ASC 310-20, Nonrefundable fees and other costs
ASC 310-30, Loans and debt securities acquired with deteriorated credit quality
ASC 310-40, Troubled Debt Restructuring by Creditors
Technical Update – ASU 2011-02
Example of different classes of receivables
Valuation allowance for uncollectible amounts
Example of percentage-of-sales method
Lending and financing activities, including trade receivables
Example of delinquency fees, prepayment fees, and rebates
Pledging, assigning, and factoring receivables
Example of disclosure for pledged receivables
Example of accounting for the factoring of receivables without recourse
Example of accounting for the factoring of receivables without recourse
Example of accounting for the factoring of receivables without recourse
Loan impairment - Example 1
Loan impairment - Example 2
Loan impairment - Example 3
ASC 310-20, Nonrefundable Fees and Other Costs
Example of a loan origination fee
Fees and costs in refinancing or restructuring
Example of a refinanced loan – favorable terms – origination fees
Example of a refinanced loan – unfavorable terms – origination fees
Purchase of a loan or group of loans
Example 5 line of credit – origination fee
Financial statement presentation
ASC 310-30, Certain Loans or Debt Securities Acquired in Transfers
Accounting for investments in loans acquired by transfer
Basic example of loans acquired via transfer
Example with decrease in expected cash flows
Example with increase in expected cash flows
Accounting for investments in loans acquired by transfer
Example of an investment in a pool of loans acquired by transfer
Accounting for investments in debt securities acquired by transfer
Example of reduction in cash flow expectations
Example with decrease in expected cash flows followed by increase in expected cash flows
Troubled Debt Restructuring, ASC 310-40
Substituted debtors in a troubled debt restructuring
ASC 310, Receivables, consists of four subtopics:
ASC 310-10-15-3 lists two exceptions to the guidance in the General Subsections of ASC 310-10: mortgage banking activities and contracts accounted for as derivative instruments under ASC 815-10. ASC 310-10-1404 states that the Acquisition, Development, and Construction Subsections guidance applies only to those acquisition, development, and construction arrangements in which the lender participates in expected residual profit.
ASC 310-20-15-3 specifically excludes from ASC 310-20 guidance:
ASC 310-30-15-2 excludes the following transactions from ASC 310-30 guidance:
ASC 310-30-15-4 further excludes the following transactions and activities:
ASC 310-40 applies to all troubled debt restructurings by creditors. Accounting by debtors is found in ASC 470-60. Interestingly the two Subtopics use different applicability tests and so, creditors and debtors applying the same facts and circumstances may not reach the same conclusion as to whether a troubled debt restructuring has occurred.
ASC 310-40-15-9 states that TDRs may include, but are not limited to one or a combination of:
ASC 310-40-15-11 excludes the following for consideration under the TDR guidance:
Receivables come from credit sales, loans, or other transactions and may be in the form of loans, notes or other type of financial instruments. Trade receivables and other customary trade term receivables that are due in no longer than one year are measured at outstanding face value (principal) adjusted for any write-offs and the allowance for doubtful accounts, provided that management has the intent and ability to hold those receivables for the foreseeable future or until maturity or payoff. Loans receivable that management will hold until maturity or payoff are valued at outstanding principal adjusted for any write-offs, the allowance for loan losses, any deferred fees or costs on originated loans, and any unamortized premiums of discounts on purchased loans.
If a receivable is due on terms exceeding one year, the proper valuation is the present value of future payments to be received, computed by using an interest (discount) rate commensurate with the risks involved, as of the date of the receivable's creation. In many situations where an explicit interest rate is provided, the rate commensurate with the risks involved is the rate stated in the agreement between the payee and the obligor. However, if the receivable is noninterest-bearing or if the rate stated in the agreement is not indicative of the market rate for a debtor of similar creditworthiness under similar terms, interest must be imputed at the market rate. The resulting discount is amortized as additional interest income over the life of the agreement, per ASC 835.
Receivables that are pledged or assigned to a lender as collateral for a lending agreement remain under the control of the reporting entity and, therefore, remain on its statement of financial position to inform readers of the financial statements about the pledge or assignment.
As an alternative to borrowing against the value of the receivables, customer obligations are sometimes sold to generate cash before their due dates. If the transferor has no continuing involvement with the transferred assets or with the transferee, it is clear that a sale has taken place, and a gain or loss on sale is measured and recognized. However, in many cases, the transferor of the receivables has continuing involvement with the transferred assets because it sells the receivables with recourse for uncollectible amounts, retains an interest in the receivables, or agrees to service the receivables after the sale. The greater the control that the transferor retains over the receivables, the more likely that the transfer will be accounted for as a secured borrowing rather than a sale.
As a result of the economic downturn, there was an increase in troubled debt restructurings. To provide clearer guidance and eliminate some inconsistencies in practice, the FASB issued ASU 2011-02, Receivables (Topic) 310: A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The FASB clarified the circumstances under which a creditor has granted a “concession” and a debtor is experiencing “financial difficulty,” for purposes of determining whether a loan modification is a troubled debt restructuring. Additional detail is provided later in this chapter.
Acquisition, development, and construction arrangements. Acquisition, development, or construction arrangements, in which a lender, usually a financial institution, participates in expected residual profit from the sale or refinancing of property.
Accretable yield. The excess of a loan's cash flows expected to be collected over the investor's initial investment in the loan.
Blended-rate loans. Blended-rate loans involve lending new funds at market interest rates combined with existing loans at rates currently lower than market rates. (Those funds are not advanced under a line of credit.)
Carrying Amount. For a receivable, the face amount increased or decreased by applicable accrued interest and applicable unamortized premium, discount, finance charges, or issue costs and also an allowance for uncollectible amounts and other valuation accounts. For a payable, the face amount increased or decreased by applicable accrued interest and applicable unamortized premium, discount, finance charges, or issue costs
Cash flows expected at acquisition. The investor's estimate, at acquisition, of the amount and timing of undiscounted principal, interest, and other cash flows expected to be collected. This would be the investor's best estimate of cash flows, including the effect of prepayments if considered, that is used in determining the acquisition price, and, in a business combination, the investor's estimate of fair value for purposes of acquisition price assignment in accordance with Subtopic 805-20. One acceptable method of making this estimate is described in paragraphs 820-10-55-3F through 55-3G and 820-10-55-4 through 55-20, which provide guidance on present value techniques.
Class of financing receivable. A group of financing receivables determined on the basis of all of the following:
See paragraphs 310-10-55-16 through 55-18 and 310-10-55-22.
Collateral-dependent loan. A loan for which the repayment is expected to be provided solely by the underlying collateral.
Commitment Fees. Fees charged for entering into an agreement that obligates the entity to make or acquire a loan or to satisfy an obligation of the other party under a specified condition. Commitment fees include fees for letters of credit and obligations to purchase a loan or group of loans and pass-through certificates.
Common risk characteristics. Loans with similar credit risk (for example, evidenced by similar Fair Isaac Company [FICO] scores, an automated rating process for credit reports) or risk ratings, and one or more predominant risk characteristics, such as financial asset type, collateral type, size, interest rate, date of origination, term, and geographic location.
Completion of a transfer. A completion of a transfer occurs for a transaction with any of the following characteristics:
Contractually Required Payments Receivable. The total undiscounted amount of all uncollected contractual principal and contractual interest payments both past due and scheduled for the future, adjusted for the timing of prepayments, if considered, less any reduction by the investor. For an acquired asset-backed security with required contractual payments of principal and interest, the contractually required payments receivable is represented by the contractual terms of the security. However, when contractual payments of principal and interest are not specified by the security, it is necessary to consider the contractual terms of the underlying loans or assets.
Control. The possession, direct or indirect, of the power to direct or cause the direction of the management and policies of an entity through ownership, by contract, or otherwise.
Credit card fees. The periodic uniform fees that entitle cardholders to use credit cards. The amount of such fees generally is not dependent upon the level of credit available or frequency of usage. Typically the use of credit cards facilitates the cardholder's payment for the purchase of goods and services on a periodic, as-billed basis (usually monthly), involves the extension of credit, and, if payment is not made when billed, involves imposition of interest or finance charges. Credit card fees include fees received in similar arrangements, such as charge card and cash card fees.
Credit quality indicator. A statistic about the credit quality of financing receivables.
Current assets. Current assets is used to designate cash and other assets or resources commonly identified as those that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.
Debt. A receivable or payable (collectively referred to as debt) represents a contractual right to receive money or a contractual obligation to pay money on demand or on fixed or determinable dates that is already included as an asset or liability in the creditor's or debtor's balance sheet at the time of the restructuring.
Debt security. Any security representing a creditor relationship with an entity. The term debt security also includes all of the following:
The term debt security excludes all of the following:
Direct loan origination costs. Direct loan origination costs represent costs associated with originating a loan. Direct loan origination costs of a completed loan shall include only the following:
The costs directly related to those activities shall include only that portion of the employees' total compensation and payroll-related fringe benefits directly related to time spent performing those activities for that loan and other costs related to those activities that would not have been incurred but for that loan. See Section 310-20-55 for examples of items.
Effective interest rate. The rate of return implicit in the loan, that is, the contractual interest rate adjusted for any net deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the loan.
Expected residual profit. The amount of profit, whether called interest or another name, such as equity kicker, above a reasonable amount of interest and fees expected to be earned by a lender.
Fair value. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Financing receivable. A financing arrangement that has both of the following characteristics:
See paragraphs 310-10-55-13 through 55-15 for more information on the definition of financing receivable, including a list of items that are excluded from the definition (for example, debt securities).
Idle time. Idle time represents the time that a lender's employees are not actively involved in performing origination activities for specific loans. Idle time can be caused by many factors, including lack of work, delays in work flow, and equipment failure. Idle time can be measured through the establishment of standard costs, time studies, ratios of productive and nonproductive time, and other methods.
Incremental direct costs. Costs to originate a loan that have both of the following characteristics:
Initial investment. The amount paid to the seller plus any fees paid or less any fees received.
Lending activities. Lending, committing to lend, refinancing or restructuring loans, arranging standby letters of credit, syndicating loans, and leasing activities are lending activities.
Loan. A contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor's statement of financial position. Examples include but are not limited to accounts receivable (with terms exceeding one year) and notes receivable.
Loan Origination Fees. Origination fees consist of all of the following:
Loan participation. A transaction in which a single lender makes a large loan to a borrower and subsequently transfers undivided interests in the loan to groups of banks or other entities.
Loan syndication. A transaction in which several lenders share in lending to a single borrower. Each lender loans a specific amount to the borrower and has the right to repayment from the borrower. It is common for groups of lenders to jointly fund those loans when the amount borrowed is greater than any one lender is willing to lend.
Net investment in an original loan. The net investment in an original loan includes the unpaid loan principal, any remaining unamortized net fees or costs, any remaining unamortized purchase premium or discount, and any accrued interest receivable.
Nonaccretable difference. A loan's contractually required payments receivable in excess of the amount of its cash flows expected to be collected.
Portfolio segment. The level at which an entity develops and documents a systematic methodology to determine its allowance for credit losses. See paragraphs 310-10-55-21 through 55-22.
Probable. The future event or events are likely to occur.
Recorded investment. The amount of the investment in a loan, which is not net of a valuation allowance, but which does reflect any direct write-down of the investment.
Recorded investment in the receivable. The recorded investment in the receivable is the face amount increased or decreased by applicable accrued interest and unamortized premium, discount, finance charges, or acquisition costs and may also reflect a previous direct write-down of the investment.
Recourse. The right of a transferee of receivables to receive payment from the transferor of those receivables for any of the following:
Related Parties. Related parties include:
Revolving Privileges. A feature in a loan that provides the borrower with the option to make multiple borrowings up to a specified maximum amount, to repay portions of previous borrowings, and to then reborrow under the same loan.
Standby Letter of Credit. A letter of credit (or similar arrangement however named or designated) that represents an obligation to the beneficiary on the part of the issuer for any of the following:
A standby letter of credit would not include the following:
Time of Restructuring. Troubled debt restructurings may occur before, at, or after the stated maturity of debt, and time may elapse between the agreement, court order, and so forth, and the transfer of assets or equity interest, the effective date of new terms, or the occurrence of another event that constitutes consummation of the restructuring. The date of consummation is the time of the restructuring.
Troubled Debt Restructuring. A restructuring of a debt constitutes a troubled debt restructuring if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider.
Financing receivables include loans, trade accounts receivable, credit cards, and receivables relating to a lessor's right to payments from a lease other than an operating lease that should be recognized as assets. Accounts receivable, open accounts, or trade accounts are agreements by customers to pay for services received or merchandise obtained. Notes receivable are formalized obligations evidenced by written promissory notes. Notes receivable generally arise from cash advances but could result from sales of merchandise or the provision of services.
The nature of amounts due from trade customers is often different from that of balances receivable from related parties, such as employees or shareholders. Thus, generally accepted accounting principles (GAAP) require that the different classes of receivables be separately identified either on the face of the statement of financial position itself, or in the notes thereto.
The FASB has given entities the option of using fair value as the measurement basis in the financial statements. Entities can record most financial instruments, including receivables, at fair value.
Receivables due within one year (or one operating cycle, if longer) generally are presented at outstanding face value (principal amount), adjusted for any write-offs already taken and valuation allowances, provided that management has the intent and ability to hold those receivables for the foreseeable future or until maturity or payoff. Valuation allowances adjust the carrying amount of receivables downward because not all of those receivables will ultimately be realized as cash. For example, valuation allowances are reported for amounts estimated to be uncollectible and also for the estimated returns, allowances, and other discounts to be taken by customers prior to or at the time of payment. If it is known that sales are recorded for merchandise that is shipped “on approval” and available data suggests that a sizable proportion of such sales are returned by the customers, then the estimated future returns must be accrued. Similarly, material amounts of anticipated discounts and allowances are to be recorded in the period of sale.
Snowy Winters & Sons is a purveyor of fine books about the Alaskan heartland. Its total ending receivable balance is $420,000. The receivable balance is affected by the following items:
Snowy Winters' controller reports this information on the Winters statement of financial position in the following manner:
The recording of a valuation allowance for anticipated uncollectible amounts is almost always necessary. The direct write-off method, in which a receivable is charged off only when it is clear that it cannot be collected, is unsatisfactory since it overstates assets and also results in a mismatching of revenues and expenses. (Note that the direct write-off method may be required for tax purposes, but if so, this results in temporary differences for which interperiod tax allocation will generally be required.) Proper matching, which remains a valid financial reporting objective, can only be achieved if bad debts are recorded in the same fiscal period as the revenues to which they are related. Since the amount of uncollectible accounts is not known with certainty, however, an estimate must generally be made.
There are two popular estimation techniques, both acceptable under GAAP:
Percentage of sales method. For the percentage-of-sales method, historical data are analyzed to ascertain the relationship between bad debts and credit sales. The derived percentage is then applied to the current period's sales revenues to arrive at the appropriate debit to bad debts expense for the year. The offsetting credit is made to allowance for uncollectible accounts (often still referred to as the reserve for bad debts). When specific customer accounts are subsequently identified as uncollectible, they are written off against this allowance.
Care must be taken to ensure that the bad debt ratio computed will be representative of uncollectibility of the current period's credit sales. A ratio based on historical experience may require an adjustment to reflect the current economic climate. For example, if a large percentage of customers are concentrated in a geographic area that is experiencing an economic downturn, the rate of default may increase over that previously suffered. Changes in credit terms and in customer mix may also affect the relationship between sales and bad debts, and should be given consideration in determining the bad debt percentage to be applied to current period credit sales. In practice, these relationships evolve slowly over time and may not always be observed over the short term.
Aging the accounts method. When aging the accounts, an analysis is prepared of the customer receivables at the date of the statement of financial position. Each customer's balance is categorized by the number of days or months the underlying invoices have remained outstanding. Based on the reporting entity's past experience or on other available statistics, such as industry trends, historical bad debts percentages are applied to each of these aggregate amounts, with larger percentages being applied to the older accounts. The end result of this process is a computed total dollar amount that implies the proper ending balance in the allowance for uncollectible receivables at the date of the statement of financial position. The computed amount is compared to the balance in the valuation account, and an adjustment is made for the differences.
The credit balance required in the allowance account is $70,125. Assuming that a debit balance of $58,250 already exists in the allowance account (from charge-offs during the year that exceeded the credit balance in the allowance account at the previous year-end), the necessary entry is
Both of the estimation techniques should produce approximately the same result over the course of a number of years. Nonetheless, these adjustments are based upon estimates and will never precisely predict ultimate results. When facts subsequently become available to indicate that the amount provided as an allowance for uncollectible accounts was incorrect, an adjustment classified as a change in estimate is made, unless this was the consequence of a failure to consider facts available at the time the estimate was made, in which case a correction of an accounting error will have to be recognized.
If a receivable is due on terms exceeding one year, the proper valuation is the present value of future payments to be received, determined by using an interest rate commensurate with the risks involved at the date of the receivable's creation. In many situations the interest rate commensurate with the risks involved is the rate stated in the agreement between the payee and the debtor. However, if the receivable is noninterest-bearing or if the rate stated in the agreement is not indicative of the market rate for a debtor of similar creditworthiness under similar terms, interest is imputed at the market rate. A valuation allowance is used to adjust the face amount of the receivable to the present value at the market rate. The balance in the valuation allowance is amortized as additional interest income so that interest income is recognized using a constant rate of interest over the life of the agreement. Initial recording of such a valuation allowance also results in the recognition of an expense, typically (for customer receivables) reported as selling expense or as a contra revenue item (sales discounts). Accounting Standards Codification (ASC) 835-30 specifies when and how interest is to be imputed when the receivable is noninterest-bearing or the stated rate on the receivable is not reasonable. It applies to transactions conducted at arm's length between unrelated parties, as well as to transactions in which captive finance companies offer favorable financing to increase sales of related companies.
Detailed information and examples can be found in the chapter on ASC 835.
Receivables generally arise from extending credit to others.
If the reporting entity has the intent and ability to hold trade receivables or loans for the foreseeable future or until maturity or payoff, those receivables are reported in the statement of financial position at their outstanding principal (face) amounts less any write-offs and allowance for uncollectible receivables or at fair value. Loans originated by the reporting entity are reported net of deferred fees or costs of originating them, and purchased loans are reported net of any unamortized premium or discount. If a decision has been made to sell loans, those loans are transferred to a held-for-sale category on the statement of financial position and reported at the lower of cost or fair value. Any amount by which cost exceeds fair value is accounted for as a valuation allowance.
When a trade receivable or loan is deemed uncollectible, the balance is written off against the allowance for uncollectible receivables. Recoveries of loans and trade receivables that were previously written off are recorded when received—either by a credit directly to earnings or by a credit to the allowance for uncollectible receivables. A credit loss on a financial instrument with off-statement-of-financial-position risk is recorded as a liability rather than being included in a valuation allowance netted against a recognized financial instrument. When settled, the credit loss is deducted from the liability.
ASC 310-10 requires disclosures about the nature of the credit risk in an entity's financing receivables, how any risk is incorporated into the allowance for credit losses, and the reasons for any changes in the allowance. This disclosure is required to be disaggregated primarily at the level at which an entity calculates its allowance for credit losses. The specific disclosures are noted in the Appendix at the end of this book. Not many entities will need to disclose this information, since ASC 310-10 exempts short-trade trade receivables or receivables measured at fair value or lower of cost or fair value from the disclosure.
ASC 310-25 also includes standards for recognizing fees related to receivables. Delinquency fees are recognized when chargeable, provided that collectibility is reasonably assured. Prepayment fees are not recognized until prepayments have occurred. Rebates of finance charges due because payments are made earlier than required are to be recognized when the receivables are prepaid and are accounted for as adjustments to interest income.
The DitchWay Company sells a ditch-digging machine called the DitchMade that contractors use to lay utility lines and pipes. DitchWay invoices customers a standard monthly fee for two years, using a book of 24 preprinted invoices, after which they receive title to their DitchMade machines. The DitchMade machine is patent-protected and unique, so contractors must purchase from DitchWay. If a contractor makes a late payment, DitchWay bills them a $150 late fee. Since DitchWay can withhold title to the equipment if all fees are not received, the collection of these fees is reasonably assured. Its entry to record a late fee follows:
One contractor enters bankruptcy proceedings. It has accumulated $450 of unpaid delinquency fees by the time it enters bankruptcy. DitchWay uses the following entry to eliminate the fees from its accounts receivable:
DitchWay's sale agreement recognizes that its billing schedule is essentially a series of loan payments with an implied interest rate of 12%. About 20% of all contractors obtain better financing elsewhere and prepay their invoices in order to reduce the interest payment. DitchWay charges a flat $500 prepayment fee when a prepayment occurs. Though the proportion of early payments is predictable, DitchWay cannot recognize prepayment fees until each prepayment actually occurs. One contractor makes a prepayment, so DitchWay records the following entry:
The DitchWay sales agreement also states that, when a contractor prepays an invoice, it should pay the full amount of the invoice, even if paid early, and DitchWay will rebate the unearned portion of the interest expense associated with the early payment. In one case, a contractor prepays a single $2,500 invoice for which the original sales entry was as follows:
The amount of interest to be rebated back to the contractor is $225, which DitchWay records with the following entry:
The use of the contra account, interest income—rebated, provides the reporting entity with greater control and information for management purposes. However, the debit could be made directly to interest income if these enhancements are not useful.
An organization can alter the timing of cash flows resulting from sales to its customers by using its accounts receivable as collateral for borrowings or by selling the receivables outright. A wide variety of arrangements can be structured by the borrower and lender, but the most common are pledging, assignment, and factoring.
Accounts receivable pledging is an agreement in which accounts receivable are used as collateral for loans. The customers whose accounts have been pledged are not aware of this event, and their payments are still remitted to the original entity to which the debt was owed. The pledged accounts merely serve as security to the lender, giving comfort that sufficient assets exist to generate cash flows adequate in amount and timing to repay the debt. However, the debt is paid by the borrower whether or not the pledged receivables are collected and whether or not the pattern of their collection matches the payments due on the debt.
The only accounting issue relating to pledging is that of adequate disclosure. The accounts receivable, which remain assets of the borrowing entity, continue to be shown as current assets in its financial statements but must be identified as having been pledged. This identification can be accomplished either parenthetically or by note disclosures. Similarly, the related debt should be identified as having been collateralized by the receivables.
Example of disclosure for pledged receivables
Current assets:
Accounts receivable ($3,500,000 of which has been pledged as collateral for bank loans), net of allowance for doubtful accounts of $600,000 | 8,450,000 |
Current liabilities:
Bank loans payable (collateralized by pledged accounts receivable) | 2,700,000 |
A more common practice is to include the disclosure in the notes to the financial statements. Since the borrower has not surrendered control of the pledged receivables, it continues to carry the pledged receivables as its assets (ASC 860).
Accounts receivable assignment is a more formalized transfer of the receivables to the lending institution. The lender investigates the specific receivables that are being proposed for assignment and will approve those that it deems worthy as collateral. Usually customers are not aware that their accounts have been assigned and they continue to forward their payments to the original obligee (the borrowing entity). In some cases, the assignment agreement requires that collection proceeds be immediately delivered to the lender. The borrower is, however, the primary obligor of the debt and is required to make timely payment on the debt whether or not the receivables are collected as anticipated. The borrowing is with recourse, and the general credit of the borrower is pledged to the payment of the debt.
Since the lender knows that not all the receivables will be collected on a timely basis by the borrower, only a fraction of the face value of the receivables will be advanced as a loan to the borrower. Typically, this amount ranges from 70 to 90%, depending upon the credit history and collection experience of the borrower.
Assigned accounts receivable remain the assets of the borrower and continue to be presented in its financial statements, with appropriate disclosure of the assignment similar to that illustrated for pledging. Prepaid finance charges would be recorded as a prepaid expense and amortized to expense over the period to which the charges apply.
In the typical case involving the assignment of receivables, the borrower retains control of the receivables, and it is clear that the transaction is a secured borrowing rather than a sale. If it is unclear whether the borrower has retained control of the receivables, a determination must be made as to whether to account for the transfer as a sale or as a secured borrowing. Making that determination is discussed in the chapter on ASC 860, Transfers of Financial Assets under ASC 860.
Accounts receivable factoring traditionally involves the outright sale of receivables to a finance company known as a factor. These arrangements involve (1) notification to the customer to remit future payments to the factor and (2) the transfer of receivables to the factor without recourse to the transferor. The factor assumes the risk of an inability to collect. Thus, once a factoring arrangement is completed, the transferor has no further involvement with the accounts, except for a return of merchandise.
In its simplest form, the receivables are sold and the difference between the cash received and the carrying value is recognized as a gain or loss.
Thirsty Corp. enters into an agreement with Rich Company to sell a group of its receivables without recourse for $180,055. A total face value of $200,000 accounts receivable (against which a 5% allowance had been recorded) are involved. The entries required are as follows:
The classic variety of factoring provides two financial services to the business: it permits the reporting entity to obtain cash earlier than waiting for customers to pay, and it transfers the risk of bad debts to the factor. The factor is compensated for each of these services. Interest is charged based on the anticipated length of time between the date the factoring arrangement is consummated and the expected collection date of the receivables sold. A fee is charged based upon the factor's anticipated bad debt losses.
Thirsty Corp. enters into an agreement with Rich Company to sell a group of its receivables without recourse. The receivables have a total face value of $200,000 (against which a 5% allowance had been recorded). The factor will charge 20% interest computed on the weighted-average time to maturity of the receivables of thirty-six days plus a 3% fee.
The entries required are as follows:
The interest expense, factor's fee and loss can be combined into a $19,945 loss on the sale of receivables.
Some companies factor receivables as a means of transferring bad debt risk, but leave the cash on deposit with the factor until the weighted-average due date of the receivables, thereby avoiding interest charges. This arrangement is still referred to as factoring, since the customer receivables have been sold. However, the borrowing entity does not receive cash but instead records a new receivable, usually captioned “Due from Factor.” This receivable, in contrast to the original customer receivables, is essentially without risk and is presented in the statement of financial position without a deduction for estimated uncollectible receivables.
Merchandise returns are normally the responsibility of the transferor, who must then make the appropriate settlement with the factor. To protect against the possibility that merchandise returns will diminish the total of receivables to be collected, a factor will frequently advance only a portion of the face amount of the factored receivables (less any interest and factoring fee deductions). The factor will retain a certain fraction of the total proceeds relating to the portion of sales that are anticipated to be returned by customers. This sum is known as the factor's holdback. When merchandise is returned to the transferor, an entry is made offsetting the receivable from the factor. At the end of the return privilege period, any remaining holdback will become due and payable to the transferor.
The entries required are as follows:
The interest expense, factor's fee and loss can be combined into a $10,445 charge to loss on the sale of receivables.
The factor's holdback receivable recorded by the seller is required by ASC 860 to be an allocation of the carrying value of the receivables ($190,000) between the assets sold (the receivables) and the assets retained (the holdback) based on their relative fair values at the date of the factoring agreement. The factor holds back 5% of the face value ($200,000) for a total of $10,000. Upon settlement the loss or gain recorded at the origination of the factoring arrangement needs to be adjusted because the factor pays the remaining holdback of $5,200 ($10,000 holdback − $4,800 returns) in settlement of an asset with a carrying value of $4,700 ($9,500 − $4,800).
Factoring results in a transfer of title to the factored receivables. Where there is a no recourse provision or other continuing involvement with the receivables, the removal of the receivables from the borrower's statement of financial position is clearly warranted.
Another variation is known as factoring with recourse. Accounting for factoring with recourse requires a determination of whether the transfer is a sale or a secured borrowing. That determination is made by applying ASC 860. See the chapter on ASC 860 for more information.
ASC 310-10-35 applies:
(ASC 310-10-35-13)
If it is probable that a creditor will not collect all amounts (principal and interest) owed to the degree specified in the loan agreement, a loan is considered impaired. (ASC 310-10-35-16) A delay does not impair the loan if the creditor collects all amounts due (including accrued interest during the delay at the contractual rate).
An impaired loan can be measured on a loan-by-loan basis in any of the following ways:
(ASC 310-10-35-22)
Other measurement considerations include:
The choice must be consistently applied. Projections of factor changes should not be made.
After impairment, creditors use existing methods to record, measure, and display interest income. If the existing policy results in a recorded investment less than fair value, no additional impairment is recognized.
Under ASC 310-10-35-16, the creditor would account for the earlier examples as follows.
Example 1
Example 2
Example 3
These fees should be deferred and recognized over the life of the loan as an adjustment of interest income. If there are any related direct loan origination costs, the origination fees and origination costs should be netted, and only the net amount should be deferred and amortized via the interest method. Origination costs include those incremental costs such as credit checks and security arrangements, among others, pertaining to a specific loan.
The only exception to the foregoing rule would be in the instance of certain loans that also qualify as debt instruments under ASC 320. For those carried in the “trading securities” portfolio, related loan origination fees should be charged to expense when incurred; the requirement that these be carried at fair value would make adding these costs to the asset carrying amounts a useless exercise.
Debtor Corp. wishes to take out a loan with Klein Bank for the purchase of new machinery. The fair value of the machinery is $614,457. The loan is for ten years, designed to give Klein an implicit return of 10% on the loan. The annual payment is calculated as follows:
Unearned interest on the loan would be $385,543 [(10 × $100,000) − $614,457].
Klein also is to receive a “nonrefundable origination fee” of $50,000. Klein incurred $20,000 of direct origination costs (for credit checks, etc.). Thus, Klein has net nonrefundable origination fees of $30,000. The new net investment in the loan is calculated below.
The new net investment in the loan can be used to find the new implicit interest rate.
Thus, the implicit interest rate is 11.002%. The amortization table for the first three years is set up as follows:
Often fees are received in advance in exchange for a commitment to originate or purchase a loan. These fees should be deferred and recognized upon exercise of the commitment as an adjustment of interest income over the life of the loan, as in Example 1 for origination costs and fees. If a commitment expires unexercised, the fees should be recognized as income upon expiration.
As with loan origination fees and costs, if both commitment fees are received and commitment costs are incurred relating to a commitment to originate or purchase a loan, the net amount of fees or costs should be deferred and recognized over the life of the loan.
If there is a remote possibility of exercise, the commitment fees may be recognized on a straight-line basis over the commitment period as “service fee income.” If there is a subsequent exercise, the unamortized fees at the date of exercise should be recognized over the life of the loan as an adjustment of interest income, as in the previous example.
In certain cases, commitment fees are determined retroactively as a percentage of available lines of credit. If the commitment fee percentage is nominal in relation to the stated rate on the related borrowing, with the borrowing earning the market rate of interest, the fees shall be recognized in income as of the determination date.
Glass Corp. has a $2 million, 10% line of credit outstanding with Ritter Bank. Ritter charges its annual commitment fee as 0.1% of any available balance as of the end of the prior period. Ritter will report $2,000 ($2 million × 0.1%) as service fee income in its current income statement.
(Assume this is not a troubled-debt restructuring.) When the terms of a refinanced/restructured loan are as favorable to the lender as the terms for loans to customers with similar risks who are not in a restructuring, the refinanced loan is treated as a new loan, and all prior fees of the old loan are recognized in interest income when the new loan is made. This condition is met if:
(ASC 310-20-35-9)
When the above situation is not satisfied, the fees or costs from the old loan become part of the net investment in the new loan.
Jeffrey Bank refinanced a loan receivable to $1,000,000, at 10% interest, with annual interest receipts for ten years. Jeffrey's “normal” loan in its portfolio to debtors with similar risks is for $500,000 at 9% interest for five years. Jeffrey had loan origination fees from the original loan of $20,000. These fees are recognized in income immediately because the terms of the restructuring are as favorable to Jeffrey as a loan to another debtor with similar risks.
Assume the same facts as in Example 3 except that the refinanced terms are $500,000 principal, 7% interest for three years. Since the terms of the restructuring are not as favorable to Jeffrey as a loan to another debtor with similar risks, the $20,000 origination fees become part of the new investment in the loan and recognized in interest income over the life of the new loan, as in Example 1.
Fees paid or fees received when purchasing a loan or group of loans should normally be considered part of the initial investment; to be recognized in income over the lives of the loans. However, if the loans qualify as debt securities under ASC 320 and are held in the lender's “trading securities” portfolio, these fees should be reported in income when paid or received, and not added to the cost of the loans.
Often lenders provide demand loans (loans with no scheduled payment terms). In this case, any net fees or costs should be recognized on a straight-line basis over a period determined by mutual agreement of the parties, usually over the estimated length of the loan.
Under a revolving line of credit, any net fees or costs are recognized in income on a straight-line basis over the period that the line of credit is active. If the line of credit is terminated due to the borrower's full payment, any unamortized net fees or costs are recognized in income.
Green Bank received $50,000 as a nonrefundable origination fee on a $2 million demand loan. Green's loan dictates that any fees are to be amortized over a period of ten years. Therefore, $5,000 (= $50,000 × 1/10) of origination fees will be recognized as an addition to interest income each year for the next ten years.
The unamortized balance of origination, commitment, and other fees/costs that are recognized as an adjustment of interest income are reported on the statement of financial position as part of the loan balance to which they relate. Except for any special cases as noted in the above paragraphs, the amount of net fees/costs recognized each period as an adjustment will be reported in the income statement as part of interest income.
ASC 310-30 requires the preparer to differentiate between securities investments acquired directly from the issuer and those obtained on the secondary market. It imposes accounting requirements for debt instruments acquired in transfers when the purchase price reflects a change in the debtor's credit standing since the original issuance of the instrument. This standard is applicable to all acquirers of loans or debt securities (bonds, securitized loans, etc.), not merely financial institutions, although fewer commercial or industrial entities would tend to be making such purchases.
Debt instruments (whole loans or loan participations, as well as securities) will generally trade in the secondary market at prices that vary from the amount at which they were issued originally. The prices may be higher or lower than the face amount, depending on the confluence of several factors. Because interest rates change almost continually, it is rare that market rates will correspond to the nominal rate on any given loan or debt security, even if the loan or instrument originally carried a market yield. Furthermore, many instruments are issued at premiums or discounts at inception, for various reasons. In the secondary market, prices will be adjusted continually to reflect current market conditions as they pertain to the loan's (or security's) coupon rate and the credit standing of the issuer/borrower, within the context of market rates of interest and other factors. If current rates are higher than the instrument's coupon (i.e., contractual) rate, it will trade at a discount from par value, while if the current rates are below the coupon rate, it will sell for a premium, if other variables are held constant.
Furthermore, the borrower's creditworthiness may well have changed since the loan was originated or the debt instrument was issued. This also impacts the price at which the loan or security will trade, with a decline in credit standing resulting in a drop in value, and an improvement in credit standing causing a rise in the value of the entity's debt. Creditworthiness pertains to the risk of default, and a number of well-regarded private sector companies closely monitor the outstanding debt of publicly held and private corporations and various governmental agencies and political subdivisions. Examples of rating agencies or measures are Moody's, Standard & Poor's, and Fitch's for publicly held companies and the Fair Isaac credit score for private companies.
Loans or debt securities may trade in the secondary market at their original issuance prices as the coincidental result of offsetting changes in the above-noted variables. Thus, market yields may have declined—which, taken alone, would cause a rise in the price of fixed coupon debt instruments—but concurrently the issuer's creditworthiness may have been reassessed downward by rating agencies—which, absent other events, would cause the price of the debt to decline. In tandem, the credit downgrade may have essentially negated the price response to lower market interest rates. In applying ASC 310-30, it is necessary to refer not simply to the price at which the loan or security has been transferred, in relation to its “par” or original issuance price, but also to examine whether there is information to suggest that there has been a change in the issuer's credit quality since inception of the obligation. Only in the latter circumstance will the provisions of this standard be applied.
The purpose of ASC 310-30 is to prescribe the accounting for debt instruments (comprising most loans and debt securities, with certain exceptions) which are acquired via a transfer (i.e., in the secondary market) and which have been affected by changes in credit quality. The standard requires that the accretable yield be determined. This derived from the relationship between the future cash flows expected to be collected and the price paid for the acquired instrument. The accretable yield is distinguished from the nonaccretable difference, which is generally the excess of the total of contractual future cash flows over the expected cash flows.
Neither the accretable yield nor the nonaccretable difference can be displayed in the financial statements. For example, consider a loan that contractually is obligated to pay a total of $85,000 in future interest and principal, but which can be purchased for $50,00 and is expected to provide future cash flows of only $73,500. The $23,500 ($73,500 − 50,000) spread between the purchase price and the undiscounted expected future cash flows is the accretable yield. The further $11,500 ($85,000 − 73,500) spread between expected and contractual cash flows, however, is the nonaccretable difference, which cannot be given accounting recognition under ASC 310-30. That is, the loan (which is an investment in the hands of the transferee) cannot be recorded or displayed at the higher $85,000 amount, with a contra account or valuation allowance pertaining to the pretransfer estimated uncollectible amount being reported. Instead, the purchase cost, $50,000, must be the initial representation of this acquired asset, which is later increased by virtue of the accretion of yield (and reduced by collections).
While ASC 310-30 applies to loans and debt securities, there are important exceptions. Derivative instruments are excluded entirely from the scope of the standard, although debt instruments that contain embedded derivatives are not excluded. Also, debt securities that are accounted for at fair value with changes taken into income currently (i.e., those held in trading portfolios) are exempted, since these are not accreted to face value or to an expected level of future cash flows. Similarly, since changes in the fair values of trading and available-for-sale securities held by not-for-profit organizations both are reflected currently in the changes in net assets (the parallel performance measure for not-for-profit entities, roughly corresponding to net income), these are also exempted. Mortgage loans classified by mortgage bankers as held-for-sale (and presented at fair value) are also exempted from the provisions of ASC 310-30.
Upon acquisition, the effective yield is to be computed based on the expected pattern (i.e., timings and amounts) of future cash flows, so that interest can be accreted on the level-yield basis (a constant rate on a changing base). Over the holding term of the investment, expected cash flows may be altered: They may decline due to perceived impairment or may increase due to upgrading of creditworthiness. The accounting for such changes will vary, with decreases in expectations triggering immediate impairment loss recognition, while increases will generally be reported prospectively over the holding period of the instrument. The precise accounting for changes in expected future cash flows also depends, per ASC 310-30, on whether the instrument is accounted for as a loan (under ASC 310-30) or as a debt security (under ASC 320). These matters are addressed in the following sections.
Under ASC 310-30, reductions in expected future cash flows will trigger the recognition of a loss in the current reporting period.
Loans acquired by transfer (i.e., in the secondary market) are recorded initially at acquisition cost. If the acquisition price differs from the par or face amount (i.e., there is a premium or a discount), the effective yield has to be computed and used to accrete the discount (or, if a premium, amortize it) over the expected term of the instrument.
However, if there is evidence of a decline in creditworthiness since the instrument's inception, such that it is deemed probable at the date of transfer that the full amount of contractual cash flows will not be received, the provisions of ASC 310-30 must be applied. In this context, probable is used in the same way as it is under ASC 450, and only if that rather high-threshold criterion is satisfied will this standard be invoked. In such cases, the transferee must estimate cash flows to be received, and accrete the initial carrying amount to that amount, rather than to the gross amount of future contractual cash flows. An uncertainty regarding future cash flows that suggests only a possible shortfall versus contractual amounts owed would not qualify under the standard for the accounting set forth in this discussion. (In such a situation, there would be disclosure of reasonably possible contingent losses, and if at a later date the loss is deemed to have become probable, a loss accrual would be recognized per ASC 450.)
The estimation of the amounts of expected future cash flows, and the timing of those cash flows, is obviously a matter of some complexity and inevitable subjectivity. For example, if payments from a credit-impaired obligor are expected to be made, say, fifteen days late on average, this will impact the computed effective yield on the loan and is to be given explicit consideration in ascertaining the effective yield, subject to the usual materiality threshold concerns. The calculation of accretable yield is made at the acquisition date, but as described in the following example, it may later have to be adjusted as expectations regarding future cash flow amounts change. Subsequent reduced expectations of cash flows will result in the recognition of impairment, while expectations of enhanced or improved cash flows may result in reversal of previously recognized impairment (if any), or increased effective yield over the instrument's remaining holding period.
Assume that Investor Co. acquires a loan with a remaining principal balance of $650,000 on January 1, 2011. The contractual terms of the loan call for interest-only payments, at 9%, annually through December 31, 2015, at which time the full principal balance is due. The debtor's credit rating has been reduced subsequent to the initiation of the borrowing, and the 2010 interest payment was not made when due. Investor Co. pays $500,000 (flat) for the loan and any unpaid interest. The expectation is that the debtor will pay $40,000 at the end of 2011, $60,000 at the end of years 2012 and 2013 (each year), $70,000 at the end of 2014, and $600,000 at the end of 2015. Total projected cash inflows, $830,000, are lower than the contractually due amount, $1,001,000 (including the arrearage for 2010), and the effective yield will be about 12.6% at transfer, the investment is recorded at cost, as follows:
At the end of 2011, immediately prior to receipt of the payment, the entry to record the accretion for the year, at the effective yield, is:
The collection of the anticipated amount at December 31, 2011, is recorded as follows:
Entries for subsequent years' accretion and collections would follow in the same manner. This presumes, of course, that amounts expected to be received indeed are received, and that expectations about the future receipts do not depart from what had been anticipated when the loan was purchased.
The changes in carrying amount and recognition of income over the full five-year period are illustrated in the following chart.
In the foregoing chart total cash collected, $830,000, consisted of $330,000 in interest, accreted at the 12.6% computed yield, and $500,000 return of investment in the loan receivable.
Contrast this result with the examples that follow.
If, subsequent to acquisition and computation of effective yield, the expected cash flows associated with a loan are revised downward, ASC 310-30 directs that this be accounted for as an impairment, with the adjustment being such that the previously determined yield percentage is maintained in future periods by applying the constant return to a downwardly adjusted carrying value. While some might argue that a diminished expectation of cash flows would imply a new lower rate of return, ASC 310-30 instead opts for recognizing an immediate impairment, measured as the then-present value of the stream of cash flow shortfalls being projected. This results in a continuing rate of return equal to the original estimate, but with a step-down in the carrying value of the loan.
To illustrate, using the same basic facts above, assume now that immediately after the 2013 payment is made, Investor Co., revises its expectation of cash flows to be received in 2014 and 2015. It now anticipates zero cash collection in 2013, and only $500,000 at year-end 2015. The present value of these shortfalls—a $70,000 shortage one year hence, followed by a $100,000 shortfall two years later—discounted at the 12.6% yield on the investment computed at the date of transfer, reveals an impairment of $141,039 as of the start of 2014. The entry to record this, given that the investment is treated as a loan rather than as a debt security, is as follows:
The reduced net carrying value of the loan receivable, which is $394,408 immediately following this adjustment, will continue to accrete at 12.6%, as the following table illustrates:
It will be observed in the foregoing chart that total cash collected, $660,000, consisted of $301,039 in interest, accreted at the 12.6% computed yield, and the recovery of only $358,961 of the $500,000 investment in the loan receivable. In other words, SOP 03-3 treats the decrease in expected cash flows as a loss of principal, accounted for as a bad debt and a provision of a valuation allowance against the $500,000 loan receivable. Note that the decreased cash flow expectation was not accounted for as a lowered future return on the investment (which would have resulted in lower interest income recognition in years 2014 and 2015, in this example, coupled with a full recovery of the principal invested).
Example with decrease in expected cash flows followed by increase in expected cash flows (recovery of uncollectible loan receivable)
If Investor Co., above, first lowers its expectation regarding future cash flows and then partially reverses its estimate, so that some or all (but not more than all) of the allowance of the uncollectible loan receivable proves unneeded, this is accounted for under ASC 310-30 as a reversal of the valuation allowance account (i.e., as a change in an accounting estimate).
To illustrate, consider again the facts in the basic example, and now assume that in 2013 Investor Co. has the expectation that no interest will be collected in 2014 and that only $500,000 will be collected in 2015. In 2014, however, $20,000 is in fact collected, and Investor Co. then expects a full collection of the $600,000 in 2015 (but no recovery of the $50,000 missed payment in 2014).
The entry to record the reduced expectation of future cash flows at the end of 2012 or beginning of 2013 is as shown previously.
In 2014, the collection of the $20,000 (when no collection at all was anticipated) coupled with the renewed expectation of collecting $600,000 in 2015 required that some of the previously provided valuation allowance be reversed. The amount of valuation allowance to be restored, per ASC 310-30, is that amount which will result in interest accretion thereafter at the previously determined 12.6% yield through the final collection of the loan. Assuming that the $20,000 collection in December 2014 came as a surprise, the adjustment will be computed with reference to the final remaining collection, $600,000, expected in December 2015, and to the $20,000 unexpected 2016 collection.
The entry to partially restore the carrying value of the loan, net of the valuation allowance, is as follows:
The computation of the foregoing amount may be somewhat confusing, unless one keeps in mind that the objective of ASC 310-30 is to provide for the reporting of interest income over the full carrying term of the loan receivable, at a constant rate on a changing balance, with that rate being the rate computed at the date of transfer. The only exception, which will be illustrated later in this section, is for situations where the total cash to be collected exceeds the estimate made at the date of transfer; in that case, a higher rate of return is reported in periods after the change in estimate, to avoid the alternative of reporting a gain at the date the new estimate is made. In this example, the anticipated “extra” 2015 collection of $100,000 ($600,000 − $500,000) has a present value at the end of 2014 of $88,802, so this previously provided valuation allowance is no longer needed. Furthermore, the $20,000 collection in 2014 was unexpected, and had previously been fully included in the valuation allowance as being uncollectible, so this too must be reversed. Therefore, the total reversal of valuation allowance is the sum of these two amounts, or $108,802. Alternatively, this can be computed as the adjustment necessary to bring the net carrying value of the loan receivable to the amount of “principal” to be collected in December 2015 (i.e., the present value, discounting at 12.6%, of the expected $600,000 collection).
The net carrying value of the loan receivable will continue to accrete at 12.6%, both after the recognition of the valuation allowance at the end of 2013 and after the partial elimination of the valuation allowance in 2014, as the following table illustrates:
It will be observed in the foregoing chart that total cash collected, $780,000, consisted of $312,237 in interest, accreted at the 12.6% computed yield, and the recovery of only $467,763 of the $500,000 investment in the loan receivable. As in the immediately preceding example, ASC 310-30 treats the decrease in expected cash flows as a loss of principal, accounted for as a bad debt and a provision of a valuation allowance against the $500,000 loan receivable. In this case, $32,237 of “principal” (i.e., of the amount recognized at the time of transfer) was lost, which is the net of the $141,039 valuation allowance provision in 2013 and the $108,802 recovery recognized in 2014.
Note that in all of the preceding examples the carrying value of the loan receivable continues to earn the computed 12.6% yield throughout the holding period. This was true if the initially estimated future cash flows were all collected as planned, or if changes to the estimated amounts or timings later were made—as long as the total cash to be collected did not exceed the amount originally (i.e., upon transfer to Invest Co.) estimated. In the next example, the collections exceed what was anticipated when the loan was acquired, and this necessitates a different approach to accounting for the interest yield on the investment.
In all cases where an allowance for uncollectible loan amounts has been provided, if the loan is subsequently foreclosed, the lender must measure the long-lived asset received in full satisfaction of a receivable at fair value less cost to sell as prescribed by ASC 310-40. That standard prescribes that after a troubled debt restructuring, the creditor must account for assets received in satisfaction of a receivable the same as if the assets had been acquired for cash. Accordingly there will be a new cost basis for the long-lived asset received in full satisfaction of a receivable; the valuation allowance would not be carried over as a separate element of the cost basis for purposes of accounting for the long-lived asset under ASC 360 subsequent to foreclosure. This treatment has been confirmed by ASC 310-40.
Assume again the basic facts of the investment in the loan receivable made by Investor Co. However, after fully collecting the anticipated amounts in 2011 and 2012, Investor revises its estimates of the amounts to be collected in 2013, 2014, and 2015. Specifically, it now expects to receive $75,000 at the end of 2013 and again at the end of 2014, and to collect the full remaining balance, $650,000, at the end of 2015. ASC 310-30 does not permit recognition of a gain or other income upon making this new estimate, but does instead require that the effective yield be recomputed and that future receipts be allocated between interest income and principal reduction consistent with the new accretable yield.
Note that no entry is required at the time of the new estimate of future cash flows because no gain or loss (or reversal of previously recognized loss) is being affected. As with changes in accounting estimates under ASC 250, this is handled strictly on a prospective basis.
In the foregoing example, $900,000 in cash is ultimately collected, allocated $400,000 to interest income and $500,000 to recovery of the amount recorded at the date of transfer, which was the sum paid for the loan receivable.
Loans that are acquired as a pool present special accounting considerations. Each individual loan must meet the criteria of ASC 310-30 in order to apply the accounting set forth in this standard. Thus, if a group of loans are acquired together and in the aggregate have expected future cash flows in an amount lower than the aggregate contractual cash flows, this does not qualify each of the loans to be accounted for under ASC 310-30. Rather, each loan must be reviewed for impairment due to credit quality, and only those individual loans exhibiting the defined characteristic would be subject to the specified accounting.
After making a determination that each loan in a proposed pool has met the threshold conditions set forth under ASC 310-30 (i.e., that there has been evidence of credit quality deterioration subsequent to the origination, and that it is probable that, as of the transfer date, the transferee will not collect all the contractually required payments), a further determination must be made that the loans share common risk characteristics. Under provisions of ASC 310-30, loans with similar credit risk or risk ratings, and one or more predominant risk characteristics, such as financial asset type, collateral type, size, interest rate, date of origination, term, and geographic location, will be considered to have common risk characteristics. Credit risk can be assessed by reference to publicly available ratings of publicly held companies or by automated ratings such as that produced by FICO (formerly Fair Isaac Corporation), called FICO scores.
The aggregate cost of the loans to be aggregated is to be apportioned to the loans in the pool in proportion to their respective fair values at date of acquisition. The aggregate accretable yield of the pool is allocated among the loans in this same manner.
Only loans acquired in a given fiscal quarter (not year!) are subject to aggregation for financial reporting purposes. Once a pool is established, its integrity must be maintained, and thus loans can only be removed from the pool upon sale, foreclosure, write-off, or settlement. New loans cannot be added to an existing pool. The excess of contractually required cash flows over the acquisition cost of the pool may not be used to offset or absorb changes to anticipated cash flows associated with other loans or pools of loans having other common risk characteristics.
Removal of a loan from a portfolio is effected at the loan's then-carrying value, and accordingly a gain or loss would be reflected in income of the period, measured as the difference between the carrying value and the fair value of the amount received in settlement (e.g., cash or collateral). Any difference between the carrying amount of the loan being removed from the pool and the fair value of the amount received will not impact the percentage yield being used to accrete value on the remainder of the pool.
Garfield Corporation acquires the following seven loans for $600,000 during the same fiscal quarter:
Garfield elects to split these loans into two groups—those having FICO scores below the minimum Fannie Mae acceptance score of 620, and those above it. Accordingly, loan numbers 2 and 5 are shifted into a separate Pool A, with the remaining loans in Pool B. The $600,000 acquisition cost is allocated to the two pools based on the relative fair values of the loans within the pools, as shown below.
Garfield expects $117,376 annual payments from the Pool B loans. It determines that the discount rate equating all cash flows expected to be collected with the $342,000 allocated purchase price is 14%. Using the 14% rate, Garfield constructs the following amortization table for Pool B:
At the beginning of Year 3, Garfield writes off the remaining balance of Loan 7. Prior to the final payment, Loan 7 has a carrying value of $31,204, as determined by apportioning the carrying amount of Pool B at the end of Year 2 amongst the five loans in the pool based on their relative fair values at the date of acquisition. This apportionment calculation is shown in the following table:
Garfield records the loan write-off with the following entry:
The following amortization table reflects the removal of Loan 7 from Pool B, proportionate share of the expected cash receipts in Years 3 and 4.
If loans are accounted for in a pool and you subsequently modify one or more of these loans, do not remove the loans from the pool even if the modification would otherwise be considered a troubled debt restructuring. The entity must continue to evaluate whether the pool is impaired if the expected cash flows associated with the pool change.
If the debt instrument acquired in a transfer to be accounted for under ASC 310-30 meets the definition of a security, as set forth in ASC 320 (namely, that it constitutes a share, participation, or other interest that is represented by a registered or bearer instrument or by book entry, and is one of a class or series of participations, interests or obligations), then ASC 310-30 prescribes a slightly different mode of accounting for changes in expected cash flows. To conform to ASC 320's requirements, an anticipated downward change in expected future cash flows must be examined to determine whether merely a temporary change in value has occurred, or whether an other than temporary decline has been signaled. While temporary impairment is not impossible, if in fact the transferee of debt securities—the issuer of which had suffered an adverse change in creditworthiness prior to the transfer—now anticipates further reduced cash flows from the security, there is substantial likelihood that the impairment in value is other than temporary. Under ASC 320, other-than-temporary impairment must be recognized by writing down the carrying value of the investment and reflecting the charge in current earnings, whether the security is being held in the available-for-sale portfolio or is being held to maturity.
If, on the other hand, the estimated future cash flows from the debt security are increased from the amounts anticipated at transfer, then similar to what was illustrated above, the accretable yield is to be recomputed and periodic interest income thereafter appropriately adjusted. This is considered a change in accounting estimate under ASC 250.
To illustrate, consider the same facts as set forth above, except now assume that the loan was instead a debt security meeting the definition set forth in ASC 320. When acquired, it was treated as being available for sale, but for this example no changes in value are addressed other than that associated with the changed expectation of cash flows.
The anticipated cash flows occurred in 2011, 2012, and 2013, but at the beginning of 2014 Investor Co. revises its expectations, and now believes that there will be a zero cash collection in 2014, and only $500,000 at year-end 2015. The present value of these shortfalls—a $70,000 shortage at year-end 2014, followed by a $100,000 gap at year-end 2015—discounted at the same 12.6% rate computed as the yield on the investment at transfer, reveals an impairment of $141,039 as of the start of 2014. The entry to record this, given that the investment is treated as a debt security, rather than as a loan, is as follows:
Apart from the bookkeeping (writing down the investment directly rather than crediting a contra asset account), the treatment is very similar to that previously presented. Most importantly, the reduced net carrying value of the debt security held as an available for sale security will continue to accrete at 12.6%, as the following table illustrates:
The total cash collected, $660,000, is accounted for as interest income, in the total amount $301,039, and recovery of the “principal” of the investment, net of the impairment recorded in 2013, amounting to $358,961.
Unlike in the earlier examples, where the investment was accounted for as a loan receivable, here the investment is in a debt security accounted for under ASC 320, which prohibits restoring an other-than-temporary decline in value. For this reason, the write-down was not reflected through a contra asset (allowance) account, and a later improvement in the outlook for future cash flows must instead be accounted for prospectively as a yield adjustment.
Assume, therefore, that Investor Co. first lowers its expectation regarding future cash flows and then partially reverses its estimate, so that some or all of the amount of future cash flow thought not to be forthcoming now again is expected to be received. Specifically, assume that in 2013 Investor Co. has the expectation that no interest will be collected in 2014 and that only $500,000 will be collected in 2015. In 2014, however, $20,000 is in fact collected, and Investor Co. then expects a full collection of the $600,000 in 2015 (but no recovery of the $50,000 missed payment in 2014).
The entry to record the reduced expectation of future cash flows at the end of 2012 or beginning of 2013 is as shown below.
In 2014, the collection of the $20,000 (when no collection at all was anticipated), coupled with the renewed expectation of collecting $600,000 in 2015, requires that the yield through the end of the expected holding period (final payoff, in this case) be recomputed. Assuming that the $20,000 payment for 2014 is received before the financial statements for 2014 have been prepared, it would be appropriate to recompute accretable yield as of the beginning of that year, so that both 2014 and 2015 will report interest income consistent with the pattern of cash flows over that two-year period. The calculated yield on an investment equal to the carrying value at the beginning of 2014 ($394,408), which is expected to generate cash inflows of $20,000 at the end of that year and $600,000 at the end of the next year, is 25.9%, and this is used to accrete yield over the remaining term.
Since this will be reported prospectively, no entry is made as of the beginning of the year (nor would the necessary information have been available), but the entry to record interest income and the accretion for uncollected interest would be as follows:
The accretion of value is akin to an amortization of discount, and represents interest earned but not received, based on the most recent estimates of future cash flows. It does not represent a recovery of the previously written down carrying value of the investment because of permanent impairment. The complete analysis can be seen in the chart that follows:
It will be observed in the foregoing chart that total cash collected, $780,000, consisted of $421,039 in interest, accreted first at the 12.6% computed yield through the end of 2013, and then at the 25.9% computed yield in light of higher expected cash flows for 2014 and 2015. The remainder of the cash flows, totaling $358,961, was attributable to the recovery of the investment, net of the write-down for impairment in 2013.
In contrast to the example where the investment was accounted for as a loan receivable, here the yield is adjusted prospectively when a recovery in value is observed, and this causes relatively more of the future cash flows to be treated as interest income, and relatively less as recovery of the investment principal.
Note that if no reduction in future cash flows had been anticipated, but if an increase in cash flows was expected at some point during the holding period of the investment, the result, from an accounting standpoint, would be as shown immediately above. The accretable yield would have been computed and recognized prospectively over the remaining holding period of the security.
As a result of the economic environment, the FASB issued ASU 2011-02, Receivables (Topic) 310: A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The ASU clarified guidance for creditors' evaluation of loans to determine whether a restructuring of a receivable is a troubled debt restructuring (TDR). The guidance specifically prohibits creditors from using the borrower's effective rate test in ASC 470-60 in evaluating whether a concession has been granted to a borrower. If it is determined that a TDR exists, the lender is required to:
All TDRs are considered impaired loans.
A TDR loan is one that is restructured or modified for economic or legal reasons, where these conditions are present:
ASC 310-40-15-5
Because of the framework in the guidance, creditors only have to evaluate modifications for debtors that are experiencing financial difficulties. “Concession” and “financial difficulties” have specific meaning under the guidance.
Lenders should consider the following factors when evaluating the first condition for a TDR − borrower's financial difficulty:
(ASC 310-40-15-20)
The assessment regarding whether it is probable the debtor will be in default in the significant future is a significant change. However, the guidance does not specify how a creditor should determine that it is probable that it will be unable to collect all amounts due according to the contractual terms of a loan. A creditor should apply its normal loan review procedures in making that judgment. An insignificant delay or insignificant shortfall in amount of payments does not require application of this guidance.
A concession has been granted as a result of a restructuring when the creditor does not expect to collect all amounts due, including interest accrued at the original contract rate. The creditor should also consider changes to underlying collateral if the principal payment is dependent on the value of the collateral.
The first thing the creditor should consider in determining whether a TDR has occurred is whether it expects to collect all amounts due. If contractual amounts due have not changed or have increased, the Codification provides additional guidance
Additional collateral and guarantees. When a creditor has restructured a debt in exchange for additional collateral or guarantees from the debtor and the nature and amount of that additional collateral or guarantees received as part of a restructuring do not serve as adequate compensation for other terms of the restructuring, the creditor needs to consider whether a concession has occurred. (ASC 310-40-15-14)
Access to market-rate funds. In a declining-rate environment, the loan may be restructured with a lower interest rate. The creditor needs to evaluate whether the debtor would be able to get the same terms and market rate from another lender. If so, a concession has not occurred. If not, the restructuring would be considered to be at a below-market rate and this may indicate that the creditor has granted a concession. (ASC 310-40-15-15)
Temporary/permanent increases in interest rate. The borrower cannot assume that a temporary or permanent increase in the contractual interest rate as a result of a restructuring is not a concession. The new contractual interest rate could still be below market interest rates for new debt with similar risk characteristics. Borrowers have to perform the TDR evaluation based on consideration any other changes as a result of the restructuring. (ASC 310-40-15-16)
Insignificant delay. A delay in payments is not considered a concession if the delay is insignificant. This is aligned with the impairment guidance in ASC 310-10.
ASC 310-40-15-17 provides that a delay may be insignificant depending on the following factors:
The preparer should use judgment in evaluating the factors listed, and other factors may also be considered in evaluating whether an insignificant delay has occurred.
ASC 310-40-40-1 addresses the situation of a sale of real estate collateral by a debtor in a troubled debt situation, with the acquirer assuming the obligation to the creditor (the reporting entity) such that the fair value of the obligation (the present value of payments, less than the net investment) was less than the creditor's carrying value of the loan receivable. In such circumstances, the creditor would be required to recognize a loss in the amount by which the net investment in the loan exceeds the fair value of the payments to be received. The fair value of the payments should be recorded as an asset by the creditor.
3.145.70.170