Determining the appropriate method of impairment evaluation
A common challenge institutions face in their FAS 114 (ASC 310-10-35) impairment analysis and evaluations is determining when it is appropriate to utilize the Fair Market Value of Collateral method vs. the Present Value of Future Cash Flow method – the two primary methods of evaluation afforded under the accounting guidance.
Accounting guidance is very clear in advising simply that all impaired loans considered “collateral-dependent” should be evaluated utilizing the Fair Market Value of Collateral method. The difficulty, however, lies in determining whether a loan should be considered “collateral-dependent” or not for the impairment analysis.
Per the guidance, a loan should be considered collateral dependent if repayment is expected solely on the basis of sale or operation of the collateral (if repayment is expected to be based on operation of the collateral, the selling expenses would not be taken into account).
Alternatively, if repayment is still expected to be based on ongoing payments from the borrower (i.e., the loan is a TDR, and the borrower has been paying as agreed), the institution should evaluate the loan using the Present Value of Future Cash Flow method.
In those instances where this determination and, consequently, the appropriate valuation method may not be obvious, the institution should select the valuation method that it believes to be the most appropriate and be certain to clearly document the substantiation of why that particular method was deemed appropriate for the loan in question.
For calculating the impairment reserve required for collateral-dependent loans, a FAS 114 worksheet should be used that describes the collateral and selling costs. A sample FAS 114 worksheet is available from Sageworks.