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Jan 1993

Accounting for in-substance foreclosures. (Accounting )

by McNamee, Dionne Driscoll

    Abstract- Accounting practitioners affiliated with financial institutions are clamoring for adequate guidelines on the accounting treatment of in-substance foreclosures. Although the FASB, the AIC, the SEC and other agencies regulating the financial services industry have already issued quite a number of papers on the subject, accountants complain that the guidance coming from these bodies is not enough to help them cope with the turbulence of the commercial property markets. In view of the state of the real estate industry, is essential for lenders to have adequate in-substance foreclosure guidance that provides the criteria for treating collaterized loans as loans or as another kind of asset for accounting purposes. Accounting standard setters may deal with calls for more guidance by leaving it up to FASB to resolve the problem, make no changes to the criteria but provide more guidance on their application, or reconsider the criteria altogether.

It Started in 1977

In-substance foreclosures were first discussed in the authoritative accounting literature in June 1977, in FASB Statement 15, Accounting by Debtors and Creditors for Troubled Debt Restructuring. Paragraph 34 of the Statement states:

A troubled debt restructuring that is in substance a repossession or foreclosure by the creditor, or in which the creditor obtains one or more of the debtor's assets in place of all or part of the receivable shall be accounted for according to the provisions of |this statement for assets received in satisfaction of a receivable.

FASB explained that conclusion in paragraph 84 of Statement 15, which says in part:

The Board agreed that a restructuring may be in substance a foreclosure, repossession, or transfer of assets even though formal foreclosure or repossession proceedings are not involved. Thus, the Statement requires accounting for a transfer of assets if, for example, the creditor obtains control or ownership (or substantially all of the benefits and risks incident to ownership) of one or more assets of the debtor and the debtor is wholly or partially relieved of the obligations under the debt.

In December 1986, the SEC issued Financial Reporting Release (FRR) 28, Accounting for Loan Losses by Registrants Engaged in Lending Activities, in response to concerns that companies were evading the fair value accounting required by FASB Statement 15 simply by avoiding formal foreclosure. FRR 28 provides criteria for determining when collateral for a loan is in-substance foreclosed that deal with borrowers with title to collateral, but little or no equity in the collateral.

The AICPA issued Practice Bulletin 7, Criteria for Determining Whether Collateral for a Loan Has Been In-Substance Foreclosed in April 1990. One of the primary objectives of Practice Bulletin 7 was to extend the criteria for in-substance foreclosure in FRR 28 to companies not registered with the SEC. The criteria in Practice Bulletin 7 are identical to those in FRR 28. If the criteria are met, both Practice Bulletin 7 and FRR 28 require that the collateral be treated as if it had been formally foreclosed.

Further, in June 1990, the Office of the Comptroller of the Currency (OCC) issued the Bank Accounting Advisory Series (BAAS), which contained the Bank Accounting Division staff's views on a variety of issues, including in-substance foreclosed assets. The staff says of in substance foreclosures:

In essence the bank is the de facto owner of the collateral... and is more exposed to the risks of ownership of the collateral and better positioned to benefit from recovery of its fair value than the borrower(s).

In June 1992, the AICPA issued Practice Bulletin 10, which responds to concerns that a particular paragraph of Practice Bulletin 7, which discusses how to apply the criteria of Practice Bulletin 7 for in substance foreclosure, had used terminology that created considerable confusion, made the guidance difficult to apply, and had unnecessarily created costly confrontations among financial institution management, examiners, and independent accountants.

On June 30, 1992, the FASB issued an exposure draft on accounting by creditors for impairment of loans, which if finalized as drafted would substantially change the way financial institutions account for certain loans. One of the provisions of the proposal is to delete paragraph 34 of FASB Statement 15, which required loans that are in-substance foreclosures be accounted for as foreclosed assets.

Why the Guidance is Important

The in-substance foreclosure guidance provides criteria for determining whether collateralized loans should be accounted for as loans or an another kind of asset, such as real estate. Both the carrying amount and the classification of the assets in the balance sheet may be affected by the distinction. The FASB, SEC, AICPA, and OCC issued guidance primarily because of concerns about the carrying amount of the assets. They generally saw in-substance foreclosure accounting as a way to prevent financial institutions from carrying troubled collateral-dependent real estate loans at more than the fair value of the underlying collateral.

Carrying Amount

How in-substance foreclosure would affect the carrying amount of an asset depends on the accounting applied to the loan. Three general approaches currently exist for determining the carrying amount of real estate loans (However, the FASB's loan impairment proposal would supersede the AICPA guidance and eliminate the three approaches for loans that are considered impaired under the proposal).

1. Net realizable value of the underlying collateral discounted at a cost of capital (debt and equity) rate. (This approach is supported in the AICPA's Industry Audit and Accounting Guide, Audits of Savings Institutions, and in AICPA Statement of Positions 75-2 and 78-2, Accounting Practices of Real Estate Investment Trusts.)

2. Net realizable value of the underlying collateral with no explicit discounting requirement. (This approach is supported in the AICPA's Industry Audit Guides, Audits of Banks, Audits of Finance Companies, and Audits of Credit Unions.)

3. Fair value of the underlying collateral, which assumes a discount rate that is based on the risk level inherent in the collateral. Though not explicitly required by generally accepted accounting principles (GAAP), this approach is supported by financial institution regulators and used by many financial institutions, particularly banks.

Under FASB Statement 15, in determining the carrying amount for loans that have been restructured by a modification of terms, creditors are allowed to use the gross expected cash flows (principal and interest) to determine the carrying amount of the loan. However, when foreclosure is deemed to have occurred, Statement 15 requires creditors to recognize the restructuring at the fair value of the collateral. Further, under the AICPA's SOP 92-3, Accounting for Foreclosed Assets, which was issued on April 28, 1992, after foreclosure, lenders account for real estate assets received through foreclosure or repossession at the lower of cost or fair value minus estimated costs to sell.

Therefore, if the third approach were used to account for real estate loans, the only difference in the carrying amount of a loan before and after in-substance foreclosure would be the amount accrued for estimated costs to sell. However, if the first or second approach were used, the carrying amount of the loan after in-substance foreclosure would likely be less than the carrying amount before in-substance foreclosure.


When it is determined a loan is in-substance foreclosed, the classification of the asset in the balance sheet changes. Nonperforming real estate loans become other real estate owned. This change in classification may affect how income is recognized on the asset after in-substance foreclosure. Impaired loans are generally nonearning assets, though in certain circumstances receipt of an interest payment may be included in income. In-substance foreclosed real estate assets may be earning or nonearning assets; revenues generally correspond with cash receipts.

Further, the classification of a real estate asset may affect certain statistics that are widely regarded as important, such as the ratio of the allowance for loan loss to nonperforming loans. Further, loans and real estate assets are often viewed differently. Some analysts and other financial statement users perceive real estate assets as being of lower quality than loans.

Problems with the Guidance

The perceived problems with the guidance on in-substance foreclosures and their application are in four areas: 1) fair values 2) the criteria for in-substance foreclosure, particularly the criterion regarding the debtor's ability to rebuild equity, 3) differences between GAAP and regulatory reporting practices (RAP) regarding direct write-downs of loans (charge-offs), and 4) how to account for assets that are legally loans as other real estate owned.

Fair Values

Evaluating estimates of fair values of real estate requires financial institutions, their accountants, and regulators to exercise careful judgment and is often considered a troublesome area, especially for real estate in a depressed market. Nonetheless, a detailed analysis of the problems in determining fair value and whether it is the best measurement attribute for real estate assets is beyond the scope of this article.

However, it is worth mentioning that estimating fair values is likely to become increasingly important and debates are likely to continue about the assumptions and methodologies used for determining fair values. The accounting profession should continue working to reduce misunderstandings about fair values and to develop consistent, practical, and generally accepted ways to develop realistic estimates of fair values.

Criteria for Foreclosure

FRR 28 and Practice Bulletin 7 contain the following three criteria that must be met for a loan to be considered an in-substance foreclosure:

1. The debtor has little or no equity in the collateral, considering the current fair value of the collateral;

2. Proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral; and

3. The debtor has either:

a) formally or effectively abandoned control to the creditor, or b) retained control of the collateral, but because of the current financial condition of the debtor, or economic prospects for the debt and/or the collateral in the foreseeable future, it is doubtful that the debtor will be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future.

As real estate values declined, debtors lost significant amounts of equity in collateral. As a result, the number of loans meeting the first criterion rose sharply. Many of those loans were nonrecourse commercial real estate loans for which the second criterion was already met. In fact, that is how the loans were underwritten. Nevertheless, for many of those loans, the debtor still controls and manages the collateral, presumably because the debtor believes that it eventually will sell or refinance the property at a profit. Thus criterion 3(a) was not met. Consequently, criterion 3(b) becomes the pivotal factor in determining whether a lender has an in-substance foreclosure. Applying criterion 3(b) requires an assessment of whether the debtor can rebuild equity in the collateral in the foreseeable future, and accordingly, is often contentious and difficult to implement in practice.

GAAP versus RAP

Under GAAP, direct charge-offs should be made in response to a determination there has been a permanent impairment of a loan; for example, a loan is deemed to be uncollectible. Because charge-offs are charged to the allowance for loan losses, capital is unaffected by the charge-off itself. It is when the provision for loan losses was made that GAAP capital was reduced.

Under regulatory rules, direct charge-offs also signify that a loan is deemed uncollectible. Until recently, for financial institutions, regulatory capital is not charged until a loan is directly charged off; all or some of the allowance for loan losses may be added back to regulatory capital. Accordingly, financial institution examiners have encouraged charge-offs in the recent economic climate that may otherwise have continued to be provided for in the allowance. In terms of regulatory objectives, a direct charge-off has been viewed as a way to ensure financial institutions are adequately capitalized, notwithstanding whether a particular loan or portion thereof is permanently impaired. Many believe that the regulatory perspective more than the accounting theory perspective has in the last few years shaped the financial reporting policies regarding charge-offs.

The reason large, regulatory-induced, partial charge-offs of real estate loans presents an issue regarding in-substance foreclosures, is that the write-down itself is perceived by some as de facto evidence that an in- substance foreclosure has occurred. They argue that a charge-off ought not to have been taken if the creditor believes the debtor can rebuild equity in the collateral or believes it can otherwise collect a loan in the foreseeable future. They believe it follows that criterion 3(b) would be met for all loans with partial charge-offs. However, it is also recognized that absent regulatory pressures certain loans would be provided for in the allowance for loan losses and not charged off and that a charge-off alone should not force in-substance foreclosures. Accordingly, numerous practice problems have arisen and practice is diverse.

In-Substance Accounting

Problems arise when there is more than one lender for a particular property that is deemed in-substance foreclosed. Consider a loan that meets the criteria for in-substance foreclosure but for which senior debt would have to be settled for the lender to gain control of the property. Should the lender in those circumstances recognize the loan and debt gross as they would if they had foreclosed? How should cash payments paid by the lender for capital improvements to the property be treated? How should cash received by the lender that is designated as interest be treated?

Potential Solutions

As discussed above, proposing solutions to the first problem regarding fair values is beyond the scope of this article. The second and third problems are related in that the criterion 3(b) for determining whether a loan should be treated as an in-substance foreclosure, which addresses whether a debtor can rebuild equity in collateral in the foreseeable future. This has become the most contentious issue in dealing with the in-substance foreclosure guidance. Three possible ways for accounting standards setters to deal with this issue are:

1. Make no changes to the criterion and provide no additional guidance on the subject. Wait for the FASB to finalize its loan impairment standard;

2. Make no changes to the criteria, but provide additional explicit detailed guidance on how to implement the criteria.

3. Reconsider the criteria. Provide criteria that focus on the probability of foreclosure rather than the probability of the debtor rebuilding equity in the collateral.

Supporters of the first option believe that in-substance foreclosure problems are not important or pervasive enough to warrant changing the guidance and that practice should be allowed to develop on its own. They assert that in-substance foreclosure problems are less a result of the guidance than a result of the overly conservative application by examiners and auditors. Further, some believe that any changes to the existing guidance on in-substance foreclosures would be perceived by critics as a loosening of accounting standards in response to pressure from banks. Finally, they note that the FASB has proposed amending Statement 15 to eliminate in-substance foreclosures.

Supporters of option 2, like supporters of option 1, believe major changes are unnecessary and may be perceived badly. However, they believe that paragraph 12 of Practice Bulletin 7 should be consistent with criterion 3(b) and that FRR 28 and Practice Bulletin 7 should be consistent. Criterion 3(b) says that if it is doubtful the debtor will be able to rebuild equity in the collateral in the foreseeable future, the criterion is met. Put differently, unless a lender concludes that it is not doubtful the debtor will be able to rebuild equity in the foreseeable future the criterion would be met. Paragraph 12 says, "Unless..it is probable that the debtor will be able to rebuild equity in the collateral in the foreseeable future" the criterion would be met. They believe that not doubtful and probable, (or conversely doubtful and not probable), define substantially different likelihoods. Further, they say that correcting the inconsistency would be responsive to the practice problems, would reduce diversity in practice and prevent costly and needless debates between bankers and auditors and examiners. Supporters of option 2 believe that the criteria are acceptable but the interpretative guidance is inadequate. Further interpretative guidance would be responsive to practice problems and reduce much of the diversity in practice. Interpretative guidance could address: how to apply criterion 3(b) when there is partial charge-off of a loan, what is meant by the foreseeable future, what is meant by formally or effectively abandoning the collateral, the extent to which guarantees and other sources of repayment of a loan may be considered in applying the criteria. However, the AICPA's accounting standards division has recently considered and rejected such a project.

Supporters of option 3 believe the criteria for in-substance foreclosure should be modified. They would retain criteria 1, 2, and 3(a) without change. However, they would modify 3(b) in a manner such as the following:

...retained control of the collateral, but because of the current financial condition of the debtor, or economic prospects for the debt and/or the collateral in the foreseeable future, it is probable the creditor will foreclose on the collateral.

Supporters of option 3 believe that as long as the criteria deal with debtors' ability to rebuild equity in the collateral, the in-substance foreclosures problems will remain troublesome. By changing the criteria as suggested loans should be transferred to other real estate owned at an appropriate time and many of the practice problems would be considered in-substance foreclosures for shorter periods. Supporters of option 3 believe it is desirable because practice has evolved to the point that many collateral-dependent real estate loans being carried at an amount no greater than the fair value of the underlying collateral. Further financial institutions are making enhanced disclosures about troubled real estate loans. Those trends are expected to continue and accordingly the costs of keeping the troublesome guidance as is now outweigh the benefits of simplifying the guidance as suggested in option 3, because the in-substance foreclosure rules are no longer needed as the hook to get lenders to write down troubled loans or to identify loans as troubled assets.

Option 3 also compares favorably with the other options. Option 1 is unresponsive to persuasive arguments that the guidance on in-substance foreclosures creates significant and pervasive practice problems. Option 2, though responsive to calls for reconsideration of the guidance and broader in scope than Option 3 would ultimately be unsuccessful because it starts with the premise that the criteria adequately define in- substance foreclosures. The partial charge-off issue would be difficult to resolve without eliminating criterion 3(b).

Ms. McNamee is an employee of the AICPA and her views as expressed in this article do not necessarily reflect those of the AICPA.

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