Holders of foreclosed real estate properties would not be required to depreciate such assets during the first year of foreclosure, but would have to record in earnings the revenue and expenses related to the operation of the asset, according to a proposed position statement to be issued soon by the American Institute of Certified Public Accountants.
The proposal would standardize the accounting for foreclosed properties by all current holders, including banks, thrifts and insurance companies that are filing financial statements based on generally accepted accounting principles.
"This will add another level of expense," said Bill O'Halloran, chairman of the American Bankers Association Accounting Committee and senior vice president/comptroller of Atlanta-based SunTrust Banks. "Also, I think a two- or three-year grace period would be more appropriate."
Financial institutions' foreclosed real estate holdings are increasing due to the high default rate on real estate loans. Such properties include empty or partially occupied office buildings that are generating either little revenue or none at all.
In the life insurance industry, for example, the percentage of loans in foreclosure to mortgages during the Jan. 1-June 30 period was 3.9%, up from 2.7% during the same period last year. The percentage of total foreclosed properties to total mortgages at year-end 1991 was 3.4%, up from 2.2% in 1990.
The Mortgage Bankers Association, which tracks just residential mortgages, reported a foreclosure rate of 1.04% at the end of June compared with 0.96% a year earlier.
By allowing a one-year holding period before depreciation, the proposal would avoid accounting problems if the asset were to be sold within that period, according to Carl Bass, a project manager with the Financial Accounting Standards Board.
FASB has approved the issuance of the draft exposure for comment after signing off on changes it had sought in April. The proposed position statement will be published by the end of October, according to AICPA project manager Dionne D. McNamee. She said a 90-day comment period would follow and a final version will be published in the third quarter of next year.
AICPA initially had proposed that foreclosed assets be treated as held-for-sale and carried at lower of cost or fair value; that losses be charged to earnings; and that revenue be credited to the asset (reduce the asset). The proposal, however, did not provide for any depreciation. Bass said many, including FASB, objected to this method, prompting AICPA to make some changes.
AICPA believed that writing down an asset to fair value is tantamount to an economic depreciation and that it was not necessary to recognize an accounting depreciation. Depreciating the asset for book purposes is essentially just an allocation of the asset over time, AICPA argued.
But FASB thought that since foreclosed assets may be held for more than a one-year period and because the initial draft proposed to reflect revenues and expenses in income, they should be depreciated.
In the second revision of the draft, AICPA proposed to take all revenues and expenses to the income statement, but still did not provide for depreciation. Again, FASB disagreed and insisted that depreciation be included.
Because there was much debate on the issue, FASB recommended that AICPA split the draft into two parts: a standard requiring a held-for-sale treatment of foreclosed assets, and a separate project that would deal with the accounting for operating results of a foreclosed property. AICPA issued the held-for-sale standard in April, while work continued on the operating results phase of the project.
Revenues generated by foreclosed properties are applied to reduce the carrying cost of the asset. Operating results are either charged or credited to earnings, with no depreciation.
Under the recent AICPA-FASB compromise, holders would have one year to dispose of the written-down asset without depreciation. Revenues and expenses would be taken to earnings. If, after a year, they still have the property in their inventory, they would be required to record depreciation.
In some states, mortgagors are allowed a period of up to one year to make improvements on the property before title passes. In such states, such assets may not be transferred from the mortgage account to the foreclosure account until the title actually passes.
During the one-year period, the troubled loans are considered in-foreclosure, similar to in-substance foreclosure for banks and thrifts when there is uncertainty that the loan would be repaid according to terms or when action has been taken by the lender to accelerate payment. However, lenders also take advantage of the time delay to work out the loan with the troubled borrower.
The AICPA's Accounting Standards Executive Committee was by means unanimous. the vote was 9-6. The dissenters supported reporting the net of revenues and expenses related to foreclosed assets with with no depreciation for the following reasons:
* Allocation of costs, which depreciation is intended to achieve, is inconsistent with reporting foreclosed assets held for sale at the lower of fair value, minus estimated costs.
* Fair value estimates, though subjective, are adequate in these circumstances.
* Fair value, as determined at the date of foreclosure, is often based on discounted cash flows. If the fair value of a foreclosed asset held for sale remains the same during the holding period, depreciation recorded prior to the sale simply becomes a gain selling the asset. If the fair value of a foreclosed asset held for sale declines during the holding period, recognizing depreciation is redundant.
Accordingly, depreciation does not provide the user with relevant information.