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Practice Bulletin no. 7 criteria for determining whether collateral for a loan has been in-substance foreclosed.


Accounting standards have produced several approaches to assessing whether collateral for a loan has been in-substance foreclosed. C. Harril Whitehurst, Jr., CPA, a partner of BDO Seidman, Richmond, Virginia, and a member of the American Institute of CPAs savings and loan associations committee, discusses how the AICPA practice bulletin on the subject addresses the issue. Last year, the American Institute of CPAs accounting standards executive committee (AcSEC) undertook a project to examine how losses on loans collateralized by real estate and on certain real estate owned were being determined under current guidance. The project was undertaken because there is diverse guidance in the authoritative accounting literature. This diversity has focused primarily on the difference between guidance for savings and loans and that for banks.

AcSEC, therefore, formed a task force to address three issues that are related to the recording of losses on collateralized loans:

1. How to determine whether collateral for a loan has been in-substance foreclosed.

2. If collateral for a loan has not been in-substance foreclosed, whether lenders should discount estimated cash flows from collateral to determine if a loss is recorded.

3. If collateral has been foreclosed or in-substance foreclosed, how such assets should be reported--in particular, whether discounting should be used in determining their value.

The task force drafted a proposed statement of position addressing these three issues. However, AcSEC then decided it was not desirable for them to resolve the issues dealing with discounting; they thought the Financial Accounting Standards Board should deal with the discounting issues.

AcSEC, however, did reach a conclusion on the in-substance foreclosure issue and issued a new practice bulletin no. 7, Criteria for Determining Whether Collateral for a Loan Has Been In-Substance Foreclosed,.

Paragraphs 34 and 84 of FASB Statement no. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, raise the issue of in-substance foreclosure. They require loss recognition based on the fair value of the collateral that is in-substance foreclosed. However, they do not provide specific criteria for what constitutes in-substance foreclosure. The only authoritative guidance previously available was the Securities and Exchange Commission's Financial Reporting Release no. 28, issued in December 1986, which provides, among other things, specific criteria for determining whether an in-substance foreclosure has occurred. The SEC issued FRR no. 28 because it recognized registrants needed additional guidance on this issue to ensure consistent reporting. However, this release applies only to public companies reporting to the SEC.

The new practice bulletin no. 7 begins discussion of the in-substance foreclosure issue by indicating a creditor should determine if an in-substance foreclosure has occurred when it is probable the creditor will not receive all the promised payments on the collateralized loan. This determination must be made before evaluating the allowance for loan loss under FASB Statement no. 5, Accounting for Contingencies, because, if an in-substance foreclosure has taken place, the reporting of the asset would change from that for a loan receivable to that for the collateral.

AcSEC concluded in the practice bulletin the criteria for determining if an in-substance foreclosure has taken place should be the same as those in FRR no. 28. The criteria, all of which must be met, are:

* The debtor has little or no equity in the collateral, considering its fair value. (Fair value is defined in paragraph 13 of FASB Statement no. 15 as "the amount that the debtor could reasonably expect to receive . . . in a current sale between a willing buyer and a willing seller, that is, other than in a forced or liquidation sale.")

* Proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral.

* The debtor has either formally or effectively abandoned control of the collateral to the creditor or the debtor has retained control but it is doubtful the debtor can rebuild equity in the collateral in the foreseeable future because of either the debtor's current financial condition or the economic prospects for the collateral.

Before discussing the financial reporting of an in-substance foreclosure, it is important to focus on what the practice bulletin no. 7 says about meeting the three criteria stated above.

First, as the SEC's FRR no. 28 did, the new practice bulletin no. 7 indicates a creditor should, in evaluating the first two criteria, look to the guidance in the AICPA's February 10, 1986, notice to practitioners that's related to accounting for real estate acquisition, development or construction (ADC) arrangements. That notice provides guidance about whether ADC arrangements should be reported as loans, investments in real estate or investments in joint ventures. The guidance in the new bulletin concludes that, if the characteristics outlined in paragraph 8 of the notice imply investments in real estate or joint ventures exist for the loan being evaluated, then the first two criteria for in-substance foreclosure likely will be met. The characteristics outlined in the ADC notice are:

* The debtor has little or no equity in the collateral.

* The creditor funds origination and commitments fees by including them in the loan amount.

* The creditor funds substantially all interest and fees during the term of the loan by adding them to the loan balance.

* The only security for the loan is the ADC project itself.

* For the creditor to recover its investment, the property must be sold to outsiders, the debtor must obtain outside financing or the property must be placed in service and generate sufficient cash flow from operations to service the debt.

* The loan is structured so foreclosure during the project's development as a result of delinquency is not likely to occur because the debtor is not required to make any payments until after the project is complete.

As the accounting and financial institution community has become familiar with evaluating these characteristics in applying the provisions of this notice to ADC transactions, evaluating whether the first two criteria have been met should not be too difficult.

The new practice bulletin no. 7 also points out the second criterion, which deals with the source of loan repayment, may always be met for certain loans.

It is common practice for creditors to underwrite a loan expecting repayment of that loan from cash flows from operations or sale of the collateral. However, the recent practice bulletin indicates if such a loan meets both the other criteria, then the collateral should be considered in-substance foreclosed.

The third criterion recognizes continuing debtor commitment to repay the loan is a factor in determining whether an in-substance foreclosure has occurred. The first part of that criterion--the debtor has formally or effectively given up control to the creditor--should be relatively easy to determine. However, the second part of the third criterion, which relates to whether the debtor can rebuild equity in the collateral in the foreseeable future, is more subjective than the first. The practice bulletin concludes this criterion would be met unless the creditor has evidence that it is probable the debtor can build or rebuild equity in the collateral in the foreseeable future. In evaluating the debtor's ability to build or rebuild equity, the recent practice bulletin allows consideration to be given to the tax aspects of the transaction; for example, if foreclosure would result in a substantial negative tax effect for the debtor, he or she would be less likely to walk away from the project.

One word of caution. FRR no. 28, in trying to use a forecast of future economic events to establish that the debtor can rebuild equity in the project, points out it is difficult to establish the reliability of assumptions that are used in forecasts and these assumptions become less reliable as the evaluator looks further into the future.

The new practice bulletin no. 7 also addresses the financial reporting of an in-substance foreclosure. If it is determined a particular loan meets the criteria for an in-substance foreclosure, the loan should be accounted for in accordance with paragraph 34 of FASB Statement no. 15; that is, the carrying amount of the loan should be written down to the fair value of the collateral and reclassified according to the type of collateral that has been in-substance foreclosed.

The new practice bulletin no. 7 points out conditions may change so that a loan that was considered in-substance foreclosed may, in the future, no longer meet the criteria for an in-substance foreclosure. For example, the practice bulletin requires any excess estimated cash receipts over the carrying amount of the asset to be amortized to income over the life of the loan, even if this results in reporting an unusually high interest rate. The original writedown should not be reversed. However, the new practice bulletin no. 7 says a turnaround in market conditions or the financial conditions of the debtor to such an extent the criteria would not be met would probably be rare and would require substantial supporting evidence.

Finally, FRR no. 28 appears to emphasize an active market value is a better indicator of the fair value of collateral, even if that market is only composed of speculators or sellers in financial difficulty. So beware of using derived values based on expectations of future economic changes in the value of collateral to establish fair value. Before using any kind of projections, always look first to see if any active market exists for the collateral.

Paul Rosenfield, CPA director, AICPA accounting standards division

Frederick Gill, CPA technical manager, AICPA accounting standards division
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Article Details
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Author:Whitehurst, C. Harril, Jr.
Publication:Journal of Accountancy
Date:Jun 1, 1990
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