FCA Exam Manual EM-325 Accounting for Problem Assets

Module: Assets
Section: Accounting for Problem Assets
EM-325

Date Published: 12/1996

Introduction

Properly accounting for problem assets is an essential element of an institution's risk identification process and overall loan portfolio management. Institutions must properly account for problem assets to ensure the board of directors, shareholders, investors, and FCA are apprised of credit risk that has, or could, adversely impact performance of the loan portfolio.

In addition to grading problem assets in accordance with a classification system such as the Uniform Classification System, Farm Credit System (System) institutions must identify and consistently report the performance status of these assets through the assignment of accounting performance categories. Performance categories identify the performance status of assets and are disclosed in the institution's financial statements to shareholders. Performance categories allow management to communicate to interested parties what portion of the loan portfolio has had repayment problems to the extent that repayment has affected the accrual of interest and the interest income generated by the institution.

FCA Regulation 12 CFR § 621.6 establishes performance categories for nonaccrual loans, formally restructured loans, loans 90 days past due still accruing interest, and other property owned. The regulation also requires management to adequately monitor, account for, report, and disclose the performance categories of problem assets. A general description and application of each performance category and related accounting issues is provided below.

Examination Objective

Determine if the institution is adequately accounting for, reporting, and disclosing to shareholders, investors, and FCA the proper performance status of all problem loans and loan-related assets.

Nonaccrual Loans

General Criteria

A loan is considered nonaccrual if any of the following conditions are met:

Collection of any amount of outstanding principal and all past and future interest accruals, considered over the full term of the asset, is not expected;
Any portion of the loan has been charged off, except for formally restructured loans; or
The loan is 90 days past due and is not both adequately secured and in process of collection.

Repayment capacity on loans categorized nonaccrual is in such doubt that the accrual and/or recognition of interest is no longer appropriate. Therefore, loans should not be transferred to a nonaccrual status if full collection of principal and interest, including further accruals of interest, is expected within a reasonable time frame Conversely, a loan which is severely past due should not continue to be carried in an accrual status solely because an excess collateral margin exists. Loans meeting the criteria for both nonaccrual and another performance category should be classified nonaccrual.

Key points the examiner should consider in applying the nonaccrual performance category include:

In the Process of Collection--A loan is considered "in process of collection" only if collection efforts are proceeding in due course and, based on a probable and specific event, are expected to result in the prompt repayment of the debt or its restoration to current status. There must be documented evidence that collection in full of amounts due and unpaid is expected to occur within a reasonable time period, not to exceed 180 days from the date that payment was due. The commencement of collection efforts through legal action, including bankruptcy or foreclosure, or through collection efforts not involving legal action, including ongoing workouts and reamortizations, do not, in and of themselves, provide sufficient cause to keep a loan out of nonaccrual status. If full collection of the debt or restoration to current status is dependent upon actions by the borrower, the institution must also obtain the borrower's written agreement to complete all such actions by the specific dates set forth in the agreement.

Documented evidence of repayment capacity should focus primarily upon repayment from normal operations or from recurring and reliable sources. However, bankruptcy may fulfill the criteria for "in process of collection," if the court terminates jurisdiction or grants relief from the automatic stay that permits collection to proceed fully. Similarly, foreclosure may be considered "in process of collection" if the institution has documented evidence that the proceedings will result in prompt repayment of all principal and interest within 180 days from the date that payment was due.

Rule of Aggregation--When a loan is placed in nonaccrual, an institution must evaluate whether its other loans to that borrower, or related borrowers, should also be placed in nonaccrual. All loans on which a borrowing entity, or a component of a borrowing entity, is primarily obligated to the reporting institution shall be considered as one loan unless a review of all pertinent facts supports a reasonable determination that a particular loan constitutes an independent credit risk and such determination is adequately documented in the loan file. In addition, when the institution becomes aware that a borrower has a nonaccrual loan with another institution, the institution must reevaluate its loan to that borrower to determine if an independent credit risk exists. Criteria that must be met to qualify as an independent credit risk are prescribed in FCA Regulation 12 CFR § 621.7(a).

Income Recognition--Recognition of interest income on nonaccrual loans, as set forth in FCA Regulation 12 CFR § 621.8, is not appropriate unless the ultimate collectibility of the recorded investment, in whole, is not in doubt. Earned but uncollected interest on loans that is determined not to be fully collectible should be reversed from interest income if accrued in the current fiscal year, or charged off against the allowance if accrued in prior fiscal years. Any payment received on such loans should be applied to the recorded investment to the extent necessary to eliminate the doubt of collectibility of the recorded investment.

Once the ultimate collectibility of the recorded investment is no longer in doubt, payments received in cash may qualify for recognition of interest income if the following conditions are met at the time the payment is received:

The loan does not have a remaining unrecovered prior chargeoff associated with it, except for formally restructured loans;

The payment received has come from an expected source of repayment according to documentation; and

After considering the payment, the loan is not contractually past due more than 90 days and is not expected to become 90 days past due, or a repayment pattern has been established that reasonably demonstrates future repayment capacity.

The characteristics of the underlying loan should support that collectibility of principal is beyond reasonable doubt and the loan is not expected to become severely past due. In evaluating these loans, institutions should complete appropriate analyses of repayment capacity, the borrower's overall financial condition, repayment history, and other pertinent factors. These determinations should focus on the expected adequacy of repayment sources to meet the required contractual payments over the term of the loan. For example, recognition of interest income on a nonaccrual loan would not be appropriate in situations where partial liquidation of essential assets was the source of repayment.

Individual payments on nonaccrual loans qualifying for cash basis income recognition should generally be applied in accordance with the contractual terms of the loan. The interest portion should be recorded as interest income upon receipt, while the portion which relates to principal should reduce the principal loan balance. If an unrecovered prior chargeoff is associated with the loan, payments should be applied as a recovery of that prior chargeoff before any amounts can be recognized as interest income.

In the case of a nonaccrual loan on which interest has been previously received and applied to principal (resulting in a difference between the contractual indebtedness of the borrower and the recorded investment), the portion of those previous payments received which would have been applied to interest income may be recognized as income (reinstated) upon qualification for cash basis income recognition. In order to apply this approach, institutions must determine that the borrower's contractual obligation (not the recorded investment) is fully collectible. If the collectibility of this amount is in doubt, the immediate and full reinstatement of interest income is not appropriate. However, the portion of future payments which would otherwise be applied to principal may be recognized as interest income until the difference between the borrower's contractual indebtedness and the recorded principal balance has been eliminated.

Reinstatement to Accrual Status--As prescribed by FCA Regulation 12 CFR § 621.9, a loan may be reinstated to accrual status when each of the following criteria are met:

All contractual principal and interest due on the loan is paid and the loan is current;

Prior chargeoffs are recovered, except for formally restructured loans;

No reasonable doubt remains regarding the willingness and ability of the borrower to perform in accordance with the contractual terms of the loan agreement; and

Reinstatement is supported by a period of sustained performance in accordance with the contractual terms of the note and/or loan agreement. Sustained performance will generally be demonstrated by six consecutive monthly payments, four consecutive quarterly payments, three consecutive semiannual payments, or two consecutive annual payments.

The receipt of additional collateral does not constitute a sufficient basis to return a loan to accrual status unless such a transfer includes the expectation that borrowers will fulfill future contractual payments. In general, institution management should use a conservative approach in making a decision to transfer a loan back to accrual status because of the loan's past history of credit problems. In determining the borrower's ability to perform in accordance with the loan agreement, management's overall analysis should consider the factors that caused the loan to be transferred to nonaccrual and whether those factors still exist.

When a loan restructuring, either through a formal restructuring or through a loan servicing action such as a renewal or a reamortization, is the basis for transferring a loan back to accrual status, the restructuring must provide reasonable assurance the borrower will be able and willing to service the restructured debt through ongoing cash payments. Generally, the borrower should have exhibited a period of sustained performance as described above; otherwise, the loan should remain in nonaccrual status until such performance has been demonstrated. Going forward, the new terms and conditions of the loan resulting from the restructuring should be used as the basis for determining whether the loan is current.

Formally Restructured

Formally restructured means loans subject to "troubled debt restructuring" as provided in the Statement of Financial Accounting Standards No. 15 (SFAS 15), "Accounting by Debtors and Creditors for Troubled Debt Restructuring," which states that one or more concessions are made to the debtor because of economic or legal reasons. In SFAS 15, "concessions" is defined as a formal agreement between the creditor and borrower to modify the existing terms of the loan, effectively reducing the repayment of the loan amount and sometimes lowering the effective interest rate below what is normally offered to other debtors. Although concessions usually involve either a lower interest rate or forgiveness of principal, or both, formal agreements for loan extensions, reamortizations, and renewals with terms that may defer payment of interest and/or principal may qualify as formally restructured loans. Concessions may also be imposed by law or a court.

A restructured loan is generally maintained in nonaccrual status until the restructured loan meets the criteria for reinstatement to accrual status. A renewal or reamortization of a formally restructured loan at maturity is not considered a restructured loan if the financial condition and loan performance of the borrower support renewal, and the loan is made under the same terms and conditions as are used to make similar loans to other borrowers whose financial condition and performance are sound and not deteriorating. However, all restructured loans must continue to comply with the distressed loan provisions of section 4.14(A) of the Farm Credit Act of 1971, as amended.

SFAS 114, " Accounting by Creditors for Impairment of a Loan," amends SFAS 15 to require a creditor to measure all loans that are restructured in a troubled debt restructuring involving a modification of terms in accordance with SFAS 114. Loans that were restructured in a troubled debt restructuring before the effective date of SFAS 114 and which are not impaired based on the terms specified by the restructuring agreement may continue to be accounted for under the provisions of SFAS 15. For loans that were restructured in a troubled debt restructuring before the effective date of SFAS 114 and which are impaired based on the terms specified by the restructuring agreement, institutions must determine the measure of impairment and provide necessary disclosures in conformity with the provisions of SFAS 114. Upon adoption of SFAS 114, all subsequent troubled debt restructurings must be accounted for and disclosed in conformity with SFAS 114 rather than under the provisions of SFAS 15.

Loans 90-Days Past Due Still Accruing Interest

Loans in this category include all loans 90 days or more contractually past due that are both adequately secured and in the process of collection. A loan is considered contractually past due when any principal or interest payment required by the loan instrument is not received on or before the due date. A loan shall remain contractually past due until it is formally restructured or until the entire past due amount, including principal, accrued interest, and any penalty interest, is collected or otherwise discharged in full.

Other Property Owned

Other property owned includes any real or personal property, other than an interest-earning asset, that has been acquired as a result of full or partial liquidation of a loan. The property may have been acquired through foreclosure, deed in lieu of foreclosure, or other means.

Other property owned is a non-interest earning asset. As such, these loan-related assets and their affect on the institution's financial condition should be monitored and reported.

To ensure shareholders are provided accurate and reliable information regarding other property owned, System institutions should maintain such property in accordance with Statement of Financial Accounting Standards No.121 (SFAS 121), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of."

Foreclosed Assets--SFAS 121 requires that foreclosed assets held for sale be carried at the lower of (a) fair value minus estimated costs to sell the assets or (b) carrying amount. As used in SFAS 121, the term fair value means the amount that the lender could reasonably expect to receive in a current sale between a willing buyer and a willing seller, that is, other than in a forced or liquidation sale. Fair value of assets shall be measured by their market value if an active market for them exists. If no active market exists for the assets but exists for similar assets, the selling prices in that market may be helpful in estimating the fair value of the assets. If no market price is available, a forecast of expected cash flows may aid in estimating the fair value of the assets, provided the expected cash flows are discounted at a rate commensurate with the risk involved. The term carrying amount means the fair value of the foreclosed assets at the time of foreclosure.

Subsequently, if the fair value of the asset minus estimated selling costs is less than the carrying amount of the asset, the deficiency should be recognized as a chargeoff directly to current period's earnings. Conversely, if the fair value of the asset minus estimated costs to sell the asset subsequently increases and this value is more than the carrying amount, a recovery should be recorded directly to earnings. However, the asset may not be written back up to a value that exceeds the "carrying amount" basis established at the date of foreclosure.

Sales of Real Estate--A significant portion of other property owned and held for sale by an institution consists of real estate. SFAS 66, "Accounting for Sales of Real Estate," provides guidance on determining when all necessary criteria have been met for the consummation of a sale, and when and how profit should be recognized. Under SFAS 66, sale shall not be considered consummated until the following criteria have been met.

The parties are bound by the terms of a contract;
All consideration has been exchanged;
Any permanent financing for which the seller is responsible has been arranged;
All benefits and risks of ownership have been substantially transferred to the new owner;
All conditions precedent to closing have been performed; and
Closing is completed.

Once it has been established that the sale has been consummated, SFAS 66 requires that additional criteria be met for full profit recognition. The criteria are as follows:

The initial and continuing payments made by the buyer must be adequate to demonstrate commitment;
The seller's receivable is not to be subject to further subordination;
All of the benefits and risks of ownership must be substantially transferred to the buyer; and
The seller must not have a substantial continuing involvement with the property after the sale.

Normally, a sale will be recognized from an accounting standpoint when consummation occurs (essentially the date of settlement), whereby the other-property-owned account is eliminated from the balance sheet. However, if a sale has not been consummated, no sale will be recorded and any initial and continuing payments will be held as deposits until consummation occurs. In situations where consummation has taken place, but the institution, as seller, has some continuing involvement with the property and does not transfer substantially all of the risks and rewards of ownership, SFAS 66 may limit: (1) the ability of the institution to account for the transaction as a sale or (2) the amount of profit which may be recognized in the event sales treatment is appropriate. A transaction that does not qualify for sales treatment because of the seller's continuing involvement is normally accounted for as a financing, leasing, or profit sharing arrangement. Refer to SFAS 66 and FCA's Accounting Practice Guide No. 5 for further guidance.

Other Considerations--In the course of selling other property owned, institutions may at times offer substantially lower-than-market interest rates on notes as an incentive for the prospective purchaser of the property. While such below-market interest-rate notes represent typical marketing tools, GAAP requires that, from the lender's perspective, the form of the transaction must not prevail over its economic substance. Accordingly, when a note is exchanged for property, Accounting Principles Board (APB) Opinion No. 21, "Interest on Receivables and Payables," maintains that the note, the sales price, and the cost of the property exchanged for the note should be recorded at the fair value of the property or at an amount that reasonably approximates the market value of the note, whichever is the more clearly determinable. Therefore, when the interest rate charged on a note in exchange for property is substantially lower than the prevailing market rate of interest for similar type transactions, it will generally be necessary to discount the note to the present value using a rate of interest commensurate with the risk involved (i.e., the prevailing rate of interest for similar type transactions). The resulting discount should be accounted for as an element of interest over the life of the note.

Loan Loss Accounting--Chargeoffs/Recoveries

FCA Regulation 12 CFR § 621.5 requires System institutions to chargeoff loans, wholly or partially, as appropriate, at the time they are determined to be uncollectible. If a chargeoff is recorded, the amount of the loss should generally be applied in the following sequence:

1. Earned but uncollected interest income that was accrued during the current fiscal year and is determined to be uncollectible should be reversed from interest income.

2. Earned but uncollected interest income that was accrued in prior fiscal years and is determined to be uncollectible should be charged off against the allowance for loan losses.

3. Principal and other related amounts (which include accounts receivable, additional advances, etc.) should be charged off.

Recoveries of previous chargeoffs should only be recorded when:

The chargeoff was recorded in error;
Cash payments on a nonaccrual loan reduce the recorded investment below zero;
Cash payments are received on a loan which would qualify for cash basis accounting treatment were it not for the existence of an unrecovered chargeoff; or
The loan is transferred from nonaccrual to accrual status (nonrestructured loans only).

Loan recoveries should never be recorded at the time of a loan restructuring. Instead, prior loan chargeoffs are recaptured through interest income via the accounting treatment prescribed in SFAS 15. Additionally, recoveries should not be recognized based on the receipt of additional collateral or a market value increase in the underlying collateral.

Internal Control Considerations

FCA Regulation 12 CFR § 621.10 requires each System institution to account for, report, and disclose to shareholders, investors, boards of directors, and FCA all material items with respect to performance categories and other property owned. The regulation also requires System institutions to disclose the nature and extent of significant potential credit risks within the loan portfolio, or other information that could adversely impact performance of the loan portfolio in the near future.

To ensure compliance with these regulatory requirements, as well as keep the board of directors fully apprised of conditions in the loan portfolio, the institution must establish adequate internal controls in this area. The internal controls prescribed by FCA Regulation include:

Policies and procedures governing performance categories;

A quarterly review of the loan portfolio to ensure that all high-risk loans have been assigned the appropriate performance category; and

A quarterly review of all high-risk loans to determine the collectibility of accrued but uncollected income.

The board of directors is responsible for ensuring that policies and procedures conform with the definitions, rules, and standards set forth by FCA Regulations, and are appropriately applied by management and staff. The board is also responsible for establishing additional controls as needed to ensure proper accounting of problem assets.

As discussed in the Loan Portfolio Management section, boards may utilize their internal credit review process to determine the reliability of management's reporting on performance categories and to monitor
compliance with related policies and procedures. The boards may also utilize their Management Information System (MIS) to report on the volume of loans in each performance category, as well as the significant potential credit risks within the loan portfolio.

Examination Procedures

Accounting for problem assets is generally examined in conjunction with the examination of the institution's risk identification process as discussed in the Loan Portfolio Management section of this module. As such, considerable coordination should take place between the examiners involved in these examination activities.

The examination scope in this area is determined by considering several factors, such as: the adequacy of policies, procedures, and internal controls; previous examination findings; the condition and trends in the loan portfolio; economic conditions; and the financial condition and performance of the institution. Based on a review of these factors, individual assets can be selected to validate the effectiveness of management's processes for identifying, categorizing, reporting, and disclosing problem assets.

When evaluating this area, examiners should consider the rules and definitions prescribed by FCA and GAAP. Examiners should also refer to the System's High Risk Accounting Guidelines for additional information.

While on site, the loan sample should be reevaluated periodically by the examiner-in-charge (EIC) to determine if the sample remains appropriate, or if the sample should be expanded or reduced. This determination should be based on completion of sufficient work to support a conclusion.

In developing conclusions, examiners should focus on the overall effectiveness of the institution's problem asset accounting processes, rather than on individual assets which may have been reported or disclosed incorrectly. Examiners should also focus on the overall effectiveness of the internal credit review process in identifying and reporting performance categories. If significant weaknesses are disclosed, the examination should concentrate on identifying the underlying causes and their effects to ensure that corrective action is achieved.

The following list of procedures is provided to assist examiners in the evaluation of this area. Consistent with risk-based examination principles, examiners should add, delete, or modify procedures as needed based on the particular circumstances of the institution.

Examiners should also coordinate their examination activities with other members of the examination team and the EIC. Emphasis should be on identifying how examination findings in other areas impact the review, ensuring sufficient work is completed to support conclusions, and avoiding duplication of examination effort.

1. In coordination with the examiner assigned loan portfolio management, review the institution's policies and procedures to determine if they include adequate direction and guidance regarding problem asset accounting. Consider factors such as:

2. Review the results of the internal credit review process to determine if the institution is adequately accounting for, reporting, and disclosing problem assets.

3. Compare the institution's credit classification statistics and delinquency reports to the loans categorized nonaccrual, formally restructured, and loans 90 days past due still accruing interest. Follow up on any inconsistencies which may indicate improper identification and disclosure of problem assets.

4. Examine a sample of loans that are 90 days past due still accruing interest to determine if the loans were properly identified or should have been placed in nonaccrual.

5. Examine a sample of nonaccrual loans in which the institution recognizes interest income to determine if the income recognition is appropriate and in compliance with FCA Regulations.

6. Examine a sample of accrual loans reinstated from nonaccrual status to determine if the reinstatement is appropriate and in compliance with FCA Regulations.

7. Examine a sample of formally restructured loans to determine if the accounting of such loans is in accordance with SFAS 15 as amended by SFAS 114.

8. Examine a sample of other property owned to determine if the assets are recorded in accordance with GAAP. Document the review and evaluation of other property owned on FCA 3020, Accounting for Other Property Owned, and FCA 3025, Administration of Other Property Owned.

9. Examine a sample of property sales to determine if they are recorded in accordance with SFAS 66 or APB Opinion No. 21, as applicable.

10. Examine a sample of chargeoffs and recoveries taken on loans for compliance with FCA Regulations and GAAP.

11. Document the examination of individual loans on FCA 3005, Asset Classification Summary, by identifying any exceptions and underlying cause(s).

12. Review the institution's studies and/or analyses completed to determine "the nature and extent of significant potential credit risks within the loan portfolio that could adversely impact performance of the loan portfolio" as disclosed to shareholders.

13. Review the institution's workpapers or other documentation that evidences, at a minimum, a quarterly review of the loan portfolio to ensure all high-risk assets have been assigned the appropriate performance category and that all high-risk assets were reviewed to determine the collectibility of accrued but uncollected income.

14. Summarize findings to arrive at an overall conclusion regarding the institution's accounting for problem assets.

15. Discuss items of concern, scope of work performed, and conclusions with the EIC and with the appropriate institution manager. Obtain a response regarding the cause(s) of deficiencies or weaknesses and anticipated corrective actions.

16. Inform affected examiners, particularly those assigned to loan portfolio management, earnings, and compliance, of exceptions identified and the potential affect of those exceptions.

17. Prepare a leadsheet or other summary document to provide workpaper support for the work performed and the conclusions reached.

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