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- Hi, I'm Kathy Moe, Deputy Regional Director
of Risk Management for the San Francisco Region.
- And I'm Shannan Todd, a Risk Management Examiner
in the Phoenix Field Office.
In this segment, we're going to review the applicability
of Accounting Standards Codification, or ASC 310
and ASC 450, using a decision tree.
We're also going to review the process to identify impaired
loans.
KATHY MOE: When estimating credit losses, the first decision to be made
is to identify which loans should be evaluated
on an individual loan basis to determine whether the loan
is impaired.
In other words, is the loan individually evaluated?
A bank should apply its established loan review
criteria when making this decision.
For example, a bank's policy might specify that loans will
be individually evaluated if they exceed a specific dollar
threshold, meet a lower size threshold but have reached
a specified past due status, or meet other review criteria.
Loans not individually reviewed for impairment should
be combined with other loans into pools having similar risk
characteristics and collectively evaluated
for estimated credit losses in accordance with the guidance
in ASC 450.
If a loan is individually reviewed, it initially falls
under the scope of ASC 310.
Then, the next decision is whether that loan is impaired
as defined in ASC 310.
If the loan is not impaired, then it should be included
in a pool of loans with similar risk characteristics,
which would be collectively evaluated for estimated credit
losses in accordance with ASC 450.
If that loan is impaired, then its impairment allowance
must be measured in accordance with ASC 310.
Please note that all Troubled Debt Restructuring or TDR
loans must also be measured for impairment in accordance
with ASC 310.
SHANNAN TODD: In short, the portion of a bank's overall Allowance
maintained under ASC 310 covers loans
that were individually evaluated and determined to be impaired
as well as all TDR loans.
The portion of the Allowance maintained under ASC 450
includes all other loans, including individually
evaluated loans that were found not to be impaired.
Financial Accounting Standards Board or FASB established
this evaluation process to ensure that loans are evaluated
under either ASC 450 or ASC 310, as appropriate, in order
to prevent loans from being double counted for purposes
of maintaining the ALLL.
As the bank reviews the credit quality and collectability
of each of the loans identified for individual evaluation,
it must determine which of these loans are impaired in order
to establish and maintain the ASC 310 portion of the overall
ALLL at an appropriate level.
- The definition of impairment reads, "A loan is impaired
when, based on current information and events,
it is probable that the creditor will be unable to collect
all amounts due according to the contractual terms of the loan
agreement."
Please keep in mind that all amounts due include both
principal and interest.
If an individually-reviewed loan is deemed impaired,
then its allowance is estimated under the ASC 310 measurement
guidance.
This guidance identifies three methods for measuring
impairment:
1. The present value of expected future cash flows;
2. The fair value of the collateral - which is only
permitted for collateral dependent loans
and is the method required by regulators for such loans; and
3. The observable market price of the loan, which would
seldom exist for a community bank's impaired loans.
SHANNAN TODD: However, if an individually evaluated loan is determined
not to be impaired, the loan is then included in the ASC 450
analysis.
The loan is grouped with other loans with similar risk
characteristics for a collective estimate of credit losses.
Unlike ASC 310, ASC 450 does not specify rules for how
estimated credit losses should be calculated.
However, there are three basic steps in the ASC 450 analysis.
1. First, segment the portfolio into groups of loans
with similar risk characteristics
for the estimation of credit losses.
2. Second, determine the historical loss rates for each
segment of the portfolio.
This includes establishing appropriate timeframes
over which to evaluate loss experience.
3. And, third, identify and consider those qualitative
factors that may impact how historical loss rates should
be adjusted so that estimated credit losses reflect
the effects of current conditions on the collectability
of the banks' loan segments.
Some of these factors will be external to the bank,
such as industry, geographical, economic, and political factors.
Other factors will be internal to the bank, such as the level
and trend of delinquencies and changes in underwriting
criteria.
- The decision tree we've shown is an informal depiction
of the process to determine whether loans will be measured
for impairment under ASC 310 or ASC 450.
The next two modules in this series of ALLL presentations
will provide more detail on the evaluation process under
each of these two ASC topics, but for now, let's discuss
in more detail, the process of identifying impaired loans
in accordance with ASC 310.
- Banks must have adequate policies, procedures,
and processes to identify which loans will be individually
evaluated.
Banks should use performance, loan grade, size,
and other risk metrics to identify these loans.
The loans that a bank identifies for individual
review under ASC 310 should reflect the application
of its internal loan review processes.
Additionally, management must document its decision
as to whether an individually evaluated loan is impaired.
Management must also support the methodology used
to measure the amount of impairment on those loans
that are determined to be impaired and support the key
assumptions used in the calculations.
- We frequently receive questions about the process
of identifying impaired loans and estimating the amounts
of impairment.
As mentioned previously, the first step in this process
is to identify when an individually evaluated loan
is impaired...
Remember the definition we shared earlier?
"A loan is impaired when, based on current information
and events, it is probable that the creditor
will be unable to collect all amounts due according
to the contractual terms of the loan agreement."
Several factors impact the assessment of whether
an individually evaluated loan is impaired, including:
1. Financial condition of the borrower,
2. Repayment sources,
3. Past performance,
4. Future payment prospects, and
5. Relevant environmental factors.
While all of these factors are important in determining
whether a loan is impaired, performance is a key indicator
that an individual loan is impaired.
This graphic illustrates the concept of the relationship
between performance and impairment.
If a loan is current, then it's possible
that it's impaired, but not likely.
Conversely, if a loan is 90 days past due, it typically
would be considered to be impaired.
Obviously, there may be exceptions to this graphic,
but as a general rule: performance is a key factor
in the identification of an impaired loan.
However, keep in mind that delinquency status is often
a lagging indicator, and ideally, management will
identify other impairment indicators before performance
problems are evident.
For example, if a borrower is current, but available
information indicates a cash flow shortfall in the near
future, the loan could be impaired even though it's not
past due.
- Another important point to remember regarding performance
is if a loan is impaired,
then it should usually be on nonaccrual.
- That's an excellent point, Shannan.
The definition of impaired and nonaccrual are very similar,
and individually evaluated loans considered impaired
by management should most likely be on nonaccrual.
- Next, let's discuss the relationship between
risk grading and impairment.
When determining impairment, remember that risk grade
is a factor to consider, but it's not an absolute
determinant.
This graphic illustrates the relationship between
Substandard, Impaired, and TDR loans.
Examiners are frequently asked about this relationship.
As illustrated, all TDR loans are impaired by definition,
no exceptions.
However, as you can see, not all impaired loans
are Substandard, but most are.
- In this segment, we walked through a decision tree
that shows the relationship between ASC 310 and ASC 450.
ASC 310 applies to loans that, upon individual review,
are found to be impaired, while ASC 450 applies to the rest
of the portfolio, including individually reviewed loans
that are not impaired.
We also discussed the definition of impairment,
which states that based on current information
and events, it's probable that the creditor will be unable
to collect all amounts due, both principal and interest,
according to contractual terms of the loan agreement.
We then reviewed the process for identifying impaired loans,
highlighting some of the factors that impact
the impairment decision.
We hope this segment has been helpful in understanding
impairment and the applicability of each
of the relevant accounting standards.