Financial institutions have had little foreclosure activity in 2020 and may expect minimal activity in the coming months due to the continued efforts to allow borrowers some relief, such as modifications and forbearances.
Though these efforts have certainly helped borrowers weather the economic turmoil from the pandemic, the reality is that many will continue to have trouble repaying debts, resulting in foreclosure.
Accounting for foreclosures can be complex and requires evaluation of the individual facts and circumstances when considering the appropriate treatment.
Below is a summary of accounting treatments for the various stages of a foreclosed property:
Foreclosed assets acquired
The first step in the process is to determine when the asset has been acquired, which is typically considered when the institution receives legal title to the asset or when the institution obtains physical possession. The next step is to determine whether the asset will be held for sale or held for use by the institution, which will determine the accounting treatment.
For purposes of this article, let’s assume the institution plans to sell the property, which is the most common practice. Foreclosed assets acquired and held for sale will be transferred from loans at the time of acquisition to the foreclosed assets or other real estate owned (OREO) account at the asset’s estimated fair value less costs to sell (the “initial carrying basis.”
Generally, the initial carrying basis of a foreclosed asset is less than the loan’s principal balance, and this difference would be charged as a loan loss to the allowance for loan losses.
If the initial carrying basis of a foreclosed asset is greater than the loan, the gain would be recorded to the income statement unless there were previous loan losses charged, in which case the gain would be applied as a recovery to the allowance for loan losses. If there is a gain, it is important to be skeptical because it would be in the best interest of the borrower in this scenario to obtain further financing or sell the property themselves before foreclosure proceedings.
Holding foreclosed assets held for sale
Foreclosed assets held for sale should be evaluated regularly for impairment for as long as they remain on the balance sheet. Any subsequent impairment charges would be recorded as a loss to the income statement.
If the value of the asset increases, it is appropriate to record the increases as a gain only to the extent of prior impairment losses. The basis of the foreclosed asset should never exceed the initial carrying basis of the asset, determined at acquisition.
Any costs recognized during the held-for-sale period, such as taxes, maintenance and marketing, are to be expensed as incurred.
If the institution incurs expenses to significantly improve the value of the asset, these costs may be capitalized. The institution would continue to evaluate the property for impairment, even with the improvements.
Sales of foreclosed assets
Determining when to recognize revenue from a sale of foreclosed assets depends primarily on the existence of a contract and controlling interest in the property. Accounting Standards Codification Topic 606 (ASC 606), Revenue from Contracts with Customers, provides a principles-based revenue recognition approach, based on a five-step process, to determine when and how revenue will be recognized:
- Identify the contract(s) with a customer.
- Identify the performance obligations (that is, the promises to deliver goods or services) in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
For a contract to exist, the arrangement between the financial institution and the buyer of the property must meet the following criteria:
- The parties to the contract have approved the contract (in writing, verbally or in accordance with customary business practices) and are committed to performing their respective obligations.
- The financial institution can identify each party’s rights regarding the OREO to be transferred.
- The financial institution can identify the payment terms for the OREO to be transferred.
- The contract has commercial substance (that is, the risk, timing or amount of the financial institution’s future cash flows is expected to change as a result of the contract).
- It is probable that the financial institution will collect substantially all of the consideration to which it will be entitled in exchange for the OREO that will be transferred to the buyer (i.e., the transaction price). In evaluating whether collection is probable, a financial institution should consider only the buyer’s intent and ability to pay the transaction price.
The determination of whether a contract exists is likely the most complex part of this analysis due to the subjectivity involved, specifically in determining the borrower’s commitment and the loan’s collectibility.
In the latest OCC Bank Accounting Advisory, the OCC provides guidance on ASC 606 as it relates to OREO, which is helpful guidance for all financial institutions. The OCC addresses considerations for assessing a buyer’s commitment to performing their obligations (as noted in the bullet above) and the collectibility of the transaction price (as noted in the last bullet above) to determine whether an accounting sale has occurred.
The institution must review the facts and circumstances surrounding the transaction to determine whether the buyer has demonstrated a commitment to executing the contract, as well as collectibility of the transaction price. Initial equity, like a down payment, and existence of recourse provisions, are two important factors to consider in making this determination.
Below is a list of factors the OCC noted as considerations in determining a buyer’s commitment and collectibility of the consideration:
- Amount of cash paid as a down payment
- Existence of recourse provisions
- Credit standing of the buyer
- Age and location of the property
- Cash flow from the property
- Payments by the buyer to third parties
- Other amounts paid to the selling bank, including current or future contingent payments
- Transfer of noncustomary consideration
- Other types of financing involved with the property or transaction
- Financing terms of the loan
- Underwriting inconsistent with the bank’s underwriting policies for loans not involving OREO sales
- Future subordination of the seller’s receivable
If it is determined a contract does not exist based on ASC 606, the institution would not record the transaction as an accounting sale but rather keep the OREO at fair value less costs to sell, and any consideration received would be recognized as a deposit liability until the criteria in ASC 606 are met.
An example of this would be if a seller-financed arrangement is established and the buyer makes a small down payment but has insufficient income to be able to repay the debt. This transaction would not meet the ASC 606 criteria and would not be treated as a sale for accounting purposes.
If a contract has been established, the next step is determining control. The transfer of control dictates when revenue will be recognized. ASC 606-10 includes the following indicators of the transfer of control:
- The institution has a present right to payment for the asset.
- The customer has legal title to the asset.
- The institution has transferred physical possession of the asset.
- The customer has the significant risks and rewards of ownership of the asset.
- The customer has accepted the asset.
Note that these are indicators of the transfer of control; the agreement does need to meet all of these indicators in order for control to transfer. Factors to consider when determining control are whether the institution has any involvement in the property following the transaction, any obligation to repurchase or to provide support, or any retention of equity interest in the property.
If it is determined the transaction meets the definition of a contract and the property has been transferred, the institution should record the gain (or loss) on sale at the time of sale. If the institution determines a transfer of control has not occurred, the transaction should be recorded as a financing arrangement in accordance with ASC 606 or as a lease under ASC 840 (soon to be ASC 842).
How Wipfli can help
Accounting for transactions related to foreclosures and OREO can be tricky, and if you are fortunate enough to not have to worry about it often, the challenge becomes remembering how to do it. At each step in the process, it is important to document management’s judgments involved, whether related to the valuation of the asset, recognition of impairment losses (or recoveries) or recognition of the sale.
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