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Portfolio Risk & CECL

How to evaluate FAS 114 (ASC 310-10-35) loans for impairment, part II

Sageworks
July 9, 2013
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In part I of this post on FAS 114 (ASC 310-10-35) valuation methods, the Fair Market Value of Collateral method was discussed. This method is used when a loan is expected to be repaid through the liquidation of collateral. In part II of this post below, the Present Value of Future Cash Flows method is discussed.

The Present Value of Future Cash Flows method

While the Fair Market Value of Collateral method is the most widely used valuation method for evaluating FAS 114 loans in the loan loss reserve, the Present Value of Future Cash Flows method is the second most popular. It should be used when there is an expectation of cash payments from the borrower. Troubled Debt Restructures (TDRs) fall into this category because these loans have been restructured in order to provide for future payments from the borrowers for at least some portion of the recorded investment.

The Present Value of Future Cash Flows evaluation should use the effective (original, contractual) interest rate as the discount rate for the cash flows. For the analysis, the institution should set up a month-by-month payment schedule with each month discounted appropriately.

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The total impairment is evaluated by subtracting the total cash flows available from the total recorded investment. This method can become subjective since the creditor makes a judgment regarding what portion of the repayments will be completed. It is also important to note that examiners are often wary of excessive optimism when reviewing cash flow expectations of impaired loans.

Consider the following example of when a reserve would be required:

 

In this example, the total recorded investment is greater than the valuation amount. Therefore, the difference of $170,494.31 is the calculated reserve amount.

There are a number of factors that can make the Present Value of Future Cash Flows calculation difficult. Trends within the borrower’s industry, political/economic changes, seasonality and the fact that the loan could become collateral-dependent resulting in a need to change the valuation method can give institutions trouble when using this method.

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About the Author

Sageworks

Raleigh, N.C.-based Sageworks, a leading provider of lending, credit risk, and portfolio risk software that enables banks and credit unions to efficiently grow and improve the borrower experience, was founded in 1998. Using its platform, Sageworks analyzed over 11.5 million loans, aggregated the corresponding loan data, and created the largest

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