Evaluating ASC 310-10-35 (FAS 114) loans for impairment and identifying the reserve for each one of those individually assessed loans is one of the most critical steps in the ALLL calculation process.
A loan is evaluated for ASC 310-10-35 (FAS 114) status when it is considered impaired, which means the creditor has some expectation that the repayment of the loan will not be realized in full. The resulting reserve for this particular loan would be the amount of loss that can be reasonably estimated. If the loss was actual, then the loan loss should be partially or completely charged off – the emphasis on what is probable and estimated versus actual comes from this difference.
There are three methods of evaluating ASC 310-10-35 (FAS 114) impairments. These consist of:
- Fair Market Value of Collateral (for collateral-dependent loans)
- Present Value of Future Cash Flows
- Loan Pricing
Fair Market Value of Collateral
This is the most widely used method of evaluating a loan for impairment. This method is collateral-dependent, meaning it assumes the loan will be repaid through the liquidation of the collateral. When the borrower is no longer able to service the debt through payments, the creditor looks at the collateral as the source of repayment. The amount the institution expects to recover is the value of the collateral, minus any liquidation costs such as selling costs, transfer taxes, legal fees, or maintenance costs. Also, a current appraisal should be used to estimate the value of the collateral.
Present Value of Future Cash Flows
Another method used to evaluate FAS 114 loans is the Present Value of Future Cash Flows. This method should be sued when there is an expectation of cash payments from the borrower, such as troubled debt restructures (TDRs). The Present Value of Future Cash Flows evaluation should use the effective (original, contractual) interest rate as the discount rate for the cash flows. For the analysis, the institution should set up a month-by-month payment schedule with each month discounted appropriately. The total impairment is evaluated by subtracting the total cash flows available from the total recorded investment. This method can become subjective since the creditor makes a judgment regarding what portion of the repayments will be completed. It is also important to note that examiners are often wary of excessive optimism when reviewing cash flow expectations of impaired loans.
Loan pricing is rarely used for impaired loans. With this method, a bank would “shop” the loan around to come up with a market price, or value, that another institution would be willing to pay for that loan. It can be challenging to defend and document the amount, source, and date of the observable market price with this method.
Regardless of the method used for impaired loans, the calculations should be based on a comprehensive, well-documented, and consistently applied methodology.