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SFAS 114 Accounting by Creditors for Impairment of a Loan

SHARING THE VISION™. SFAS 114 Accounting by Creditors for Impairment of a Loan. Jaime Boone, CPA Manager August 28, 2008. SHARING THE VISION™. Discussion Topics 2006 Interagency Policy Statement FAS 5, Accounting for Contingencies (1975)

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SFAS 114 Accounting by Creditors for Impairment of a Loan

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  1. SHARING THE VISION™ SFAS 114Accounting by Creditors for Impairment of a Loan Jaime Boone, CPA Manager August 28, 2008

  2. SHARING THE VISION™ Discussion Topics • 2006 Interagency Policy Statement • FAS 5, Accounting for Contingencies (1975) • FAS 114, Accounting by Creditors for Impairment of a Loan (1993) • Interagency Q&A • FAS 114 Example

  3. SHARING THE VISION™ Allowance for Loan and Lease Losses 2006 Interagency Policy Statement “The purpose of the ALLL is not to absorb all of the risk in the loan portfolio, but to cover probable losses that have already been incurred.”

  4. SHARING THE VISION™ Current Supervisory Guidance 2006 Interagency Policy Statement • Revision replaces 1993 policy statement to ensure consistency with GAAP (FAS 5 and FAS 114). • Applies to all depository institutions except U.S. branches of and agencies of foreign banks • “As of the end of each quarter, or more frequently if warranted, each institution must analyze the collectability of its loans and maintain an ALLL at a level that is appropriate and determined in accordance with GAAP.”

  5. SHARING THE VISION™ SFAS 5 • SFAS 5 defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. • SFAS 5 requires the accrual of a loss contingency when information available prior to the issuance of the financial statements indicates it is probable that an asset has been impaired at the date of the financial statements and the amount of the loss can be reasonably estimated. • A reserve may be considered in relation to individual loans or groups of similar types of loans.

  6. SHARING THE VISION™ SFAS 5 • Paragraph 23 : Collectability of Receivables • “If it is possible that the Company will not be able to collect all amounts due (principal and interest) in accordance with the contractual terms, then a loss contingency should be accrued. Whether the amount of loss can be reasonably estimated (the condition in paragraph 8(b)) will normally depend on, among other things, the experience of the enterprise, information about the ability of individual debtors to pay, and appraisal of the receivables in light of the current economic environment. In the case of an enterprise that has no experience of its own, reference to the experience of other enterprises in the same business may be appropriate.”

  7. SHARING THE VISION™ Interagency Policy Measurement of Estimated Credit Losses When measuring estimated credit losses on groups of loans with similar risk characteristics in accordance with FAS 5, a widely used method is based on each group’s historical charge off rate adjusted for the effects of the qualitative and environmental factors.

  8. Example FAS 5 Analysis

  9. SHARING THE VISION™ SFAS 114 • An individual loan is impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. • SFAS 114 does not specify how a creditor should identify loan to be evaluated for collectability.

  10. SHARING THE VISION™ SFAS 114 • Measure the impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate. • Loan’s observable market price; OR • Fair value of the collateral less costs to sell if the loan is collateral dependent • All loans that have been restructured are impaired since the original loan agreement has been modified and principal and interest will not be fully collected. • An insignificant delay (typically 90 days) does not mean that a loan is impaired.

  11. SHARING THE VISION™ Steps for determining FAS 114 component of the ALLL • Establish criteria for loans that will be reviewed individually. • Review loans to determine if any impairment. • Categorize impaired loans as collateral dependent, saleable or cash flow. • Sum the 3 categories, omitting the loans whose fair value exceeds their book value. The sum of the 3 categories less the outstanding balance on the loans to derive the amount for the FAS 114 component.

  12. FAS 114 Analysis

  13. SHARING THE VISION™ FAS 114 Disclosures • As of the date of each statement of financial position presented, the total recorded investment in the impaired loans at the end of each period and (1) the amount of that recorded investment for which there is a related allowance for credit losses determined in accordance with this Statement and the amount of that allowance and (2) the amount of that recorded investment for which there is no related allowance for credit losses determined in accordance with this Statement • The creditor's policy for recognizing interest income on impaired loans, including how cash receipts are recorded • For each period for which results of operations are presented, the average recorded investment in the impaired loans during each period, the related amount of interest income recognized during the time within that period that the loans were impaired, and, unless not practicable, the amount of interest income recognized using a cash-basis method of accounting during the time within that period that the loans were impaired.

  14. FAS 114 Disclosure - Bank of AmericaThe following table presents the recorded loan amounts, without consideration for the specific component of the allowance for loan and lease losses, that were considered individually impaired in accordance with SFAS 114 at December 31, 2007 and 2006. SFAS 114 impairment includes performing troubled debt restructurings and excludes all commercial leases.The average recorded investment in certain impaired loans for 2007, 2006 and 2005 was approximately $1.2 billion, $722 million and $852million, respectively. At December 31, 2007 and 2006, the recorded investment in impaired loans requiring an allowance for loan and lease losses based on individual analysis per SFAS 114 guidelines was $1.2 billion and $567 million, and the related allowance for loan and lease losses was $123 million and $43 million. For 2007, 2006 and 2005, interest income recognized on impaired loans totaled $130 million, $36 million and $17 million, respectively, all of which was recognized on a cash basis.At December 31, 2007 and 2006, nonperforming loans and leases, including impaired and nonaccrual consumer loans, totaled $5.6 billion and $1.8 billion. In addition, included in other assets were consumer and commercial nonperforming loans held-for-sale of $188 million and $80 million at December 31, 2007 and 2006.The Corporation has loan products with varying terms (e.g., interest-only mortgages, option adjustable rate mortgages, etc.) and loans with high loan-to-value ratios. Exposure to any of these loan products does not result in a significant concentration of credit risk. Terms of loan products, collateral coverage, the borrower’s credit history, and the amount of these loans that are retained on the Corporation’s balance sheet are included in the Corporation’s assessment when establishing its allowance for loan and lease losses.

  15. SHARING THE VISION™ Interagency Q&A • #2 How should an institution identify loans to be evaluated for impairment under SFAS 114? Answer: An institution should apply its normal review procedures including watch list, past due report, overdraft listings, loans to insiders, historical loss experience, loan files lacking current financial data related to borrowers and guarantors, borrowers experiencing financial difficulty. Also, consider examination reports and materiality.

  16. SHARING THE VISION™ Interagency Q&A • #3 If an institution concludes that an individual loan specifically identified for evaluation is NOT impaired under SFAS 114, should that loan be included in the assessment of the ALLL under SFAS 5? Answer: Yes, if the specific characteristics of the individually evaluated loan that is not impaired indicate that it is probable that there would be an incurred loss in a group of loans with those characteristics, then the loan should be included in the assessment of the ALLL for that group of loans under SFAS 5.

  17. SHARING THE VISION™ Interagency Q&A • #4 If an institution assesses an individual loan under SFAS 114 and determines that it is impaired, but it measures the amount of the impairment as zero, may it include that loan in a group of loans collectively assessed under SFAS 5 for estimation of the ALLL? Answer: No, for an individual loan that is impaired, no additional loss is appropriate under SFAS 5 even if the measurement of impairment results in no allowance.

  18. SHARING THE VISION™ Interagency Q&A • #11 Are all substandard loans individually impaired loans that should be evaluated under SFAS 114? Answer: No, for an individual loan that is impaired, no additional loss is appropriate under SFAS 5 even if the measurement of impairment results in no allowance.

  19. SHARING THE VISION™ FAS 114 Example Hatz’s Hamburger Stand missed the last three payments on its loan to Small Bank.  The original loan was for $100,000, and the current balance is $90,000.  Although the collateral for the loan, the restaurant building itself, has an appraised value of $107,000, the management of Small Bank believes the bank will be lucky to find a buyer who will pay $100,000.  Management estimates that the building may take as long as a year to sell.  The utilities for the building are projected to be about $200 a month.  To improve the chances of a sale, the bank will have the building’s exterior repainted, for a cost of $6,000.  The bank will also have to pay a realtor a 10 percent commission to sell the building, the going rate for commercial property sales. Finally, management believes that the bank would have earned an 8 percent return on the money tied up in the building if it had been available to lend. If the loan is impaired, how much should Small Bank increase its provision to cover the expected loss on the loan? Assume the loan is categorized as collateral dependent for your analysis. A. $8,400   B. $15,600   C. $6,000   D. $8,600  

  20. SHARING THE VISION™ FAS 114 Example The correct answer is $8,400. This is the appraised value $107,000; less $7,000 (the bank believes it can only get $100,000 out of the building because it is the seller); less $2,400 for utilities for a year; less $6,000 for a paint job; less $10,000 sales commission = $81,600.  With a loan balance of $90,000, the amount of expected loss is thus $8,400 ($90,000-81,600).  The lost interest income is not used in the loss calculation.

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