Simplifying the ALLL: Present value of cash flows
Sep 22, 2015
Although bankers and credit union professionals spend considerable time on their institution’s ALLL calculation, it is often an imperfect system. Regulatory changes, gathering supporting documentation, training new staff members and any number of other factors can make the regular calculation an increasingly complicated process.
Even with these factors aside, the ALLL is a time-consuming process that requires an extensive amount of knowledge to calculate accurately and defensibly against regulator criticisms. Despite a solid interpretation and understanding of the regulatory guidance and its intricacies, the process can leave some of the most experienced bank and credit union professionals frazzled.
One such area of confusion lies within the criteria that defines an individual loan as impaired, and that loan’s calculated impairment. “Impaired” versus “impairment” can carry a misconception of its own, too (this article on CUES.org succinctly clarifies this common practice of both banks and credit unions). When calculating the impairment of a loan deemed to be impaired, guidance requires that the loan should be evaluated using one of three valuation methods: present value of cash flows, fair value of collateral or observable market price. Many institutions question how and when to use two of the valuation methods — present value of cash flows and fair value of collateral — in order to determine the impairment and potential reserve. There are key distinctions to these methods of calculation, and regulators may scrutinize a bank or credit union’s choice in valuing the impairment of a loan.
In short, unless there is sufficient collateral that will pay 100 percent of loan amount still due to the bank or credit union, the present value of cash flows should be the default method used by the institution to evaluate the loan’s impairment. ASC 310-10-35 (FAS 114) states institutions should use “fair value of collateral when the creditor determines that foreclosure is probable.” An institution may wish to rely on the fair value of collateral method for its convenience, even if the borrower continues to pay. But, if the loan is cash flowing even with collateral, present value of cash flows must be used to determine the impairment. Any liquidation proceeds net of selling costs would be used to supplement cash flow.
Using present value of cash flows to determine the impairment does not need to be a difficult determination. Unless collateral is the institution’s sole source of repayment or there is a market price for the loan, the financial institution should use present value of cash flows. Regulators will test the bank or credit union based on this logic. A properly thought out and documented cash flow calculation will result in an accurate and defensible ALLL calculation which will stand up to regulator and auditor scrutiny.
For a complete look how to calculate the present value of cash flows, download this complimentary whitepaper. This resource offers a deeper dive into the three primary components of a present value calculation, as well as detailed examples.
Related Asset - Blog
Impaired vs. Impairment: A Common Misconception
Excerpt Pulled From Blog:
"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. Understanding the distinction is best accomplished by dissecting the two words in accordance with guidance from the regulating bodies."