Foreclosing on assets pledged as collateral is usually the last step a bank will take with borrowers who are delinquent in repaying their loans — but it’s a step that, unfortunately, must sometimes be taken. Once foreclosure takes place, the lending relationship with a borrower effectively ceases, and the bank becomes the owner of a hard asset — an important distinction.
A foreclosed asset is defined as a loan in which the bank has received physical possession of a borrower’s assets, regardless of whether formal foreclosure proceedings have taken place or a deed in lieu of foreclosure has been issued. The secured loan should be re-categorized as an asset on the bank’s balance sheet in the appropriate asset category, such as other real estate owned, or OREO.
Banks are required to follow certain practices when holding OREO, including:
- Maintain the property and prevent deterioration of its condition
- Actively market the property and maintain insurance
- Determine if any property code violations exist, or if there are any environmental issues or issues with regard to compliance with the ADA
- Determine proper handling of income and expenses
In addition, banks must follow a variety of different accounting and reporting standards for foreclosed assets:
- OREO is considered to be held for sale, and should be accounted for at its fair value less cost to sell. In a declining real estate environment, banks may need to order periodic reappraisals.
- The fair value less cost to sell — not the lower of cost or market — becomes the “cost” of the foreclosed asset.
- Expenses that don’t add value to the property should be recognized through the income statement as incurred. Expenses that do add value to the property may be capitalized.
Call us if you have questions about accounting and reporting standards for OREO.