Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (SFAS No. 114), was issued in May 1993. This Statement has been the subject of much controversy on its road from exposure draft to find statement. While there were many opponents to this Statement, the banking industry was adamantly opposed to the standard. Its value was largely ignored, and now this community, as are all creditors, are faced with the tremendous task of implementing the statements requirements.

The basic requirements of SFAS No. 114 can be summarized as follows:

SFAS No. 114 applies to all creditors and all loans identified for evaluation, uncollateralized and collateralized. It does not apply to large groups of smaller-balance homogeneous loans collectively evaluated for impairment (e.g., credit card receivables, residential mortgages, and consumer installment loans), as well as loans measured at fair value or at the lower of cost or fair value (e.g., mortgage company loans measured in accordance with SFAS No. 65, Accounting for Certain Mortgage Banking Activities), leases, and debt securities as defined by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. It includes all loans that had been restructured in accordance with SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, including smaller-balance homogeneous loans collectively evaluated for impairment.

All impaired loans within the scope of SFAS No. 114 will be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent.

SFAS No. 114 amends SFAS No. 5, Accounting for Contingencies, to indicate a creditor should evaluate the collectibility of both contractual principal and interest of all loans when assessing the need for a loss accrual.

SFAS No. 15 is amended to apply the provisions of SFAS No. 114 to those loans restructured in a troubled debt restructuring involving a modification of terms.

SFAS No. 114 is effective for financial statements for fiscal years beginning after December 15, 1994.

There are several issues the banking community is wrestling with in response to SFAS No. 114 and to meet SFAS No. 114's requirements by its effective date.

Identification

SFAS No. 114 admittedly does not specify how a creditor should identify loans to be evaluated for collectibility; it specifies that a creditor should use normal loan review procedures in making that determination. A footnote refers to the AICPA's Auditing Procedure Study, Auditing the Allowance for Credit Losses by Banks, that includes a list of traditional sources for identifying potential credit losses. Although the method of identification may not have changed, the criterion for impairment has been clarified to include principal and contractual interest. The FASB has changed the basic concept of how one views a recorded asset balance. Previously the focus was the loan principal; now it is the sum of the present values of two cash flow streams, principal and interest. When there is uncertainty about the collectibility of a receivable, management now has to focus not only on the receivable but also on the unrecorded income-producing potential of the receivable. Even though the net present value concept is not unique to loan officers, it presents a new concept about how to view the realization of recorded asset balances.

A loan is impaired when it is probable (likely to occur) that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.

Segregation and Aggregation by Risk Characteristics

Application of the SFAS No. 114 involves significant judgment and estimates. It indicates creditors should have latitude to develop measurement methods that are practical in their circumstances. What does that really mean?

SFAS No. 114 refers to risk characteristics and suggests loans may be grouped by similar risk characteristics. If not readily available, a meaningful aggregation level based on risk characteristics needs to be developed. These groupings will differ from one bank to another.

Similar to the aggregation used for SFAS No. 107, Disclosures about Fair Value of Financial Instruments, a bank could begin with classification levels it currently has on the balance sheet and loans systems, e.g., loan types, call report classifications, collateral codes, purpose codes. Primarily, aggregation will result in segregating unique and high-risk impaired loans and grouping the remainder into like kinds. The purpose of aggregation is to minimize the number of loans that will have to be evaluated individually. Grouping loans by their risk characteristics will result in at least three categories of impaired loans:

* Loans that have unique or high-risk characteristics (e.g., specific to an individual borrower or borrowing relationship, industry, region, loan size, etc.) that must be evaluated individually;

* Groups of loans that have common risk characteristics and common historical statistics that are evaluated as a group or groups and smaller balance, non-homogeneous loans evaluated collectively for impairment (not addressed by SFAS No. 114); and

* Impaired loans otherwise outside the scope of SFAS No. 114.

Cutoff. Management may determine a cutoff threshold for unique, high- risk impaired loans is necessary for cost effectiveness and/or practicability. A loan balance that is material to an institution will constitute unique risk. Based on the institution's size, loans should be evaluated individually based on materiality and other risk characteristics.

Materiality Threshold. Although a threshold based on materiality is not unique to accountants, it will cause financial statements to lose comparability between institutions. For example, given the same asset size, a single bank holding company will have a much larger threshold for individual loan reviews than a multi-bank holding company. It could be argued this type of threshold has been used before SFAS No. 114 entered the scene; however, a similar method of measurement would have been applied then. Under SFAS No. 114, different measurement methods will be used for evaluation.

Thresholds to consider may include the regulators' real estate appraisal requirement or the bank's internal threshold for credit reviews. The bank's external auditor should be informed of decisions made on dollar value criteria prior to implementation.

Aggregation. Aggregation of impaired loans that have common risk characteristics will be the most difficult to plan for. For aggregation to be effective, an institution will need to develop meaningful historical statistics such as average recovery period, average amounts recovered, and a composite effective interest rate for each group of impaired loans for use in projecting cash flows. The first two statistics may not be readily available. The level of aggregation should be planned carefully so that useful, meaningful statistics can be developed. Once again, a good place to start would be the aggregation level developed for SFAS No. 107 disclosure purposes. Meaningful statistics with regard to this group of loans may be readily available for establishing their observable market price.

SFAS No. 114 does not prescribe the method for measuring impairment of smaller-balance homogeneous loans traditionally evaluated collectively. Institutions will presumably have the liberty to make the decision that the combination of the uniqueness and size of such loans causes them to fall within one class of risk and could, for consistency, be evaluated for impairment under the rules of SFAS No. 114 utilizing certain year- to-date collectibility averages and a composite effective interest rate.

There are no changes in the methods of valuation of impaired loans outside the scope of SFAS No. 114, e.g., smaller balance homogeneous loans collectively evaluated for impairment. Prospectively, all restructured loans shall be accounted for under the guidance of SFAS No. 114. However, as a phase-in requirement, only loans restructured prior to the adoption of SFAS No. 114 that are not performing in accordance with their restructured terms will have to be accounted for under the guidance of SFAS No. 114. It is recommended such loans be grouped as having common risk characteristics and treated accordingly.

Measurement: The Effect of the Credit-Review Process

Banks will have to consider rewriting credit-review procedures with a choice among three methods.

Present Value of Expected Future Cash Flows. Management must estimate not only the amount, but also the timing, of future cash flows. This is defined to be the best estimate based on reasonable and supportable assumptions and projections, giving consideration to the extent to which the evidence can be verified objectively. It is unlikely two people will arrive at precisely the same estimate. An institution is required to consider an estimated cost to sell, on a discounted basis, if those costs are expected to reduce the cash flows available to repay or satisfy the loan.

SFAS No. 114 indicates that if a range of projections is used, the likelihood of the possible outcomes shall be considered in determining the best estimate of expected future cash flows. The present values of the various discounted cash-flow streams should be computed first, then probability applied to the results. To prevent second guessing and potential accusations that an institution is manipulating the information, it might be useful to develop a policy regarding use of ranges. For example, if ranges are used, then a mid-point value could be used to determine the cash flows. Any policy should be discussed with and approved by the external auditor prior to implementation.

Once the expected future cash flows have been determined, they are discounted using the loan's effective interest rate. The effective interest rate is defined as the contractual rate adjusted for any net deferred fees or costs, premium or discount existing at the origination of the loan, frequently referred to as the originated expected yield. An institution will have to decide how and when to compute this rate. For fixed rate loans, one of the following methods could be utilized in determining the effective interest rate:

* Compute the effective rate at the inception of the loan and retain that rate in a manner that could be subsequently verified if and when such loan becomes impaired either on or off the loan system;

* Retain sufficient information so this rate can be computed when a loan becomes impaired. This may be difficult to implement and verify because loan systems usually will not retain historical balances of deferred fees, etc.

* Use the contract rate if the difference between the contractual rate and the effective rate is not material (providing the external auditors concur with the assessment of immateriality); or

* Record the loan at its effective rate versus its contractual rate. Although this option represents the most direct interpretation of SFAS No. 114, it is impractical for lending operations where the accounting system is programmed to accrue interest income due from customers and reflect actual cash receipts.

A determination of the effective rate becomes more complicated for variable rate loans. A choice has to be made between either a) a calculated rate based on the factor as it changes over the life of the loan (a life-to-date effective yield), or b) the rate in effect at the date the loan meets the impairment criterion. This choice, once made, must be applied consistently for all impaired variable rate loans.

The easier choice to implement is to fix the rate at the date the loan meets the impairment criterion. Furthermore, because SFAS No. 114 is being implemented during historically low rate years, using the rate in effect at the date the loan meets impairment criteria may minimize the negative impact of adoption.

The "effective rate" of a loan prior to restructuring must be maintained. According to SFAS No. 114, the effective rate for a troubled debt restructuring under SFAS No. 15 is based on the original contract rate, not the rate specified in the restructuring agreement. In practice this rate may not be available for loans restructured prior to the adoption of SFAS No. 114. In a grandfathering approach, loans restructured prior to adoption of SFAS No. 114 that are performing in accordance with the terms of their restructuring agreements will not have to be remeasured. However, when such loans become impaired based on the restructuring agreement, remeasurement will be required by SFAS No. 114 using the effective rate in the original loan contract.

Duplicative systems will need to be developed for SFAS No. 114 versus SFAS No. 107, Disclosures about Fair Value of Financial Instruments, if the discounted cash flow method is selected because of the difference in interest rates used to discount the cash flows (market interest rates versus effective interest rates).

The measurement process will need to be supported by a system that calculates present value of expected future cash flows, e.g., a "loan calc" routine, such as TVALUE. Although the mechanics of discounting are cumbersome and labor-intensive, it is the level of verifiable documentation that will be time-consuming to develop. For loans individually evaluated, the process of estimating the amount and timing of future cash flows will require human judgment and verifiable documentation. This must be a disciplined evaluation, but one that is also very subjective. This is quite different from current techniques in which a loan officer often will be able to indicate that a payment (or a payment stream) of $X, or ($Y and $X) are expected in the next month(s). This projection is usually followed by an assumption about economic conditions and payment streams without detailing the timing of such payments.

Presumably, under the discounting method, however, each credit review officer would need to have a spread-sheet that computes present value containing a certain level of written documentation to support the assumptions regarding the projected cash flows, based on information from the debtor's business. Once a loan is impaired and is segregated or flagged on the system, the only people who should cause changes in the loan records, other than for the application of payments, interest accruals, etc., would be certain approved loan officers. A question arises as to the frequency and appropriate level of detail required in scheduling out the expected future cash flow streams.

For groups of loans collectively evaluated for impairment, either because of similar risk characteristics or because of their small size, a forecasting system is helpful in projecting the amount and timing of expected future cash flows based upon historic performance data. Documentation to support the calculated cash flow projections must be maintained.

Observable Market Price. This method reflects the FASB's attempt to give latitude to creditors to develop or select a measurement method practical in their circumstances. This method will be most useful for groups of similar impaired loans that are salable. As market price represents a liquidation value, it will probably yield a rather conservative outcome.

Fair Value of the Collateral. Although the "solely" caveat within SFAS No. 114 seems to contradict the intent to allow the use of fair value of collateral for ease of valuation, the statement appears to establish collateral value as the minimum net realizable amount from the impaired loans. That is, collateral represents the last resort for repayment and will probably be used as the last resort for estimating impaired value as well.

The estimated costs to sell, on a discounted basis, must be considered for all the methods in the measurement of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan. Thus, SFAS No. 114 has endorsed the net realizable value concept and shifted the cost to dispose into the credit loss versus general expenses category as set forth in the AICPA's Statement of Position 92-3.

Accounting and Recording Impairment

The value of an impaired loan, determined from one of the above methods, is compared to the recorded investment in the loan to determine impairment. The recorded investment in the loan may not be readily available on a loan by loan basis as it includes net deferred loan fees or costs, unamortized premium or discount as well as accrued interest. Depending on how an institution accounts for its loan origination fees per SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (i.e. pool method versus loan by loan), this amount may not be readily determinable. In addition, by explicitly including accrued interest in this balance, SFAS No. 114 will clearly cause a change in a predominant regulatory accounting principle (RAP) where charged-off interest is frequently reversed through interest income rather than included as bad debt expense.

Under GAAP, loans will further depart from legal and contractual balances, stressing the need for an institution to support multiple basis balances.

There will be a need for an accounting system to track the valuation allowance related to each impaired loan or each group of impaired loans. If the loans are evaluated individually, the system must either track each loan's reserve separately or be able to compute that amount from the loan's original amount and the current balance. One way to do this is to have the impaired loan system track each reserve as a negative principle amount, similar to a loan participation.

Significant Change Standard

Even though the measurement process is cumbersome, it needs to be updated at least quarterly. SFAS No. 114 indicates a recalculation of impairment must be done if a significant change in the amount and timing of expected future cash flows is expected or if actual cash flows are significantly different from the cash flows previously projected. The same standard applies to the use of observable market price or the fair value of collateral methods. An institution and its independent accountant need to agree on the definition of "significant change" and ensure it is included in the implementation policy.

Current Developments

In March 1994, the FASB issued an exposure draft of a proposed Statement, Accounting by Creditors for Impairment of a Loan-Income Recognition (Editor's note: A final statement embodying the proposals was issued as SFAS No. 118 in November 1994). The proposed statement was issued in response to expressed concerns about the effective date of SFAS No. 114 and would amend SFAS No. 114 to allow a creditor to use existing methods for recognizing interest income on an impaired loan. This would be accomplished by eliminating the provisions of SFAS No. 114 that describe how a creditor should report income on an impaired loan (paragraphs 17-19). The proposed statement would be effective upon issuance. This proposal generally would affect the classification of income or expense that results from the net carrying amount of the loan, not the total income or expense recognized. The proposed Statement would also acknowledge that a creditor's policies for recognizing interest income and for charging off loans may result in a recorded investment in an impaired loan that is less than the present value of expected future cash flows discounted at the loan's effective interest rate (or the observable market price of the loan or the fair value of collateral). In those cases, the proposed statement would affect both the classification and the total amount of income or expense recognized. The proposed statement would amend the disclosure requirements contained in SFAS No. 114 to require information about how a creditor recognizes interest income related to impaired loans.

The FASB has reviewed the comment letters received on the exposure draft and has concluded that income recognition provisions in paragraphs 17-19 should be eliminated and the effective date should not be delayed. The FASB also concluded that the disclosures proposed in the exposure draft about how a creditor recognizes interest related to impaired loans should be simplified. A final statement is expected before the end of the year.

The AICPA Accounting Standards Executive Committee has voted to withdraw Practice Bulletin 7, Criteria for Determining Whether Collateral for a Loan Has Been In-Substance Foreclosed, and Practice Bulletin 10, Amendment to Practice Bulletin 7, because the underlying issues about substantive repossessions have been addressed in SFAS No. 114. The practice bulletins are withdrawn as of the effective date of SFAS No. 114.

EXHIBIT

THEIMPLEMENTATIONTEAM

DEPARTMENTROLE

Controller'sTospearheadSFASNo.114

implementation

SystemsToprovidesupportinautomating

theprocess

Loanofficers/TounderstandtheimpactofSFASNo.

Relationship114ontheircustomers'loans

managers

Loanreview/Toreviewthecreditfileand

Riskmanagementcalculateprojectedcashflows

TaxTomeettaxreportingrequirements

InternalauditTounderstandandapprovethe

methodologyemployed

ExternalauditTounderstandandapprovethe

methodologyemployed

The Regulators' Perspective

As with every new accounting standard, Federal bank regulators must evaluate whether to adopt SFAS No. 114 in whole or in part for regulatory accounting principles (RAP), The FDIC Improvement Act of 1991 (FDICIA) constrains their decision by requiring that RAP be "no less stringent" than generally accepted accounting principles.

Federal regulators could have interpreted "no less stringent" by requiring banks to use the higher of the loan loss reserve compiled under GAAS or the examiners' method. Rather than take this approach or create a harsher standard, in May 1994, regulators adopted SFAS No. 114, with one exception and two key questions, for fiscal years beginning after December 15, 1994.

The exception: for collateral dependent loans, when foreclosure becomes probable, impairment must be measured based on the collateral's fair value less estimated selling costs. If this measure is less than the loan's recorded balance,a valuation allowance must be established.

The regulators' two key questions relate to income recognition and regulatory capital.

The regulators ask: "Should regulatory nonaccrual standards be maintained for loans subject to SFAS No. 1147" Under RAP, banks cannot accrue income on seriously delinquent loans. The income recognition guidance in SFAS 114 contradicts this by requiring income recognition for the increase "in present value of the expected future cash flows that is attributable to the passage of time."

The regulators' desire to maintain their nonaccrual concept figured significantly in the FASB's March 1994 proposal to amend SFAS No. 114 by eliminating the income recognition guidance. With the effective date of SFAS No. 114 upon us, regulators are still pondering whether nonaccrual reporting should continue. Their analysis, which lists six reasons supporting nonaccrual and two against, reveals their reluctance to drop nonaccrual standards. The regulators also have to determine whether SFAS No. 114--or a more conservative cousin--should change the regulatory capital calculation. The key question: Are SFAS 114 valuation allowances specific or general reserves?

For regulatory capital purposes, general loan loss reserves are included in Tier 2 capital, although limited to 1.25% of risk weighted assets. General loan loss reserves not included in capital reduce total risk- weighted assets. Specific loan loss reserves, established against specific loans, are used more frequently by thrifts than banks. Specific reserves provide no capital benefit.

Ominously, FDICIA has created capital-driven regulations while FASB has introduced standards that increase volatility. FDICIA Sec. 131 requires regulators to take "prompt corrective action" when institutions fall below defined minimum capital standards. Capital adequacy calculations follow RAP, based primarily on historical costs.

However, since FDICIA was enacted, FASB has issued standards reflecting a present-value/market-value driven approach. Along with SFAS No. 115, SFAS No. 114 will likely increase the volatility of regulatory capital.

On an overall industry basis, an economic downturn would produce more impaired loans that could lead to greater reserves and reduced capital. Bank closures could result from prompt corrective action. Numerous bank closings would further fuel the downward spiral.

The emphasis on capital, based on a cumulative, historical cost approach, while U.S. and international accounting standard setters gravitate toward present/market values can have unintended consequences. Viewing capital as a steady, easily monitored base is questionable when volatile values become more prevalent. While regulators are currently studying how best to inject market value risk into existing capital standards, the accounting evolution towards present/market values continues. To avoid bank closings due to temporary market conditions, Congress should consider suspending prompt corrective action when it results from accounting rides that did not exist when FDICIA was enacted.

While evaluating SFAS No. 114 is primarily the province of Federal bank regulators, other interested regulators may push their perspectives. The General Accounting Office (GAO) has been vocally committed to changing the term "probable"--as used in SFAS 5 and repeated in SFAS 114--to "more likely than not." They also support market interest rates over effective interest rates. Joined with their criticisms of Federal bank regulators, the GAO may seek to make RAP for impaired loans stricter than GAAP.

The Securities and Exchange Commission (SEC) may raise its voice as well. SEC Chief Accountant Walter Schuetze has expressed a desire for detailed criteria to determine when a loan becomes impaired. The SEC could promote its own rules or provide a more restrictive interpretation; its crusade in the trading versus investment securities controversy accelerated the shift to market value accounting as now expressed in SFAS 115.

Prior to SFAS 114, regulatory practices (i.e. classifying loans into certain categories and applying fixed percentages against each category) had superseded SFAS 5's broader guidelines. SFAS No. 114 should reestablish GAAP as the pre-dominant practice for determining loan loss reserves.

Implementation will require extensive training efforts to immerse examiners in present value concepts. Considering the importance of credit analysis in regulatory efforts, SFAS No. 114 will necessitate a basic cultural change for examiners.

Regulators are concerned with whether SFAS No. 114 serves the objectives of safety and soundness for each bank and the entire industry. The judgments and estimates required by SFAS No. 114 create risks of income manipulation and errors. Some aspects of SFAS No. 114 are also being questioned for practicality. For instance, creditors' ability to measure impairment on a loan-by-loan basis could strain regulatory resources.

Get a regulator in a philosophical mood and he or she might ask: is loan loss reserving an art or a science? While SFAS No. 114 will clearly result in more precisely calculated loan loss reserves, it is unclear whether it will help or hinder regulators in preserving the safety and soundness of the banking system.

Implementation

If not already established, each company should immediately form a SFAS No. 114 implementation team. At a minimum, there should be representatives from key areas as indicated in the grid in the accompanying exhibit.

Implementing SFAS No. 114 will not be an easy task. While the loan impairment project's primary purpose was to eliminate inconsistencies, the various options allowed by SFAS No. 114 guarantee incompatibility between entities. Each institution will arrive at a methodology and accounting policies that will invariably fall into a diverse and wide range. Institutions that have not yet addressed these issues should focus on implementation quickly.