Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
individual appraisal and, in all cases, the applicable
unearned income discount should be deducted when such
loans are classified.
Impaired Loans, Troubled Debt
Restructurings, Foreclosures and
Repossessions
Loan Impairment - A loan is impaired when, based on
current information and events, it is likely that an
institution will be unable to collect all amounts due
according to the contractual terms of the loan agreement
(i.e., principal and interest). The accounting standard for
impaired loans is set forth in FAS 114, Accounting by
Creditors for Impairment of a Loan as amended by FAS
118, Accounting by Creditors for Impairment of a Loan -
Income Recognition and Disclosures. FAS 114 applies to
all loans, except large groups of smaller-balance
homogenous loans that are collectively evaluated for
impairment and loans that are measured at fair value or the
lower of cost or fair value.
When a loan is impaired under FAS 114, the amount of
impairment should be measured based on the present value
of expected future cash flows discounted at the loan’s
effective interest rate (i.e., the contractual interest rate
adjusted for any net deferred loan fees or costs and
premium or discount existing at the origination or
acquisition of the loan). As a practical expedient,
impairment may also be measured based on a loan’s
observable market price, or the fair value of the collateral,
if the loan is collateral dependent. A loan is collateral
dependent if repayment is expected to be provided solely
by the underlying collateral and there are no other
available and reliable sources of repayment.
If the measure of a loan calculated in accordance with FAS
114 is less than the book value of that loan, impairment
should be recognized as a valuation allowance against the
loan. For regulatory reporting and examination report
purposes, this valuation allowance is included as part of the
general allowance for loan and lease losses. In general,
when the excess amount of the loan’s book value is
determined to be uncollectible, this excess amount should
be promptly charged-off against the ALLL. When a loan is
collateral dependent, any portion of the loan balance in
excess of the fair value of the collateral (or fair value less
cost to sell) should similarly be charged-off.
Troubled Debt Restructuring - Troubled debt
restructuring takes placed when a bank grants a concession
to a debtor in financial difficulty. The accounting
standards for troubled debt restructurings are set forth in
FAS 15, Accounting by Debtors and Creditors for
Troubled Debt Restructurings, as amended by FAS 114.
In certain situations FASB 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, also applies.
It is the FDIC’s policy that restructurings be reflected in
examination reports in accordance with this accounting
guidance. In addition, banks are expected to follow these
principles when filing the Call Report.
Troubled debt restructurings may be divided into two
broad groups: those where the borrower transfers assets to
the creditor to satisfy the claim, which would include
foreclosures; and those in which the terms of a debtor’s
obligation are modified, which may include reduction in
the interest rate to an interest rate that is less than the
current market rate for new obligations with similar risk ,
extension of the maturity date, or forgiveness of principal
or interest. A third type of restructuring combines a receipt
of assets and a modification of loan terms. A loan
extended or renewed at an interest rate equal to the current
interest rate for new debt with similar risk is not reported
as a restructured loan for examination purposes.
Transfer of Assets to the Creditor - A bank that receives
assets (except long-lived assets that will be sold) from a
borrower in full satisfaction of the book value of a loan
should record those assets at fair value. If the fair value of
the assets received is less than the institution’s recorded
investment in the loan, a loss is charged to the ALLL.
When property is received in full satisfaction of an asset
other than a loan (e.g., a debt security), the loss should be
reflected in a manner consistent with the balance sheet
classification of the asset satisfied. When long-lived assets
that will be sold, such as real estate, are received in full
satisfaction of a loan, the real estate is recorded at its fair
value less cost to sell. This fair value (less cost to sell)
becomes the “cost” of the foreclosed asset.
To illustrate, assume a bank forecloses on a defaulted
mortgage loan of $100,000 and takes title to the property.
If the fair value of the realty at the time of foreclosure is
$90,000 and costs to sell are estimated at $10,000, a
$20,000 loss should be immediately recognized by a
charge to the ALLL. The cost of the foreclosed asset
becomes $80,000. If the bank is on an accrual basis of
accounting, there may also be adjusting entries necessary
to reduce both the accrued interest receivable and loan
interest income accounts. Assume further that in order to
effect sale of the realty to a third party, the bank is willing
to offer a new mortgage loan (e.g., of $100,000) at a
concessionary rate of interest (e.g., 10 percent while the
market rate for new loans with similar risk is 20 percent).
Before booking this new transaction, the bank must
establish its "economic value". Pursuant to Accounting
Principles Board Opinion No. 21 (APB 21, Interest on
Receivables and Payables), the value is represented by the
sum of the present value of the income stream to be
DSC Risk Management Manual of Examination Policies 3.2-47 Loans (12-04)
Federal Deposit Insurance Corporation