In May of 1993, the FASB issued Statement No. 114, Accounting by Creditors for Impairment of a Loan, that is intended to minimize inconsistencies in lenders' accounting for, and measurement of, loan losses. The provisions of Statement No. 114 apply to all creditors, not just financial institutions. It applies to most types of loans, including collateralized and uncollateralized, as well as loans whose terms are modified in a troubled debt restructuring. Excluded from the scope of the new standard are large groups of smaller-balance, homogeneous loans that are collectively evaluated for impairment, loans measured at fair value or at the lower of cost or fair value, leases, and certain investments in debt securities.

Statement No. 114 requires a creditor to measure impairment of a loan based on the present value of expected future cash flows. Three different measures of impairment may be used for quantifying an impairment loss. Expected future cash flows may be discounted at the loan's original effective interest rate. Alternatively, a creditor may use the observable market price of the loan, if one exists. The third measure would be the fair value of collateral when the loan is collateralized. Permitting the use of the two alternatives to the discount approach for measuring impairment loss may be viewed by some as the Board's adoption of some aspect of current value accounting.

The requirements of Statement No. 114 are likely to generate higher valuation allowances for certain creditors, particularly those in the financial services industry. For lenders, the standard's provisions should improve the information provided to users of financial statements about impaired loans. Further, Statement No. 114 should enhance comparability in reporting among different types of creditors for similar loans.

Recognizing Impairments

A loan is impaired when, based on current information and events, it is probable a creditor will be unable to collect all amounts due (interest as well as principal) according to the contractual terms of the loan agreement. Prior to the issuance of Statement No. 114, the phrase "all amounts due" was not always interpreted to include both contractual interest and principal. In this regard, the new standard amends FASB Statement No. 5, Accounting for Contingencies, by clarifying that a creditor must evaluate the collectibility of both contractual interest and principal of all receivables when assessing the need for a loss accrual.

The requirement for assessing collectibility of interest as well as principal is consistent with the recording of a loan under APB Opinion No. 21, Interest on Receivables and Payables. Under the provisions of Opinion No. 21, a creditor, in recording a receivable, discounts, at the loan's effective interest rate, the loan's principal and contractual interest. This time value of money approach continues throughout the term of the loan, as long as the loan's cash flows are in accordance with the original terms of the contract.

Under Statement No. 114, a loan also is impaired when its original terms are modified in a troubled debt restructuring. Thus, the statement also amends FASB Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, by requiring a creditor to discount estimated future cash flows in measuring impairment loss after a loan has undergone a troubled debt restructuring involving a modification in terms. Under Statement No. 15, an impairment loss is not recognized as long as the carrying amount of the loan on the date of restructure does not exceed the loan's future estimated undiscounted cash flows.

Statement No. 114 does not specify how a creditor should identify loans to be evaluated for collectibility. Nor does it indicate how a creditor should determine the overall adequacy of the allowance for credit losses and the probability it will be unable to collect all amounts due according to the loan's contractual terms. The standard only states a creditor should apply its normal loan procedures in making such determinations. Essentially, these and other matters require the application of judgment.

The statement does make clear, however, that its use of the term probable is consistent with its use in Statement No. 5, which defines probable as meaning "the future event or events are likely to occur." In defining loan impairments as probable losses, the FASB reiterated its position, as described in paragraph 84 of Statement No. 5, that the conditions for accrual "are not intended to be so rigid that they require virtual certainty before a loss is accrued." They require only that it be probable an asset (receivable) has been impaired and the amount of loss be reasonably estimable.

Measuring Impairments

The recognition of loan impairment is the critical event that necessitates remeasurement of the loan. Since a lender's recorded investment in a loan is at an appropriate discounted amount, it follows that an impaired loan should be carried at the present value of expected future cash flows. To the extent the present value of those cash flows is less than the creditor's investment in the loan, an impairment loss is recorded through a valuation allowance with a corresponding charge to bad-debt expense.

Before an impaired loan is remeasured on a discounted basis, estimates of the amount and timing of future cash flows must be made based on assumptions and projections that are reasonable and supportable. All available evidence--including disposal costs if such costs are anticipated to decrease cash flows available to satisfy the loan--should be considered in developing the best estimate of expected future cash flows. The potential effect of evidence should be weighed according to the ability to verify that evidence objectively. However, information or evidence not verifiable may nevertheless be significant.

For some loan impairments, such as those involving a variable interest rate, a creditor may develop a range of estimates for the amount and/or timing of future cash flows. When this occurs, a creditor should assess the likelihood of the possible outcomes in making the best estimate of expected future cash flows.

Since estimates of the amount and timing of expected future cash flows usually involve uncertainty, judgment should be exercised. Despite the uncertainty involving judgments of this nature, the FASB has concluded uncertainty is not a valid reason to ignore discounting when applying Statement No. 114.

What Rate Should Be Used In Discounting

The crux of the new standard is the requirement that impairment loss be measured by discounting expected future cash flows to present value. But, what is the appropriate discount rate? Since the rate employed directly affects the amount of impairment loss recognized, the selection of the appropriate discount rate is critical.

The FASB has concluded the expected future cash flows from an impaired loan should be discounted at the loan's effective interest rate. The effective interest rate is the contractual rate of the loan as adjusted for deferred loan fees or costs and any premium or discount. In essence, the measurement basis for an impaired loan is identical to that loan's measurement basis before it became impaired. The loan's original effective rate also is the appropriate discount rate when the terms of the loan have been modified in a troubled debt restructuring.

In explaining its selection of a loan's effective interest rate, the Board concluded that a loan impairment measurement should be based only on deterioration of the lender's credit quality and not changes in market rates of interest. An impairment loss reflective of credit deterioration is manifested by a decline in a loan's expected future cash flows.

In cases where an impaired loan's stated interest rate varies based on subsequent changes in an independent factor (e.g., the prime rate or the U.S. Treasury bill weekly average), the effective interest rate may be based on the factor as it changes over the term of the loan. Alternatively, it may be fixed at the rate in effect at the time the loan is recognized as impaired. Whatever approach is selected, it should be applied consistently for all variable interest rate loans.

As a practical expedient, a creditor may use the observable market price of the impaired loan, if one exists, or the fair value of the collateral for collateral-dependent loans as alternatives to estimating and discounting the loan's expected future cash flows. Statement No. 114 defines a collateral dependent loan as one in which repayment is expected to be provided solely by the underlying collateral. The standard also requires a creditor to measure impairment based on the fair value of the collateral when it is determined that foreclosure is probable.

Allowing a creditor to measure loan impairment based on the fair value of collateral acknowledges that some banks and other depository institutions are required by regulatory agencies to recognize the fair value of collateral. Similarly, a creditor's use of a loan's observable market price would facilitate measurement of impairment loss in situations involving commercial real estate loans. Traditionally, loan losses on receivables of this type reflect appraised value.

Applying a Measurement Approach

A creditor may use a loan-by-loan approach in applying a measurement method. However, when impaired loans share common risk characteristics, impairment loss may be based on aggregation techniques. A creditor's experience with loans possessing similar risk characteristics may provide estimates of the average time it takes to resolve an impaired loan, as well as the average amount recoverable. A composite effective interest rate is used for discounting the expected future cash flows of impaired loans that are pooled.

Income Recognition

Paragraphs 17 through 19 of SFAS No. 114 contained requirements for recognition of income and expense in applying the statement. The Statement pointed out that the discounted net carrying value of an impaired loan may change from one reporting period to the next not only because of the passage of time but also because of revisions in the amount and timing of future cash flows. It stipulated that an impaired loan's net carrying value be revised at each reporting date subsequent to impairment to reflect the present value of expected future cash flows (or the observable market price or the fair value of collateral). A creditor that measured impairment based on discounted cash flows could elect to report the entire change in present value as bad-debt expense or as a reduction in the amount of bad-debt expense that otherwise would be reported. Alternatively, the increase in present value attributable to the passage of time could be reported as interest income and the change in present value, if any, reflective of revisions in the amount and timing of possible cash flows reported as bad-debt expense or as a reduction in the amount of bad-debt expense that otherwise would be reported. Whatever approach was chosen, it was to be applied consistently from one reporting period to another.

A creditor that measured impairment based on the observable market price or the fair value of collateral was required to report changes in the measure as bad-debt expense or as a reduction in the amount of bad-debt expense that otherwise would have been reported.

The discussion of the requirements of paragraphs 17 through 19 used the past tense. This is because the FASB is in the process of amending No. 114 to eliminate these paragraphs. Certain entities were experiencing difficulty in attempting to implement them and requested an extension of the effective date of the statement. Rather than change the effective date, the Board opted to drop the requirements. The Board issued an exposure draft on March 31, 1994, and the amendment is expected to be finalized before the effective date.

With these paragraphs dropped, entities can now continue to follow their previous accounting systems and methods. The proposed amendment acknowledges that some accounting methods for recognizing income (e.g., cost recovery, cash basis) may result in a recorded investment in the impaired loan that is less than the present value of expected future cash flows or the observable market price or the fair value of the collateral. While meeting the definition of an impaired loan, no additional impairment would be recognized in these circumstances.

Other Matters

Several disclosures, either in the body of the financial statements or in the accompanying notes, which may be useful in understanding a creditor's accounting for impaired loans, are required by Statement No. 114. Specifically, as of the current balance sheet date, a creditor must disclose the recorded investment in the loans for which impairment has been recognized as well as the total allowance for credit losses related to those impaired loans. Required disclosures also include an analysis of the activity in the allowance for credit losses account. The statement originally required disclosure relating to the creditor's income recognition policy as elected under paragraph 17. The proposed amendment requires disclosure of the creditor's policy for recognizing income, including that for recording cash receipts. For each period for which results of operations are presented, required disclosures include interest income recognized, the amount that would have been accrued according to the original contractual terms, total cash receipts, and the allocation of these receipts between interest and reduction in principal balance.

Statement No. 114 is effective for financial statements for fiscal years beginning after December 31, 1994, although earlier adoption is encouraged. In recognition of the difficulty in "re-creating" historical estimates of the amounts and timing of cash flows, observable market prices, or the fair value of collateral, the FASB proscribes retroactive application of the statement.

The exhibit shows how Statement No. 114 would be implemented when an enterprise concludes it is probable it will be unable to collect principal and interest due according to the contractual terms of the loan agreement. The exhibit illustrates the effects of the statement on financial reporting under two different case scenarios.

TWO EXAMPLES OF ACCOUNTING FOR LOAN IMPAIRMENT

Facts

* On January 1, 19X1, the Enterprise lends Company X $10,000 at 7% interest with the principal payable on December 31, 19X4. Interest is payable each December 31.

* The loan is not a component of a large group of homogeneous loans that are collectively evaluated for impairment and the Enterprise does not account for loans under specialized industry practice.

* Towards the close of 19X1, X notifies the Enterprise it is unable to make the $700 interest payment on the loan payable on December 31, 19X1.

* At the date of notification, the Enterprise concludes it is probable it will be unable to collect principal and interest due according to the contractual terms of the loan agreement.

Presented below are two different scenarios of accounting for loan impairment under SFAS 114. Case 1 illustrates the accounting using the discounted cash flow method. Case 2 shows the accounting based on the loan's observable market price.

CASE 1

* At the close of 19X1, the Enterprise negotiates with X to modify the terms of the loan and the parties agree to add the $700 of accrued interest to the principal loan balance payable at December 31, 19X4. Company X will continue to pay $700 interest on each subsequent December 31st.

* The loan is not secured by collateral subject to foreclosure in the event Company X defaults on the loan.

* To determine if the loan is impaired, the present value of the new expected future cash flows based on the loan's implicit rate of return (7%) is computed.

ContractualCashFlowsPVFactorPresentImpairment

InterestPrinciple

Dec.31(a)(b)(c)(d)(b-d)

19X2$700.9346$654

19X3700.8734611

19X4700$10,700.81639,306

$2,100$10,700$10,571$129

Analysis

* Since the present value ($10,571) of cash flows is less than the loan's carrying amount ($10,700), a $129 impairment loss is recognized.

* The enterprise has elected to recognize the increase in present value attributable to the passage of time as interest income accrued on the net carrying amount of the loan at the 7% effective interest rate. Case 1 assumes no revisions in the amount and/or timing of the new expected future cash flows.

* Summaries of the loan's net carrying amount and income statement effects follow:

SummaryofLoan'sNetCarryingAmount

DateRecordedInvestmentValuationAllowanceNetCarryingAmount

12-31-X1$10,700$129$10,571

12-31-X210,74012910,611

12-31-X310,78312910,654

12-31-X4000

SummaryofLoan'sIncomeStatementEffects

YearBadDebtExpenseInterestIncomeTotalIncome

19X1$129$700$571

19X20740740

19X30743743

19X40746746

$129$2,929$2,800

CASE 2

* The specifics are the same as Case 1 except management, as a practical expedient, decides to measure impairment using the "observable market price" of the loan, assumed to be $10,400 at December 31, 19X1, $10,200 at December 31, 19X2, and $9,400 at December 31, 19X3.

Analysis

* Since the loan's recorded investment ($10,700) exceeds its observable market value ($10,400) at December 31, 19X1, a $300 impairment loss is recognized.

* The loan's net carrying amount at each December 31 through maturity is shown below:

TABULAR DATA OMITTED

William J. Read, PhD, CPA, is professor of accountancy at Bentley College and K. Raghunandan, PhD, is assistant professor of accounting, University of Massachusetts.