Converting Non Earning Assets Into Earning Assets
Financial institutions have seen significant increases in foreclosures and Troubled Debt Restructurings (TDRs) in recent years as more borrowers continue to experience financial difficulty due to ongoing economic and real estate market turmoil in many areas of the United States. The accounting rules regarding Real Estate Owned (REO) and TDRs are complex and this article will focus on several key current issues related to these topics.
Real estate owned (REO)
Determining the amount to transfer at time of repossession
REO represents real estate acquired by an institution through foreclosure or deed in lieu of foreclosure after a borrower defaults on a loan. Accounting rules state that foreclosed real estate acquired in satisfaction of a defaulted loan should be recorded at fair value less estimated costs to sell at the time of foreclosure, which then becomes the institution’s new cost basis in that REO property.
The fair value of REO will generally be derived from an independent appraisal. Due to the subjective nature of the assumptions and methodologies used in appraisals, institutions should ensure they are engaging qualified independent appraisers and implement procedures for reviewing the conclusions in the appraisal reports. Institutions should also give consideration to the age of the appraisal being used to determine the fair value at the time of foreclosure and implement procedures to obtain updated appraisals when necessary to ensure any material changes in the market are properly reflected in the value. Updated appraisals should be obtained more frequently during times of real estate market turmoil when rapid changes in market values are likely.
Accounting for further changes in value and holding costs
After the REO property’s new cost basis has been established and recorded, accounting rules require an ongoing analysis of the current fair value less estimated costs to sell compared to the cost basis. At the end of each reporting period, institutions need to consider whether the fair value has deteriorated further during the period, in which case that deterioration must be charged to current period expense. Alternatively, if the fair value has increased during the period, the cost basis remains the same as no gain is recorded until disposition.
Other costs incurred by institutions while holding the REO property such as maintenance costs, property taxes and insurance are generally required to be recorded as current period expenses as they are incurred. While most holding costs are required to be expensed, certain costs may qualify to be capitalized when they result in permanent improvements that add value to the property. For example, if an institution forecloses on a partially completed residential subdivision development, costs incurred by the institution to complete the development while the property is in REO may be capitalized.
Gain recognition on sales of REO properties
A key element to consider related to gain recognition when an institution sells an REO property is whether the institution is providing financing to the buyer. If the selling institution is not providing financing to the buyer, then any gain on the sale is fully recognized immediately. In instances where the selling institution is providing financing to the buyer, the amount of gain recognized will primarily depend on the size of the buyer’s down payment. Accounting rules outline six different methods for gain recognition depending on the size of the down payment and other criteria.
In general, accounting rules state that in situations where the new buyer is providing only a minimal down payment, the bank still retains risk and as such, is not allowed to recognize the full gain on a sale until the borrower has assumed the risk through an established history of making payments. Accounting rules related to gain recognition on real estate sales are relatively specific and should be closely analyzed by institutions for each sale where financing is provided to the buyer. Regardless of whether the selling institution provides financing to the borrower, losses on sales are recognized immediately.
Troubled debt restructurings (TDRs)
Troubled debt restructurings are currently a hot-button topic for financial institution regulators and auditors alike. In general, a TDR is deemed to have occurred whenever a loan modification for a borrower in financial difficulty results in the institution granting a concession to the borrower. This definition results in every loan modification potentially constituting a TDR. The accounting rules provide various indicators but don’t provide any bright lines for evaluating whether a borrower is experiencing financial difficulty or whether a concession has been granted, resulting in a relatively subjective analysis.
Determining whether a TDR has occurred is essentially a two-step process. Institutions should first evaluate whether the borrower is experiencing financial difficulty. If the borrower is not having financial difficulty, then by definition a modification is not a TDR. If the borrower is experiencing financial difficulty, then the institution must determine whether the modification has resulted in a concession being granted to the borrower. A concession could result from a variety of factors, including changes in a loan’s payment terms, interest rate or collateral.
The loan’s interest rate is a key factor to consider when evaluating whether a concession has been granted. If the interest rate has been modified to a below-market rate then a TDR has clearly occurred. However, a TDR may also have occurred, even if a loan is being renewed and the interest rate remains the same. Institutions must evaluate whether the new interest rate would be offered to a new borrower with similar credit quality at the time of the modification or renewal. Institutions must also consider whether other market participants would offer those terms to the borrower. If the institution concludes that a new borrower would not have been offered the same terms, then modifying or renewing a loan to an existing troubled borrower and keeping the interest rate the same results in a TDR.
In addition to the interest rate, there are many other considerations when determining if a TDR has occurred. New accounting guidance related to TDRs was issued in April 2011 in FASB Accounting Standards Update No. 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring. While this guidance did not change any of the rules, it did provide clarification. Institutions should refer to this guidance when evaluating their loan modifications as TDRs. Due to the complexity and subjectivity of the TDR rules, it is very important that institutions fully document the analysis and considerations going into their TDR conclusions.
While some REO and TDR transactions are straightforward, many have complex accounting and tax implications. For more information or assistance with these topics, please contact your local financial institution specialist or McGladrey & Pullen Director Brett Hartema at 515.558.6644.