Determining ALLL Allocation on Impaired Loans
Author: Bob Swartz
As one of the most significant estimates of a financial institution, the allowance for loan and lease losses (ALLL) requires substantial time and consideration by management. While the ALLL calculation involves subjectivity leading to increased scrutiny from regulators and auditors, financial institutions can work to make sure the calculation is completed in accordance with the applicable regulatory guidance.
One scrutinized area of the calculation is the measurement of impairment for impaired loans. The guidance for loans identified for evaluation and individually deemed impaired falls under Accounting Standards Codification (ASC) 310-10-35, Receivables – Overall – Subsequent Measurement. The general concept surrounding loan impairment under generally accepted accounting principles is that “impairment of receivables shall be recognized, based on all available information, when it is probable that a loss has been incurred based on past events and conditions existing at the date of the financial statements.” In addition, impairment of receivables should not be recognized based on potential outcomes; the allowance should be supported by appropriate analyses and well-documented.
In following this concept, financial institutions must first make a decision whether the loan is impaired. If the loan is considered impaired, the next step would be to determine how the impairment should be measured. A loan is considered impaired when “it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.” Financial institutions should follow their normal loan review procedures to make this determination and should consider the loan’s payment history, the borrower’s ability and intent to repay the loan and the value of the collateral.
Once a loan is determined to be impaired, many financial institutions default to using the fair value of the collateral method, which determines the impairment by calculating the excess of the recorded loan over the fair value of the collateral. However, this method only is allowed if the loan is considered collateral-dependent, i.e., the loan only will be repaid by the disposition of the underlying collateral.
The method required under ASC 310-10-35 to measure impairment is the present value of expected cash flow discounted at the loan’s effective interest rate. This method should be used when foreclosure isn’t probable and when cash flow can be reasonably estimated. Determining the expected cash flow includes several judgments and uncertainties based on the information available, and assumptions should be reasonable and well-supported. Examples of these judgments are when delinquent payments will be made and whether the income-producing collateral does not provide adequate cash flow to service the debt, in which case the borrower’s ability and intent to cover the deficiencies must be determined. Other factors to consider in estimating the expected cash flow include the following:
- Contractual terms of the loan agreement
- Existing arrangements with the borrowers for repayment
- Fair value of the collateral
- Reasonableness of the underlying assumptions
The discount rate to be used in the calculation is the loan’s effective interest rate or the contractual interest rate. If the rate is adjustable, use the interest rate in effect at the date the loan is first considered to be impaired.
If a specific allowance is provided on the impaired loan, the present value of future cash flow should be recalculated on at least an annual basis. The calculation should be revisited more often if there are known changes in the borrower’s circumstances.
Once the calculation is complete, the present value of cash flow should be compared to the recorded investment in the loan. The recorded investment in the loan is the principal balance plus accrued interest receivable, deferred loan fees/costs and remaining premiums/discounts. If the present value of cash flow is less than the recorded investment in the loan, a specific allowance must be recorded in the ALLL for the impaired loan.
Calculating the present value of cash flow on impaired loans can be a significant burden on the institution’s management, and a one-size-fits-all approach may not be attainable with the amount of judgment involved in the process. However, with the proper training and guidance, the process can be a valuable tool in determining the institution’s exposure on impaired loans.
For more information on allowance for loan and lease losses, contact your BKD advisor.