ASC 310-10, Overall

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 310-10-15-5 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, Nonrefundable Fees and Other Costs

ASC 310-20-15-3 specifically excludes from ASC 310-20 guidance:

1. Loan origination or commitment fees that are refundable; however, the guidance does apply when such fees subsequently become nonrefundable.
2. Costs that are incurred by the lender in transactions with independent third parties if the lender bills those costs directly to the borrower.
3. Nonrefundable fees and costs associated with originating or acquiring loans that are carried at fair value if the changes in fair value are included in earnings of a business entity or change in net assets of a not-for-profit entity (NFP). The exclusion provided in this paragraph and the preceding paragraph applies to nonrefundable fees and costs associated with originating loans that are reported at fair value and premiums or discounts associated with acquiring loans that are reported at fair value. Loans that are reported at cost or the lower of cost or fair value, loans or debt securities reported at fair value with changes in fair value reported in other comprehensive income (includes financial assets subject to prepayment as defined in paragraph 860-20-35-2, and debt securities classified as available-for-sale under Topic 320), and loans that have a market interest rate, or adjust to a market interest rate, are not considered to be loans carried at fair value.
4. Fees and costs related to a commitment to originate, sell, or purchase loans that is accounted for as a derivative instrument under Subtopic 815-10.
5. Fees and costs related to a standby commitment to purchase loans if the settlement date of that commitment is not within a reasonable period or the entity does not have the intent and ability to accept delivery without selling assets. For guidance on fees and costs related to such a commitment, see paragraph 310-10-30-7.

ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality

ASC 310-30-15-2 excludes the following transactions from ASC 310-30 guidance:

1. Loans that are measured at fair value if all changes in fair value are included in earnings or, for an NFP, loans that are measured at fair value if all changes in fair value are included in the statement of activities and included in the performance indicator if a performance indicator is presented. Examples include those loans classified as trading securities under Topic 320 and Subtopic 948-310.
2. Mortgage loans classified as held for sale under paragraph 948-310-35-1.
3. Leases as defined in Topic 840. Only contracts that are classified by the purchaser as leases under that Topic meet this exclusion. The distinction between purchasing a lease and purchasing a stream of cash flows must be drawn to determine applicability of this Section.
4. Loans acquired in a business combination accounted for at historical cost, including business combinations of two or more NFPs, the acquisition of a for-profit business entity by an NFP, and combinations of two or more mutual entities.
5. Loans held by liquidating banks (financial reporting by liquidating banks is discussed in Topic 942).
6. Revolving credit agreements, such as credit cards and home equity loans, if at the acquisition date the borrower has revolving privileges.
7. Loans that are a transferor's interests (see Subtopic 325-40).

ASC 310-30-15-4 further excludes the following transactions and activities:

1. Loans that are derivative instruments subject to the requirements of Topic 815. If a loan would otherwise be in the scope of this paragraph of this Section and has within it an embedded derivative that is subject to that Topic, the host instrument (as described in that Topic) remains within the scope of this paragraph of this Section if it satisfies the conditions in this paragraph.
2. Loans for which it is possible, but not probable, that the investor will be unable to collect all amounts due according to the contractual terms of the loan.
3. Situations in which credit is still being offered, and the entire relationship is excluded if, at the acquisition date, the borrower has revolving privileges. This scope exclusion is appropriate because lenders generally will not continue to make credit available to borrowers from whom it is probable that the lender will not collect all contractually required payments receivable.

ASC 310-40, Troubled Debt Restructuring by Creditors

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 (TDR) has occurred.

ASC 310-40-15-9 states that TDRs may include, but are not limited to, one or a combination of:

• Transfer from the debtor to the creditor of receivables from third parties, real estate, or other assets to satisfy fully or partially a debt
• Issuance or other granting of an equity interest to the creditor by the debtor to satisfy fully or partially a debt unless the equity interest is granted pursuant to existing terms for converting the debt into an equity interest
• Modifications of terms of a debt, such as
  • Reduction of the stated interest rate
  • Extension of the maturity date at a stated interest rate lower than the current market rate
  • Reduction of accrued interest.

ASC 310-40-15-11 excludes the following for consideration under the TDR guidance:

• Changes in lease agreements
• Changes in employment-related agreements
• Unless they involve an agreement between debtor and creditor to restructure,
  • Debtors' failures to pay trade accounts according to their terms or
  • Creditors' delays in taking legal action to collect overdue amounts of interest and principal
• Modifications of loans within a pool accounted for as impaired loans
• Changes in expected cash flows of a pool of loans accounted for as impaired loans resulting from the modification of one or more loans within the pool.

Types of Receivables

Financing receivables include:

• trade accounts receivable,
• loans,
• credit cards,
• notes receivable,
• 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. Entities may enter into forward standby commitments to purchase loans at a stated price in return for a standby commitment fee. Settlement is in the hands of the seller. The seller would deliver the loans only when and if the contract price is equal to or executes the market price on the settlement date. This arrangement is, in effect, a written put option. Factored receivables are sold usually to a factor. The factor assumes the risk of collection, without recourse to the transferor. Debtors pay the factor directly. Rebates are refunds of portions of precomputed finance charges on installment loans or trade receivables. Rebate calculations are often governed by law. (ASC 310-10-05-4 through 05-7)

Presentation

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.

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.

Change in Estimate

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.

Imputed Interest

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.

Lending and Financing Activities, Including Trade Receivables

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 835-10-35-3)

ASC 310-10-25 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 recognized when the receivables are prepaid and are accounted for as adjustments to interest income. (ASC 310-10-25-11 through 25-13)

Pledging

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.

Disclosures. The only accounting issue relating to pledging is that of adequate disclosure. See Appendix—Disclosure Checklist for Commercial Businesses

Assignment

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.

Factoring

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.

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.

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.

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.

Measurement

An impaired loan can be measured on a loan-by-loan basis in any of the following ways:

1. Present value of expected future cash flows using the loan's original effective interest rate (the contractual interest rate adjusted for premium or discount and net deferred loan costs or fees at acquisition or origination)
2. Loan's observable market price
3. Fair value of the collateral if the loan is collateral dependent (repayment expected to be provided by the collateral). If foreclosure is probable, this measurement must be used. (If this method is used, ASC 820 on fair value applies.)

   (ASC 310-10-35-22)

Other measurement considerations include:

1. Costs to sell, on a discounted basis, if they will reduce cash flows to satisfy the loan
2. Creation of or adjustment to a valuation allowance account with the offset to bad-debt expense if the recorded investment is greater than the impaired loan measurement
3. If the contractual interest rate varies based on changes in an independent factor, the creditor can choose between:
   1. Calculating the effective interest on the factor as it changes over the loan's life, or
   2. Calculating the effective interest as fixed at the rate in effect at the date of impairment.

   The choice must be consistently applied. Projections of factor changes should not be made. (ASC 310-10-35-28)

4. Cash flow estimates should be the creditors' best estimate based on reasonable and supportable assumptions. (ASC 310-10-35-26)
5. Significant changes occurring in measurement values require recalculation and adjustment of the valuation allowance. Net carrying amount of the loan should not exceed the recorded investment.

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. (ASC 310-10-35-37)

Under ASC 310-10-35-16, the creditor would account for the examples above as follows.

Loan Origination Fees

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.

Commitment Fees and Costs

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. (ASC 310-20-25-11) 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.

Fees and Costs in Refinancing or Restructurings

(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:

1. The new loan's effective yield at least equals the effective yield for similar loans, and
2. Modifications of the original debt are more than minor.

   (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.

Purchase of a Loan or Group of Loans

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.

Special Arrangements

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.

Other Lending-Related Costs

Some ancillary costs do not qualify for deferral and should be expensed. The Exhibit below lists some of those costs and others that do qualify for deferral. (ASC 310-20-25-3 through 25-7)

Exhibit – Other Lending Related Costs Incurred by Lender

Overview

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.

ASC 310-30 in Greater Detail

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.

Accounting for Investments in Loans Acquired by Transfer

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.

Accounting for Investments in Pools of Loans Acquired by Transfer

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.

Accounting for Investments in Debt Securities Acquired by Transfer

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 a 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.

Is it a TDR Loan?

A TDR loan is one that is restructured or modified for economic or legal reasons, where these conditions are present:

1. The creditor grants a concession that it otherwise would not consider and
2. The borrower is having financial difficulties.

   (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 meanings under the guidance.

Financial Difficulty

Lenders should consider the following factors when evaluating the first condition for a TDR – borrower's financial difficulty:

• Borrower is in payment default on any of its debt; or it is probable the debtor will be in payment default on any of its debt in the foreseeable future without the modification.
• The borrower has declared or is in the process of declaring bankruptcy.
• There is significant doubt about the borrower's business continuing as a going concern.
• Borrower has securities that have been delisted or are in the process or threat of being delisted from an exchange.
• Based on estimates and projections that encompass only the current business capabilities, The creditor forecasts that the debtor's entity-specific cash flows will be insufficient to service any of its debt in accordance with contractual terms for the foreseeable future.
• Without the modification, the borrower cannot obtain funds from sources other than the existing creditors at an effective interest rate equal to the current market interest rate for similar debt for a nontroubled debtor.

  (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.

Granting a Concession

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)

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. (ASC 310-40-15-8A) If it is determined that a TDR exists, the lender is required to:

• Make certain disclosures, and
• Calculate the allowance for credit losses following the impairment guidance for impaired receivables in 310-10-35, discussed earlier in this chapter. (ASC 310-40-65-1)

All TDRs are considered impaired loans.

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 of 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:

1. The amount of payment subject to delay is insignificant relative to the unpaid principal
2. The restructuring results in an insignificant shortfall in the contractual amount due
3. The delay in the timing is insignificant with respect to:
   1. The frequency of payments due
   2. The original contractual maturity
   3. The original expected duration.

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.

Substituted Debtors in a Troubled Debt Restructuring

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.

When a Creditor is Considered to have Received Physical Possession of Residential Real Property Collateralized

There had been a perceived a lack of clarity around when a creditor should be considered to have received physical possession of residential real property collateralizing a mortgage loan, FASB issued guidance that clarifies that the receivable should be derecognized and the real property recognized when either:

1. The creditor obtains legal title to the property upon completion of foreclosure, or
2. The borrower conveys all interest in the property to the creditor to satisfy the loan through completion of a deed in lieu of foreclosure or a similar legal agreement.