New FASB rule clarifies loan impairment.
Over the past several years, the Accounting Standards Executive Committee (AcSEC), General Accounting Office (GAO), Federal Deposit Insurance Corporation (FDIC), and others have voiced concern about the practices used by creditors to account for loan losses. Some lenders recognize loss to the extent a loan's net carrying amount exceeds its undiscounted expected future cash flows. However, others measure loan impairment based on discounted cash flows. In response to the inconsistency, the Financial Accounting Standards Board (FASB) issued Statement No. 114, Accounting by Creditors for Impairment of a Loan. The new statement, which requires that loan impairment be recognized on a discounted basis, should help to standardize the measurement of loan losses in the financial services industry.
While the new standard should enhance comparability in loan-impairment reporting among creditors, Statement No. 114 left a set of issues on the table that include:
What is a charge-off and is it necessary?
What is the purpose of accrual versus non-accrual categories, and are there still such things as non-performing loans?
If a bond is restructured, does SFAS No. 114 apply?
Are allowances for loan losses, pursuant to FASB Statement No. 5, Accounting for Contingencies, required above the valuation allowance on loans within the scope of SFAS No. 114?
For loans where the fair value of the collateral has been used to measure impairment, what type of change in circumstances justifies changing to a discounted cash flow approach?
If a loan's observable market price (or fair value of collateral) exceeds its recorded investment, should a gain be recorded?
What financial disclosures (in addition to that required by SFAS No. 114) concerning the credit aspects of a loan portfolio should financial institutions that file with the Securities Exchange Commission (SEC) consider reporting?
Delays or Shortfalls Don't Trigger Statement
Under Statement No. 114, a loan is considered to be impaired when it is probable that contractual interest and contractual principal will not be collected according to the terms of the loan agreement. An insignificant delay or insignificant shortfall in amount of payments are not circumstances that warrant application of Statement 114.
Once it is determined that a loan is impaired, a creditor measures loss based on expected future cash flows as discounted at the loan's original effective interest rate. The use of a discounted approach is consistent with generally accepted accounting principles (GAAP) that require creditors to incorporate the time value of money in measuring receivables. Under current rules, the recorded investment in a loan at any time during its term equates to the present value of contractual interest and principal obligation as long as the receivable performs according to the loan agreement. For example, a $20,000 loan for five years at 5 percent annual interest would have a recorded amount of $20,000, the sum of the present values of annual interest ($4,329) and principal ($15,671), at origination. After two years, the $20,000 recorded amount equates to the present value of principal obligation ($17,277), plus the present value of interest ($2,723).
Impairment loss also may be measured based on the loan's observable market price, if one exists, or the fair value of the collateral for collateral-dependent loans. If the resultant present value of anticipated future cash flows (or observable market price or fair value of collateral) is less than the loan's carrying amount, an impairment loss is recognized for the shortfall. An impairment should be recorded through a valuation allowance with a corresponding charge to bad-debt expense.
The measurement of loan impairment is not a one-time event. FASB No. 114 requires that an impaired loan's net carrying value be revised, at each reporting date subsequent to impairment, to reflect the present value of expected future cash flows (or current market price or current fair value of collateral). However, an impaired loan's net carrying amount should never exceed its recorded investment.
Look for the Warning Signs
Statement No. 114 does not specify how a creditor should identify loans that are to be evaluated for collectibility. The decision requires professional judgment and is influenced by a creditor's normal loan review procedures. However, Statement No. 114 does indicate that sources of information useful in identifying loans for evaluation that are listed in the AICPA's Auditing Procedure Study, Auditing the Allowance for Credit Losses of Banks, include a specific materiality criterion; regulatory reports of examination; internally generated lists such as "watch lists," past due credit reports, overdraft listings, and listings of loans to insiders; management reports of total loan amounts by borrowers and grantors; and borrowers experiencing problems, such as operating losses, marginal working capital, inadequate cash flow, or business interruptions. Other sources cited in the study are loans secured by collateral that is not readily marketable or that is susceptible to deterioration in realizable value; loans to borrowers in industries or countries experiencing economic instability; and loan documentation and compliance exception reports.
Charge-Offs Are Not Included in FASB Rule
The term charge-off is defined as the elimination by transfer to expense of a portion or all of the balance of an account in recognition of the expiration of any continuing value. Most charge-offs require authorizations at top-management levels. If a valuation allowance has been established as a reduction of a specific loan prior to its being charged off, it is eliminated against the loan balance during a direct write-off.
In its deliberations culminating in the issuance of Statement No. 114, the Board concluded that because of the subjectivity inherent in the valuation of an impaired loan and because estimates in the amount and timing of an impaired loan's cash flows (or observable market price or fair value of collateral) may change, impairment should be recognized through a valuation allowance. The valuation allowance subsequently may change to reflect changes in the measure of an impaired loan.
The FASB chose not to include charge-offs within the scope of Statement No. 114 because the standard is applicable to all enterprises, not just banks and thrifts, and decisions on charge-offs are often made as a result of an enterprise's desire to establish a deduction for tax purposes. Further, regulators of financial institutions have different rules or require different policies with respect to charge-offs. Subsequent to the adoption of Statement No. 114, it is expected that direct charge-offs will continue to be made at the discretion of management or regulators. Subsequent a charge-off, recoveries of amounts written-off are not allowed under GAAP.
Loan Charges Are Risky
The designations "accrual" and "non-accrual" are used by financial institutions to segregate their loan portfolios. The practice developed as a result of regulatory directives and examiners' need to assess a financial institution's liquidity and the amount of risk in its loan portfolio. The non-accrual classification assists regulators in evaluating liquidity and risk since it identifies loans that are not performing according to their contractual terms (non-performing loans).
What changes regulators will make to the non-accrual loan classification requirements, in the wake of Statement no. 114, remain to be seen. On June 10, 1993, the four federal banking agencies (Office of the Comptroller of the Currency, FDIC, Federal Reserve Board, and Office of Thrift Supervision) issued an Interagency Policy Statement on Credit Availability. The guidance revises certain regulations involving non-accrual loans, acknowledging the issuance of Statement No. 114 and concluding that in light of the significant changes that will be required as a result of its adoption, the agencies are re-evaluating regulatory disclosure and non-accrual requirements that will apply when the statement becomes effective. The agencies indicated in the statement that they expect to issue revised policies later.
Creditors Must Measure Restructured Receivables
Under Statement No. 114, a loan also is impaired when its original terms are modified in a troubled-debt restructuring. Thus, the new standard amends Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, by requiring that creditors measure all receivables that are restructured in a troubled debt restructuring involving a modification in terms according to the provisions of Statement No. 114. Statement No. 15 includes bonds in its definition of receivables, which may suggest that Statement No. 114 applies when a bond is restructured. However, paragraph 6(d) of Statement No. 114 states that debt securities, as defined by Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (bonds included in definition), are not within its scope.
A recent issue of Highlights of Financial Reporting Issues prepared by the FASB staff indicated that Statement No. 114 does not apply to bonds that are restructured. Further, paragraph 16 of Statement No. 115 states that when it is probable that an investor will be unable to collect all amounts due according to the contractual terms of the debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred. In such circumstances, an other-than-temporary impairment usually should be recognized prior to a troubled debt restructuring.
FASB 5 and FASB 114 Allowances May Apply
Since FASB Statement No. 5, Accounting for Contingencies, includes, in its examples of loss contingencies, the collectibility of receivables, there may be some concern that GAAP embraces an additional allowance for loan losses beyond that required under Statement No. 114. This is not the case; for loans evaluated under the new standard, no additional allowance for losses pursuant to FASB Statement No. 5 is required. However, for receivables outside of the new standard, such as consumer-installment loans, residential mortgages, or credit-card loans, paragraph 22 of Statement No. 5 requires that loan losses be accrued when both conditions (probably an asset has been impaired and the amount of loss can be reasonably estimated) described in the statement are met. Thus, the total loss reserve on a loan portfolio may comprise Statement No. 114's valuation allowance and an allowance established under the provisions of Statement No. 5.
Discounted Approach Benefits Creditors
Statement No. 114 requires a lender to measure impairment based on the fair value of the collateral when it is determined that foreclosure is probable. However, there are circumstances that would justify changing the measurement method from fair value to the discounted cash flow approach. For example, a change may be warranted when a reasonable estimate of fair value cannot be made or when foreclosure is no longer probable. A change in method also might be appropriate when a loan has been restructured with a modification in terms and, as a result, the creditor is now able to make reasonable estimates of expected cash flows.
Creditors who change impairment measurement from fair value of the collateral to the discounted cash flow approach will benefit. Under the provisions of Statement No. 114, creditors who measure impairment based on the fair value of the collateral do not accrue interest income on the loan. However, under the discounted cash flow approach, accrued interest income is recognized at the loan's effective interest rate.
How a Valuation Allowance Works
Under the new rules, a valuation allowance is created or adjusted only if the measure of the impaired loan is less than the recorded investment in it. No gain is recognized if a loan's observable market price (or fair value of collateral) is greater than its recorded investment. For example, assume an enterprise, at Dec. 31, 19XX, appropriately recognizes an impairment loss of $2,000 after comparing a loan's observable market price of $4,000 with its recorded investment of $6,000 at that date. A year later, assume that the loan's recorded investment and observable market price are $5,000 and $5,500, respectively. This results in a reduction of $2,000 in the amount of bad-debt expense that would otherwise be reported. The enterprise is proscribed from writing up the receivable $500 and recognizing a gain for that amount.
SEC Recommends Additional Disclosures
Financial institutions that file with the SEC are required to make disclosures about the credit aspects of loans according to the requirements enumerated in the Commission's Guide 3. Presently, the SEC staff is preparing recommendations to the Commission that would revise the Guide to reflect changes brought about by the issuance of Statement No. 114. The SEC staff reports that if financial institutions adopt the new standard before Guide 3 has been revised, they should consider making the following financial disclosures in addition to that required under Statement No. 114:
1. A table of impaired loans by type of loan;
2. The total amount of impaired loans measured using the present value of expected future cash flows; the fair value of the loans' collateral; and the observable market price of the loans;
3. A description of the factors that influenced management's judgment in determining whether a loan was impaired, including a description of the minimum period of delay without payment that can occur before a loan is considered impaired. That means that the disclosures should describe the process or methods used to determine whether a loan is impaired; and
4. Disclosures of the impact that the adoption of Statement No. 114 has on the comparability of the credit risk tables.
End Justifies Costs
The new standard is effective for fiscal years beginning after Dec. 15, 1994, although earlier adoption is encouraged. A creditor who elects early adoption of Statement No. 114 during an interim period other than the first must restate all prior interim periods of that fiscal year. While the Board acknowledges the benefits of comparable financial statements, it prohibits retroactive application of the new standard. The Board questions whether a creditor has the ability to measure impairment loss for an earlier reporting period based on recollection of events and circumstances that existed at that time.
The costs (incremental or other costs) to implement Statement No. 114 may be considerable, but consistent credit impairment accounting is important to achieving relevant and comparable financial information. Diversity in credit impairment accounting among industries--when lending transactions are similar--confuses users and inevitably leads to a conclusion that one or more of the methods is inferior.
William J. Read, Ph.D., CPA, is professor of accountancy and K. Raghunandan, Ph.D., is assistant professor of accountancy at Bentley College, Waltham, Mass. Robert A. J. Bartsch, CPA, is senior manager of Deloitte & Touche, Wilton, Conn.
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|Title Annotation:||Financial Accounting Standards Board's Statement 114|
|Author:||Read, William J.; Bartsch, Robert A.J.; Raghunandan, K.|
|Date:||Jul 1, 1994|
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