Reviewing FAS 114 and Impaired Loans
Feb 2, 2017
A principal source of guidance on accounting for impairment in a loan portfolio under GAAP is Accounting Standards Codification Subtopic 310-10, which was formerly known as the Statement of Financial Accounting Standards No. 114 (FAS 114), “Accounting by Creditors for Impairment of a Loan.”
Under FAS 114, a loan is impaired when it is probable that the bank will be unable to collect all amounts due (including both interest and principal) according to the contractual terms of the loan agreement. FAS 114 applies to all loans except:
- Large groups of smaller balance homogeneous loans that are collectively evaluated for impairment (such as credit card, residential mortgage, and consumer installment loans) and which have not been restructured as troubled debt
- Loans that are recorded at fair value or at the lower of cost or fair value (e.g., loans held for sale)
- Debt securities
FAS 114 requires that the lending institution evaluate each loan individually to determine a reasonable estimate of the amount that can be realized or recovered. Accounting guidance approves three valuation methods: the Fair Market Value of Collateral, the Present Value of Future Cash Flows and the seldom-used Loan Pricing method, in which the bank “shops” the loan around to come up with a market price (the value) that another institution would be willing to pay for that loan.
If the value of an impaired loan, determined using one of the aforementioned methods, is less than its recorded balance, the bank must recognize the impairment that was not previously provided for through a provision to its allowance for the difference and a corresponding bad-debt expense. In some cases, an impaired loan may have zero impairment once evaluated using one of the three valuation methods, but the loan should remain under FAS 114 nonetheless, according to guidance.