Volume 1 Issue 4
Accounting for Loan Impairment and Troubled Debt Restructuring (TDR) – Part I
Loan impairment is an inherent risk in a credit-granting environment. Lenders extend credit in a risky environment and there is a calculated probability that some of the loans will not be collected in full. A loan is impaired when, based on current information and events, it is probable1 that the creditor will be unable to collect all amounts due according to the contractual terms2 of the loan agreement.
BusinessDictionary.com defines debt restructuring generically and from a borrower’s standpoint as “Court ordered or mutual agreement, between a financially troubled firm and its creditors, to reorganize its liabilities as a more feasible alternative to foreclosure or liquidation. Debt restructuring may involve debt forgiveness, debt rescheduling, and/or conversion of a portion of debt into equity”. In the business world, debt may be restructured for a variety of circumstances. For example, a creditor may reduce effective rate primarily because market rates have decreased and the debtor can borrow money elsewhere at a lower rate.
A restructuring of debt is considered a TDR if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider. A debtor in a TDR can obtain funds from sources other than the existing creditor in the troubled debt restructuring, if at all, only at prevailing market interest rates typically so high that it cannot afford to pay them. Thus, in an attempt to protect as much of its investment as possible, the creditor in a TDR grants a concession to the debtor that it would not otherwise consider. The concession made by the creditor may arise from an agreement between the creditor and the debtor or it may be imposed by law or court.
Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan, (SFAS 114), as codified in FASB ASC 310-10-35, and Statement of Financial Accounting Standards No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures, (SFAS 118), provide standards for evaluating the existence of impairment in the value of investments in loans. Based on these standards, creditors should consider all currently available financial and qualitative information as well as be aware of situations that do not constitute impairment or TDR. Examples of situations that do not constitute impairment include an insignificant delay or insignificant shortfall in amount of payments and situations where a creditor expects to collect all amounts due including interest accrued at the contractual interest rate for the period of delay. An example of situations that do not constitute troubled debt restructuring would be situations where a debtor can obtain funds from sources other than the existing creditor at market interest rates at or near those for non-troubled debt.
Lenders apply their normal loan review procedures to establish loan loss reserves for uncollectible loans and to identify loans that should be evaluated for collectibility. A regular refreshing and review of borrowers’ credit scores may be very helpful in identifying potential problem loans.
Measuring Impairment of a Loan
In general, measuring loan impairment requires judgment and estimates, and the eventual outcomes may differ from those estimates. Creditors typically have latitude to develop measurement methods that are practical in their circumstances.
One way to measure impairment is to calculate the difference between the present value of expected future cash flows discounted at the loan's effective interest rate3 and the recorded investment in the loan4.
In estimating future cash flows, creditors typically use their best estimate based on reasonable and supportable assumptions and projections. All available evidence, including estimated costs to sell if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan, should be considered. The weight given to the evidence should be commensurate with the extent to which the evidence can be verified objectively. SFAS 114, paragraph 15 requires that the likelihood of the possible outcomes be considered in determining the best estimate of expected future cash flows, if a creditor estimates a range for either the amount or timing of possible cash flows.
Other measurement bases permitted include the loan's observable market price or the fair value of the collateral if the loan is collateral dependent5. If foreclosure for a collateral dependent loan is probable, a creditor must measure impairment based on the fair value of the collateral when the creditor determines that foreclosure is probable.
Recognizing Impairment Losses
When the present value (or alternative measurement) of the loan investment is less than the recorded value, create a valuation allowance with a corresponding charge to bad debt expense or adjust an existing valuation allowance for the impaired loan with a corresponding charge or credit to bad-debt expense.
Under Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, (SFAS 5), as codified in FASB ASC 450-10 to 20, creditors should also maintain “allowance for credit losses” accounts related to loans that do not meet the impairment criteria.
Subsequent Evaluation of Impaired Loans
Due to various methods of recognizing interest income on impaired loans (i.e., cost-recovery method, a cash-basis method, etc.); the recorded investment in an impaired loan may be less than the present value of expected future cash flows (or an alternative measurement basis). In this case, no additional impairment would be recognized.
The recorded investment in an impaired loan also may be less than the present value of expected future cash flows (or an alternative measurement basis) because the creditor has charged off part of the loan. Again, in this case, no additional impairment would be recognized nor should the allowance provided be decreased because of the rule that precludes a valuation allowance that would make the net carrying amount6 of the loan greater than the recorded investment in the loan. Specifically, SFAS 114, paragraph 16 states, among others things, that the net carrying amount of the loan shall at no time exceed the recorded investment in the loan.
Significant Changes in Conditions
Subsequent to the initial measurement of impairment, if there is a significant change (increase or decrease) in the amount or timing of an impaired loan's expected future cash flows, or if actual cash flows are significantly different from the cash flows previously projected, the creditor shall recalculate the impairment by applying the procedures described earlier and making adjustments to the valuation allowance.
SFAS 114 (FASB ASC 310-10-35) impairment rules exclude (1) leases (2) marketable debt securities (3) large groups of smaller-balance homogeneous loans (credit cards, residential mortgages, etc.) that are collectively evaluated for impairment and (4) certain loans measured at fair value (or lower of cost or fair value) under specialized industry practice standards.
Our next issue will include Accounting for Loan Impairment and Troubled Debt Restructuring (TDR) – Part II, a continuation of this article.
Allen DeLeon, CPA
Lutamila Sallu, CPA
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1“Probable” is defined in the same way the term is used in Statement of Financial Accounting Standards No. 5 (SFAS 5) regarding contingent liabilities. Virtual certainty of a loss is not necessary. The rules require only that it be probable that an asset has been impaired or a liability has been incurred and that the amount of loss be reasonably estimable.
2As used in SFAS 114, paragraph 8, “amounts due according to the contractual terms” means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement. For a loan that has been restructured in a troubled debt restructuring, the contractual terms of the loan agreement refers to the contractual terms specified by the original loan agreement, not the contractual terms specified by the restructuring agreement. [SFAS 118, paragraph 6(a)]
3The effective interest rate of a loan is the rate of return implicit in the loan (that is, the original contractual interest rate adjusted for any net deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the loan). A loan may be purchased at a discount due to changing interest rates or a change in credit quality. The effective interest rate is the discount rate that equates the present value of the investor’s estimate of the loan’s future cash flows (at the date of purchase) with the purchase price of the loan. The effective interest rate for a loan restructured in a troubled debt restructuring is based on the original contractual rate, not the rate specified in the restructuring agreement. If the contractual rate is a floating rate tied to an index like U.S. Treasury bill weekly average, the loan's effective interest rate may be calculated based on the factor as it changes over the life of the loan, or may be fixed at the rate in effect at the date the loan meets the impairment criterion. Creditor’s choice is to be applied consistently and projects of changes in the index rate should not be used to determine the effective interest rate.
4Recorded investment in the loan includes accrued interest, net deferred loan fees or costs, and unamortized premium or discount. It excludes any valuation allowance associated with the loan. The amount is reduced by any direct write-down of the investment.
5A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral.
6Net carrying amount of the loan is the sum of all accounts related to the loan including any valuation allowance. Note that the difference between “recorded investment” and “net carrying amount” is the valuation allowance.