THE IMPACT will depend upon the composition of the lender's loan portfolio.
By restructuring their troubled loans before a new FASB accounting standard takes effect, banks and other lenders can reduce the loan losses they will have to recognize when they finally adopt the standard.
Statement of Financial Accounting Standards No. 114 -- "Accounting by Creditors for Impairment of a Loan" -- requires creditors to establish and maintain a valuation allowance for covered impaired loans based on the discounted value of expected cash flows from the loans.
Currently, most creditors recognize impairment of a loan only when and to the extent that the net carrying amount of the loan exceeds the undiscounted expected future cash flows from the loan.
Hence, they will have to charge earnings to provide additional allowances for loans impaired at the beginning of the year of in which they initially adopt the statement. SFAS No. 114 will become effective for fiscal years beginning after Dec. 15 for those who do not opt to adopt it earlier.
Current Practice
The predominant current practice for measuring loan losses is consistent with the requirements of SFAS No. 15 -- "Accounting by Debtors and Creditors for Troubled Debt Restructurings" -- which is amended by the new statement.
SFAS No. 15 requires creditors to record a loan loss provision upon formally restructuring a troubled loan only if 1) the aggregate interest and principal payments to be received by the creditor under the modified terms total less than the carrying amount of the loan and 2) an adequate valuation allowance has not previously been provided.
Any excess of total cash interest and principal payments specified by the new terms over the recorded investment in the receivable is recognized as interest income at a constant interest rate throughout the restructured loan term.
In effect, SFAS No. 15 requires creditors to account for the effects of troubled loan restructurings involving modifications of terms prospectively by reducing the rate at which interest income is calculated from the date of the restructuring through the maturity of the restructured loan.
New Requirements
On the other hand, under SFAS No. 114, creditors will continue to recognize interest income at the same rate as before identifying a loan as impaired.
In order to maintain the interest rate, the new standard requires creditors to provide allowances for covered "impaired" loans based upon the present value of their expected future cash flows. (Alternatively, they may measure a loan's impairment by its observable market price or, if the loan is collateral dependent, the fair value of the collateral.)
Present values are to be determined using the rate of return implicit in the loan at its origination as the discount rate. For variable rate loans, the creditor may fix the discount rate at the interest rate in effeft on the date the loan became impaired or allow it to continue to vary as specified in the loan contract.
In later accounting periods, creditors will need to reassess impaired loans and recognize significant changes in a loan's impairment by adjusting the valuation allowance with a corresponding charge or credit to bad debt expense.
They may elect to account for the portion of the impairment adjustment due to present value changes attributable to the passage of time either as interest income or bad debt offsets.
Creditors are to use their normal loan review procedures in identifying impaired loans. A loan is impaired if it is probable that the creditor will not collect all contractually due amounts, including interest that accrues on delinquent payments.
All loans, except large groups of smaller-balance homogeneous loans that have not been individually restructured and are evaluated for impairment collectively, loans carried in the financial statements at amounts not exceeding their fair values, leases and debt securities, are to be considered.
SFAS No. 114 does not specify how creditors should determine the overall adequacy of the allowance for loan losses. In addition to loan loss provisions for identified impaired loans, they will need to continue to provide allowances for loans that may become impaired in the future.
Impact of Accounting Change
Although SFAS No. 114 changes both the timing and manner of recognizing the effects of loan impairment in financial statements, it does not alter them. To the extent that a creditor must record higher loan losses upon identifying an impaired loan, it will recognize an equal amount of additional interest income (or reduced loan losses) in the future.
Also, SFAS No. 114 is broader than SFAS No. 15 in that it establishes principles for measuring losses on all covered impaired loans, not just those that are restructured. The restructuring of a troubled loan -- other than a smaller-balance loan that was evaluated for impairment collectively as part of a homogeneous group -- will not ordinarily trigger a loan loss provision.
In most cases, the valuation allowance required under SFAS No. 114 will have been provided at the time the loan was evaluated for impairment, usually well in advance of the date of the restructuring.
(A loan loss provision may be required at the time smaller balance homogenous loans that are evaluated for impairment collectively are restructured since, upon restructuring, such loans must be evaluated for impairment individually under SFAS No. 114.) The effective date and transition provision of SFAS No. 114 provides a window of opportunity, enabling creditors to manage when they recognize the effects of impairment of certain restructured troubled loans for financial accounting purposes.
As long as a loan that was restructured in a troubled debt restructuring involving a modification of terms prior to the effective date of SFAS No. 114 is not impaired based on the terms in the restructuring agreement, the creditor may continue to account for it in accordance with SFAS No. 15, the presently effective accounting rule.
Thus, the impact of adopting the statement may be mitigated by restructuring impaired loans prior to the statement's effective date.
The impact of adopting the statement may be significant for some lenders. The impact on any given lender will depend upon the composition of the lender's loan portfolio, the manner in which the lender evaluates the adequacy of its allowance for loan losses currently, general economic conditions, and a host of other factors.
Lenders may find it prudent to review their portfolios early in 1994, assess the statement's potential impact on their financial statements, evaluate the extent to which it might be advantageous to restructure impaired loans prior to the end of the year, and design and implement programs to achieve their objectives.
Special procedures might be required both to assure that advantageous restructurings are completed on time, and that quality is maintained with respect to restructuring efforts conducted on a fast track. The following strategic factors should be considered in the evaluation:
* Not all impaired loans are viable restructuring candidates. If the account debtor is unable to comply with the restructured loan terms, the restructured loan will be impaired, and the creditor will have to provide for loan losses in the financial statements anyway (albeit, in a lesser amount than if the loan had not been restructured).
More importantly, having compromised some of its rights to effect the restructuring, the creditor may be in a less advantageous position in facing the failed restructuring.
* The accounting rule change does not alter the economics of the lender's portfolio, it merely changes the timing of financial statement recognition of revenues and loan losses.
By restructuring an impaired loan in 1994 to avoid a 1995 loan loss provision, the lender also would be reducing the interest revenues it could otherwise recognize over the entire life of the loan.
A lender might prefer to position itself to maximize reported profits in the future and explain that its extraordinarily large 1995 loan loss provision is due to an accounting.
