Accounting for Loans with Deteriorated Credit Quality – FAS ASC 310-30
Accounting for loans with deteriorated credit quality is one of instant payday loans online Mansfeild, OH the most complex accounting tasks financial institutions undertake. Proper accounting requires a thorough knowledge of the accounting standard, discounted cash flow techniques and loan valuation methodologies. We combine this knowledge with a realistic and practical perspective.
In our experience, most financial institution’s core systems cannot comply with the intricacies of FAS ASC 310-30. One alternative is to license FAS ASC 310-30 software to help perform the accounting, but many have found these solutions to be cost-prohibitive. Instead, we offer a comprehensive and cost-effective solution.
If we did not perform the initial fair value estimate, we begin with a thorough review of our client’s initial loan valuation to better understand the repayment risks and valuation input assumptions. We then discuss the loans with our client’s credit management personnel to determine if they agree with the valuation firm’s estimates regarding the extent and timing of the expected credit losses. Next, we discuss how our client plans to manage the loans and if they plan to extend the loans when the loans become due. This is critical because the discount rates on ASC 310-30 loans are often quite high, and probable extensions of loan term, if not properly considered upfront, can lead to significant losses later on even if the credit loss exposure stays the same or decreases. The loss arises from the effect of the present value discounting when pushing expected cash flows into the future.
Once we have a thorough understanding of the loans and our client’s expected credit management techniques, we determine the amount and timing of the cash flows expected to be collected. Through this process we identify the accretable and non-accretable yield on the loans. We help our clients identify the loans we believe should be accounted for at the loan level and those which we believe would benefit from pooling. Our reports show the loan amount, the valuation allowance, and the carrying value at the loan level. We also show the amounts of principal and interest collected, the amount of interest income recorded by their core system, and the amount of accretion income that should have been recorded – again all at the loan level. Our reports detail the journal entries to be made to properly account for the loans for the reporting period.
Loans acquired in a merger or acquisition are accounted for in two ways. If the acquirer expects to receive all of the loan’s contractual cash flows, it accounts for the loan and the related purchase discount or premium under FAS ASC 310-20 Receivables, Non-Refundable Fees and Other Costs. Interest income is recognized on a level-yield basis. Contractual interest income is accrued and the accrual is relieved when the payment is received. Meanwhile, the discount or premium is amortized or accreted. In our experience, accounting for this group of loans is “business as usual.”
If the loan has deteriorated in credit quality since origination and an acquirer does not expect to receive all of the contractual cash flows, then the loan must be accounted for under FAS ASC 310-30. In this case, the expected cash flows that exceed the initial investment in the loan (the fair value at acquisition) represent the accretable yield, which is recognized as interest income over the life of the loan. The accretable yield increases the carrying value of the loan and all cash received is treated as a reduction in the carrying value. FAS ASC 310-30 requires that a financial institution estimate the amounts and timing of the cash flows to be received. Thus, an acquirer needs to adjust the contractual cash flows for estimated prepayments, defaults, and the severity of a loss to be incurred on the liquidation of a foreclosure. The expected cash flow estimates must be updated periodically, and we recommend that it be done on a quarterly basis.
The allowance can be drawn back into income if the cash flows increase in a subsequent valuation
The accounting itself also leads to complexities. In our experience, our clients’ core systems will divide a payment received into contractual interest and principal. However, under the standard, the “interest” received should be accounted for as a reduction of the carrying amount of the loan. Therefore, we recommend that financial institutions account for their FAS ASC 310-30 loans “offline.”
Two additional accounting subtleties arise in connection with the re-estimates. If the expected cash flows increase, then the increase must be accounted for as an increase to the accretable yield – the yield is increased in order to account for the increase in cash flows over the expected life of the loan. Conversely, if the expected cash flows decrease, then the acquirer must establish a loan loss allowance to account for the drop.
Wilary Winn also notes that a financial institution can elect to perform the FAS ASC 310-30 accounting at the loan level or at a group level. Loans with similar characteristics can be pooled and accounted for as a single asset.
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The standard thus introduces two complexities – one relating to estimating the cash flows and the second relating to the accounting itself
TruStone Financial has used Wilary Winn’s services for valuation of mortgage servicing rights, mergers/acquisitions and goodwill impairment testing. The entire team at Wilary Winn is professional and very knowledgeable of […]