Credit unions face increased scrutiny over liquidation rules
By Justin Kudick
It has been more than a year since the National Credit Union Association (NCUA) has amended part §715.7 of the Other Supervisory Committee Minimum Procedures Guide. With expanded procedures and additional areas of focus, many credit unions are finding additional scrutiny related to the accounting for assets acquired in liquidation.
Assets acquired in liquidation include any collateral used for a secured loan and are now in the possession of the credit union until sold.
Even in a global pandemic, many credit unions have seen a decrease in repossessions and foreclosures this past year. Most likely as a result of certain borrower relief benefits such as deferrals on loan payments or the ability to use stimulus funds to keep current on their loans.
But there is no telling how long this trend is going to last.
The accounting for assets acquired in liquidation can be applied to both repossessions and foreclosures, whether voluntary or involuntary. Foreclosures tend to take longer to acquire the property as opposed to a repossession.
This is also true as to how quick the collateral typically can be sold. Many credit unions utilize local auctions to sell collateral to prevent any losses attributable to holding the collateral as the fair value is more volatile compared to real estate.
Although many repossessions are sold within a short period of time generally accepted accounting principles require assets to be reclassified as held for sale once they are in possession. However, common credit union practice is to wait to charge-off the loan until they receive the proceeds on the sale of the collateral.
While this practice allows the credit union to record a more accurate charge-off, at a minimum, NCUA requires assets held in liquidation to be reported in other assets on the Call Report.
Overall, when a credit union obtains the title or deed of the collateral, the asset is to be transferred and recorded as collateral held in the process of liquidation. The following steps should be taken when a credit union takes possession of the collateral:
- On the date the credit union takes possession in substance of the collateral, all interest and fees are to be reversed. Although at this point the loan is most likely in nonaccrual status, there may be collection costs that were added to the loan balance in accordance with the loan agreement, if applicable. Collection costs should be expensed but can be considered when determining if the borrower has fulfilled the debt obligation. The remaining balance should represent only the principal amount of the outstanding debt.
- As required by a credit union’s bylaws, a borrower is to maintain a share account to be eligible to obtain a loan. In most cases, certain verbiage is included in loan agreements that allows the credit union to utilize a member’s share account to fulfill any debt obligations. As such, the member’s share account should be applied the principal balance of the loan as allowable by law.
- The new principal balance becomes the cost basis which should be compared to the collateral’s fair value less estimated costs to sell. The lower of the two values would become the new cost basis of the collateral held in the process of liquidation. In most cases, the fair value less estimated costs to sell is less than the cost basis of the loan, at which time the difference would be recognized as a charge-off and recorded against the allowance for loan and lease losses.
- When the asset is sold, the difference would be recorded as a gain or loss. However, recognition should be in accordance with Accounting Standards Codification Topic 606 (ASC 606), Revenue from Contracts with Customers.
In addition to the steps noted above, several other factors should be considered:
- Although unlikely for repossessions, any major repairs or physical improvements to the asset should be capitalized if they significantly increase the fair value of the asset. Otherwise, they should be expensed as incurred.
- If the asset is held for an extended period of time, management should analyze if the asset is impaired. That is, the value has decreased due to holding the asset for sale. Generally, assets should be assessed for impairment at a minimum on an annual basis or more frequent if a triggering event occurs. If considered impaired, the write down should be recorded as an expense through the income statement.
- Write downs, gains, and losses should be recorded as a result of the fair value decreasing or increasing while the asset is held for sale. If shortly after the asset is transferred and the collateral value has changed, it most likely is not a result of the value decreasing or increasing due to holding the asset. In cases like this, any adjustment could be recorded against the allowance for loan and lease losses as an adjustment to the charge-off.
- In most cases, the credit union receives insurance proceeds (e.g., GAP insurance, partial refunds of force placed insurance, etc.) after the asset is in the credit union’s possession. The proceeds should be treated as a recovery on the charged-off loan up to the amount the loan has been charged-off. Although uncommon, if the amount received is in excess of the amount charged-off we believe in most circumstances the excess amount should be recognized as a reduction of the repossessed asset’s carrying basis.
- Most loan agreements include a provision that the cost of collections is the borrower’s responsibility. However, until the entire loan principal is recovered, these costs should be expensed as incurred.
Every repossession or foreclosure always seem to have their own quirk, but the overall process remains the same.
It would be best to review, at a minimum, assets held in the process of liquidation near quarter end to ensure appropriate reporting. Getting the appropriate amount recorded as a charge-off is crucial to ensure there are no long-lasting effect on your allowance for loan and lease calculation.
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