Banks today are continuing to deal with a high volume of substandard and problem loans. Part of the process of dealing with these loans is testing them for impairment.
ASC 310-40 (formerly known as FAS 114) requires loans to be tested for impairment if the bank determines, based on the facts and circumstances surrounding the local market, the loan won’t be re-paid in accordance with the contracted terms and conditions. If it is determined that a collateral-dependent loan is impaired, the loan must be accounted for and written down to the fair value of the collateral less the estimated costs to dispose of the collateral.
Timely and Accurate Appraisals
The key to accurate fair value accounting is having current, qualified and credentialed appraisals for real estate held as collateral on loans. Of course, in the continuing volatility of today’s commercial real estate market, ensuring the relevance of appraisals is challenging, to say the least.
Given this, regulators are taking an especially close look at the timeliness and accuracy of appraisals on commercial real estate held as collateral. They expect banks not only to challenge the assumptions appraisals are based on (e.g., realistic time to sell, accurate assessment of both physical and shadow inventory, use of appropriate comparables), but also to periodically reexamine the current market value of property, if necessary — either by obtaining a new appraisal or adjusting the current appraisal using new, more realistic assumptions reflecting current market conditions.
To determine if a loan is impaired, the appraisal must be adjusted for the estimated cost to hold and sell the collateral (e.g., insurance, taxes, sales commission). Loans determined to be impaired will impact the calculation of the adequacy of the bank’s allowance for loan and lease losses (ALLL).
Fair value accounting is only to be used on loans that are collateral dependent. Historical cost basis accounting should continue to be used for non-impaired loans. Note: Be careful not to mistake loans that simply carry more risk characteristics with impaired loans, which are loans that you do not expect to be repaid in accordance with the contractual terms.
How Current is Current Enough?
Of course, this is the $64,000 question. Unfortunately, there’s not a one-size-fits-all answer.
Whether an appraisal is current enough or not will vary from one market to the next, based on current conditions in each market. In markets that have begun to stabilize, regulators may determine that appraisals up to one year old are acceptable. However, in markets where real estate values remain volatile, appraisals older than three months might be considered out of date.
For example, let’s say that you are analyzing a loan impairment on December 31 and receive an appraisal dated June 30. Unfortunately, in the past six months, average commercial real estate values in your market have fallen 13 percent. In this case, you’ll need to either obtain a new appraisal or adjust the existing one.
Adjusting the existing appraisal down by 13 percent is obviously an easier and less expensive option. However, regulators may want to know what assumptions you used to make this adjustment, so be prepared to back it up with concrete data and statistics. Loan file documentation is the key: If it’s not in the file, it doesn’t exist.
For assistance with impairment testing and fair value measurement, please give us a call.