Practice Bulletin No. 7 Criteria for Determining Whether Collateral for a Loan Has Been In-Substance Foreclosed

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Accounting standards have produced several approaches to assessing whether collateral for a loan has been in-substance foreclosed. C. Harril Whitehurst, Jr., CPA, a partner of BDO Seidman, Richmond, Virginia, and a member of the American Institute of CPAs savings and loan associations committee, discusses how the AICPA practice bulletin on the subject addresses the issue. Last year, the American Institute of CPAs accounting standards executive committee (AcSEC) undertook a project to examine how losses on loans collateralized by real estate and on certain real estate owned were being determined under current guidance. The project was undertaken because there is diverse guidance in the authoritative accounting literature. This diversity has focused primarily on the difference between guidance for savings and loans and that for banks.

AcSEC, therefore, formed a task force to address three issues that are related to the recording of losses on collateralized loans:

1. How to determine whether collateral for a loan has been in-substance foreclosed.

2. If collateral for a loan has not been in-substance foreclosed, whether lenders should discount estimated cash flows from collateral to determine if a loss is recorded.

3. If collateral has been foreclosed or in-substance foreclosed, how such assets should be reported--in particular, whether discounting should be used in determining their value.

The task force drafted a proposed statement of position addressing these three issues. However, AcSEC then decided it was not desirable for them to resolve the issues dealing with discounting; they thought the Financial Accounting Standards Board should deal with the discounting issues.

AcSEC, however, did reach a conclusion on the in-substance foreclosure issue and issued a new practice bulletin no. 7, Criteria for Determining Whether Collateral for a Loan Has Been In-Substance Foreclosed,.

Paragraphs 34 and 84 of FASB Statement no. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, raise the issue of in-substance foreclosure. They require loss recognition based on the fair value of the collateral that is in-substance foreclosed. However, they do not provide specific criteria for what constitutes in-substance foreclosure. The only authoritative guidance previously available was the Securities and Exchange Commission's Financial Reporting Release no. 28, issued in December 1986, which provides, among other things, specific criteria for determining whether an in-substance foreclosure has occurred. The SEC issued FRR no. 28 because it recognized registrants needed additional guidance on this issue to ensure consistent reporting. However, this release applies only to public companies reporting to the SEC.

The new practice bulletin no. 7 begins discussion of the in-substance foreclosure issue by indicating a creditor should determine if an in-substance foreclosure has occurred when it is probable the creditor will not receive all the promised payments on the collateralized loan. This determination must be made before evaluating the allowance for loan loss under FASB Statement no. 5, Accounting for Contingencies, because, if an in-substance foreclosure has taken place, the reporting of the asset would change from that for a loan receivable to that for the collateral.

AcSEC concluded in the practice bulletin the criteria for determining if an in-substance foreclosure has taken place should be the same as those in FRR no. 28. The criteria, all of which must be met, are:

* The debtor has little or no equity in the collateral, considering its fair value. (Fair value is defined in paragraph 13 of FASB Statement no. 15 as "the amount that the debtor could reasonably expect to receive . . . in a current sale between a willing buyer and a willing seller, that is, other than in a forced or liquidation sale. …


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