Accounting 414 – Spring 2010 Professor Teresa Gordon

Loan Impairments & Troubled Debt Restructuring

Accounting by Creditors
ASC 310-40

Overview:

Debt may be restructured for a variety of circumstances.

Example:

Creditor reduces effective rate primarily because market rates have decreased and the debtor can borrow money elsewhere at a lower rate.

If a debtor can obtain funds from sources other than the existing creditor at market interest rates at or near those for non-troubled debt, it is not considered a troubled debt restructuring.

Troubled Debt Restructuring

ASC 310-40-15-5 A restructuring of a debt constitutes a troubled debt restructuring for purposes of this Subtopic 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.

ASC 310-40-15-6 That concession is granted by the creditor in an attempt to protect as much of its investment as possible. That concession either stems from an agreement between the creditor and the debtor or is imposed by law or a court; for example, either of the following circumstances might occur:

· a. A creditor may restructure the terms of a debt to alleviate the burden of the debtor's near-term cash requirements, and many troubled debt restructurings involve modifying !terms to reduce or defer cash payments required of the debtor in the near future to help the debtor attempt to improve its financial condition and eventually be able to pay the creditor.

· b. The creditor may accept cash, other assets, or an equity interest in the debtor in satisfaction of the debt though the value received is less than the amount of the debt because the creditor concludes that step will maximize recovery of its investment. Although troubled debt that is fully satisfied by foreclosure, repossession, or other transfer of assets or by grant of equity securities by the debtor is, in a technical sense, not restructured, that kind of event is included in the term troubled debt restructuring in this Subtopic.

ASC 410-40-15-7 Whatever the form of concession granted by the creditor to the debtor in a troubled debt restructuring, the creditor's objective is to make the best of a difficult situation. That is, the creditor expects to obtain more cash or other value from the debtor, or to increase the probability of receipt, by granting the concession than by not granting it.

Impairment

310-40-35-8 Paragraph 310-10-35-16 explains that a loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of 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. That paragraph explains that the related guidance does not specify how a creditor should determine that it is probable that it will be unable to collect all amounts due according to the contractual terms of a loan. …

“Probable” is defined in the same way the term is used in ASC 450 contingencies. 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.

This is a normal occurrence in a credit-granting environment. Creditors extend credit in a risky environment and there is a calculated probability that some of the loans will not be collected in full. Just as short-term receivables must be valued at their “net realizable value”, long-term loan portfolios must be similarly assessed.

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.

Lenders apply their normal loan review procedures establish allowance accounts for uncollectible loans and to identify loans that should be evaluated for collectibility.

Situations that do NOT constitute impairment:

An insignificant delay or insignificant shortfall in amount of payments is not considered an impairment. In addition, a loan is not impaired during a period of delay in payment if the creditor expects to collect all amounts due including interest accrued at the contractual interest rate for the period of delay. Thus, a demand loan or other loan with no stated maturity is not impaired if the creditor expects to collect all amounts due including interest accrued at the contractual interest rate during the period the loan is outstanding. [FAS114, ¶8]

Measuring impairment of a loan

Measure impairment based on the difference between the present value of expected future cash flows discounted at the loan's effective interest rate and the recorded investment in the loan.

Measurement requires judgment and estimates, and the eventual outcomes may differ from those estimates.

Creditors should have latitude to develop measurement methods that are practical in their circumstances.

The 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 in paragraph .

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.

Expected future cash flows

Creditors should 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.

If a creditor estimates a range for either the amount or timing of possible cash flows, the likelihood of the possible outcomes shall be considered in determining the best estimate of expected future cash flows. [FAS114, ¶15]

Recorded 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.

Alternative measurement basis permitted

The loan's observable market price, or

The fair value of the collateral if the loan is collateral dependent.

If foreclosure for a collateral dependent loan is probable, a creditor shall measure impairment based on the fair value of the collateral when the creditor determines that foreclosure is probable.

A loan is “collateral dependent” if the repayment of the loan is expected to be provided solely by the underlying collateral.

Measurement of loan values can be in aggregate or loan-by-loan

Some impaired loans may be evaluated in aggregate with other loans that have similar risk characteristics using historical statistics such as average recovery period and average amount recovered, along with a composite effective interest rate.

Other impaired loans have risk characteristics that are unique to an individual borrower, and the creditor will apply the measurement methods on a loan-by-loan basis.

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 ASC 450 (FASB 5) rules on contingencies, 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 next rule which precludes a valuation allowance that would make the net carrying value greater than the recorded investment in the loan.]

The net carrying amount of the loan shall at no time exceed the recorded investment in the loan.

Net 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.

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.

Impairment rules exclude:

Leases

Marketable debt securities

Large groups of smaller-balance homogeneous loans (credit cards, residential mortgages, etc.) that are collectively evaluated for impairment.

Certain loans measured at fair value( or lower of cost or fair value) under specialized industry practice standards.

Troubled Debt Accounting by Debtors

ASC 470-60

The entries are often different: the creditor’s basis in the note receivable may be different than the debtor’s carrying value for the note payable. That makes debtor accounting a totally different process which you will need to research if you are involved with the debtor-side of a troubled debt restructuring! The following flowchart is an introduction (but it has not been updated for the ASC).

I am NOT currently test the debtor side in Acct 414 but some of the older exams did. So be careful to study from the more recent exams posted.

Creditor Accounting Notes on Loan Impairments (ASC) S10.docx as of 2/1/10 Page 5