Impaired vs. Impairment: A Common Misconception
Jul 29, 2015
Although many institutions believe “impaired” and “impairment” are one and the same, they in fact have very different meanings within the allowance for loan and lease losses (ALLL) calculation. Contrary to popular belief, an impaired loan with no calculated impairment or reserve, according to guidance, should remain within ASC 310-10-35 (FAS 114). Understanding the distinction is best accomplished by dissecting the two words in accordance with guidance from the regulating bodies. The guidance for impaired loans under ASC 310-10-35, formerly FAS 114, specifically defines the difference between these two terms.
The OCC writes in its Bank Accounting Advisory series, “A loan is impaired when, based on current information and events, it is probable that an institution will be unable to collect all amounts due, according to the original contractual terms of the loan agreement.” As stated within this publication, the definition of an impaired loan depends on whether or not the borrower is paying according to the contractual agreement.
Identifying Impaired Loans
Institutions should begin identifying impaired loans by determining which characteristics best represent impaired loans within their portfolios. The most common characteristics used to identify impaired loans include:
- Non-accrual status
- Troubled debt restructuring “TDR”
- Substandard risk ratings (or worse)
- Days past due (i.e., 90 days)
- Loan to value ratios
Loans that have been restructured (TDRs) would automatically fall into the impaired bucket because the original contractual terms have been altered and, therefore, will not be collected according to the original structure. Nonaccrual loans are by nature non-performing and, therefore, can easily be defined as impaired loans.
The definition of a non-accrual loan as written by the Federal Reserve is,
“(1) any asset which is maintained on a cash basis because of deterioration in the financial position of the borrower, (2) any asset for which payment in full of interest or principal is not expected, or (3) any asset upon which principal or interest has been in default for a period of 90 days or more unless it is both well secured and in the process of collection.”
Regulatory guidance does not specifically state how an institution should determine whether repayment is probable but does specifically refer to TDR loans and the probability of repayment as it relates to accrual status. As a result, institutions should, at the least, adopt these two methodologies as ways of identifying impaired loans. Aside from non-accrual and TDR distinctions, institutions have the ability to determine additional characteristics from which to identify impaired loans. Institutions will often use risk ratings (substandard or worse) and days past due to monitor loans that are deteriorating and should be considered impaired.
The Federal Reserve explains that an impairment is “the portion of the overall allowance for loan and lease losses attributable to individually impaired loans.” There are three accepted valuation methods recommended for calculating impairment. Once loans are identified as impaired, financial institutions must calculate or measure the impairment by using one of three valuation methods. The ASC 310-10-35 guidance requires that “[impaired loans] be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent.”