Accounting for foreclosed assets.

The American Institute of CPAs accounting standards executive committee (AcSEC) has undertaken a project 0n accounting for foreclosed assets. This month Dionne D. McNamee, CPA, technical manager, AICPA accounting standards division, describes the project's status.

Before the AcSEC project, authoritative accounting guidance on foreclosed assets was diverse, contained principally in AICPA audit and accounting guides and statements of position. Three kinds of guidance prevailed:

* The industry audit guide Audits of Stock Lite Insurance Companies supported carrying foreclosed assets at the lower of depreciated cost or market value, net of any encumbrances.

* SOP no. 75-2, Accounting Practices of Real Estate Investment Trusts, and three audit and accounting guides, Audits of Savings Institutions Audits of Finance companies (Including Independent and Captive Financing Activities of Other Companies) and Audits' of Banks, all supported carrying fore-closed assets at the lower of cost or net realizable value. Audits off Banks, however, provided little guidance on determining net realizable value and did not require the use of discounting for purposes of determining net realizable value as the SOP and the other audit and accounting guides did.

* The audit and accounting guides Audits of Credit |Unions and Audits of Property and Liability Companies did not address accounting for loreclosed assets.

In addition, little guidance exists on accounting for the results of operations related to foreclosed assets.

WHY A PROJECT ON FORECLOSED ASSETS?

AcSEC's objectives are to eliminate diverse accounting practices and improve the understandability, comparability and relevance of amounts reported as foreclosed assets and the amounts reported in the income statement related to holding and operating foreclosed assets. Believing the playing field should be level as soon as possible, AcSEC decided to accomplish these objectives in two steps.

The first step was accomplished when SOP no. 92-3, Accounting for Foreclosed Assets, was issued in April 1992. SOP no. 92-3 deals with the measurement of foreclosed assets in the balance sheet and should be applied to foreclosed assets in annual financial statements for periods ending after December 14, 1992. The second step is under way following issuance of a proposed SOP, Accounting for the Results of Operations of Foreclosed Assets Held for Sale, in November 1992.

OVERVIEW OF SOP 92-3

Accounting at foreclosure. Financial Accounting Standards Board Statement no. 15, Troubled Debt Re.structurings deal with accounting for foreclosure or repossession of assets in satisfaction of receivables and requires foreclosed assets be accounted for at their fair value at the time of foreclosure. Exhibit 1, below, illustrates this for EJM Savings institution.

Held-for-sale presumption. Statement no. 15 deals with accounting for the foreclosure transaction; SOP no. 92-3 deals with the measurement of foreclosed assets in the balance sheets after foreclosure. Under the SOP there is a rebuttable presumption foreclosed assets are held for sale. Because most lenders do not intend to hold foreclosed assets for the production of income and regulations often require foreclosed assets be sold within a specified time, as a practical matter most foreclosed assets will be considered held for sale under the SOP.

The building EJM obtained through foreclosure is located in a stagnant real estate market where prices characteristically are depressed. EJM has no immediate plans to sell the building; however, the bank is required by regulation to sell the property within five years and, accordingly, considers the building to be held for sale.

Accounting for foreclosed assets held for sale after foreclosure. SOP no. 92-3 requires foreclosed assets held for sale after foreclosure be carried at the lower of

* Fair value (as defined in Statement no. 15) minus estimated costs to sell.

* Cost. (The fair value of a foreclosed or repossessed asset becomes the asset's cost on the foreclosure date. Expenditures for capital additions and improvements are examples of items that increase the asset's cost; depreciation is an example of an item that decreases the cost. )

If the fair value minus estimated costs to sell declines to a point below the asset's cost, the resulting deficiency should be recognized as a valuation allowance. If the fair value minus estimated costs to sell subsequently increases, the valuation allowance should bc reduced. Changes in the valuation allowance should be included in income. Exhibit 2, page 75, illustrates how this works in the case of EJM.

OVERVIEW OF THE PROPOSED SOP

The proposed SOP provides guidance on accounting for the results of operations of foreclosed assets held for sale.

Depreciation. The proposed SOP recommends depreciation expense be recognized on depreciable foreclosed assets held for sale beginning no later than one year after foreclosure. Depreciation would be recognized over the asset's estimated remaining useful life in a systematic and rational manner based on the cost of the asset at the time depreciation begins.

Operating revenues and expenses. The proposed SOP also recommends the net of revenues and expenses related to operating or holding foreclosed assets held for sale be credited or charged to income. The revenues ,red expenses making up the amounts included in income related to foreclosed assets held for sale, including depreciation expense and changes in the valuation allowance, would be disclosed in the notes to the financial statements.

Relationship to SO1' no. 92-3. Under the proposed SOP, depreciation expense would be recognized on certain foreclosed assets held for more than one year and would reduce the cost basis of those assets. Depreciation, by reducing the asset's cost, would reduce the need for valuation allowances that might be required based on the lower of fair value minus estimated costs to sell or the cost test required under SOP no. 92-3.

The requirement to depreciate foreclosed assets held for sale would change net income and the asset's carrying amount, which would have been reported if the assets were not depreciated, when depreciated cost is less than fair value minus estimated costs to sell the asset. The likelihood that this will happen grows as the fair value minus estimated costs to sell the asset increase and as the time the asset is held increases. Exhibit 3, above, illustrates these concepts.

PLANS FOR COMPLETION

The deadline for receiving comments on the proposed SOP is February 18, 1993. AcSEC encourages all interested parties to comment on any aspect of the proposal. AcSEC expects to issue a final statement later this year.

EXECUTIVE SUMMARY

* THE AICPA accounting standards executive committee (AcSEC) has an ongoing project to provide guidance on accounting for foreclosed assets.

* AcSEC's GOAL IS to eliminate diverse accounting practices and improve the understandability, comparability and relevance of financial statement disclosures.

* IN APRIL 1992, SOP no. 92-3, Accounting the Foreclosed Assets, was issued. It deals with the measurement of foreclosed assets in the balance sheet and should be applied to financial statements for periods ending after December 14, 1992.

* IN NOVEMBER 1992, a proposed SOP, Accounting for the Results of Operations of Foreclosed Assets Held for Sale, was issued. The proposed SOP provides guidance on how to account for the results of operating foreclosed assets held for sale.

* THE DEADLINE FOR commenting on the proposed SOP is February 18, 1993. AcSEC expects to issue a final SOP later this year

Ms. McNamee is an employee of the American Institute of CPAs and her views, as expressed in this article. do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.