two sets of requirements, which can be diametrically opposed. For example, the IRS Treasury Regulations require you to allocate loan payments to interest, except for certain types of late charges. 26 CFR 1.446-2(e).  However, banking accounting standards require you to characterize payments as loan principal. COMPTROLLER OF THE CURRENCY BANK ACCOUNTING ADVISORY SERIES October 2010, p. 52, Question 1. Regardless, these issues should be discussed with your accounting department, outside auditors, and bank counsel.

As to consumer compliance law, we do not believe this issue is directly addressed by the banking regulations. (Regulation Z does not specifically govern how to apply loan payments for consumer loans secured by the consumer’s principal dwelling, stating that “payments should be credited based on the legal obligation between the creditor and consumer,” though it does govern when payments should be credited. See 12 CFR 1026.36Comment 2, Official Staff Commentary, 1026.36(c)(1)(i). Regulation AA indirectly governs the application of payments — it prohibits the pyramiding of late fees (charging a late fee when the delinquency is attributable only to late fees assessed on earlier payments). 12 CFR 227.15. This means that you cannot apply payments to old late fees before covering the current payment. See FRB Consumer Compliance Handbook, Chapter III, p. 78.  Also note that this issue is on the CFPB’s radar. See CFPB Mortgage Servicing – Examination Procedures, which directs examiners to “determine whether the servicer credits payments toward principal and interest before it applies payments to fees and other charges” under the heading “Other Risks to Consumers — Payment Posting.”