FASB 114: Accounting for Impaired Loans

The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 114 to establish a uniform approach for creditors in accounting for impaired loans. It created consistency in how lenders identified and measured losses when it became apparent that the full principal and interest on a loan would not be collected. This standard was a part of U.S. Generally Accepted Accounting Principles (GAAP) for many years, providing specific guidance for a wide range of lending situations.

FASB 114 is now obsolete, having been superseded by provisions within Accounting Standards Codification (ASC) 310 and more comprehensively by ASC 326, which introduced the Current Expected Credit Losses (CECL) model. The change was driven by a view that the FASB 114 model recognized losses “too little, too late,” a concern that gained prominence during the 2008 financial crisis. A historical understanding of FASB 114 remains valuable for analyzing the evolution of accounting standards and for comprehending financial statements prepared before the adoption of CECL.

Applicability of the Standard

The guidance in FASB 114 was directed at creditors and applied to a broad array of loans and financing receivables. This included both collateralized and uncollateralized loans that were evaluated for impairment on an individual basis, such as large commercial and industrial loans. The standard also specifically applied to all loans that were restructured in a troubled debt restructuring involving a modification of terms.

The standard’s scope had several notable exclusions. It did not apply to large groups of smaller-balance, homogeneous loans that are evaluated for impairment on a collective or pooled basis. Examples of these excluded loans include residential mortgages, credit card receivables, and consumer installment loans. This distinction was made because the risk characteristics of these portfolios differ from individually significant loans.

Further exclusions were loans measured at fair value or at the lower of cost or fair value, since these valuation methods already incorporate current market conditions. The standard also did not cover leases or debt securities, as these financial instruments were addressed by other specific accounting standards.

Identifying an Impaired Loan

Under the FASB 114 framework, a loan was identified as impaired when it became “probable” that the creditor would be unable to collect all amounts due according to the loan’s contractual terms. This evaluation included both principal and interest payments. The term “probable” in this context signifies that the event of non-collection is likely to occur, a higher threshold of certainty than “reasonably possible” but lower than “virtually certain.”

The determination of probability was based on current information and events available to the creditor, requiring judgment to evaluate all available evidence. Specific events that could trigger an impairment analysis include:

• A significant period of payment delinquency by the borrower.
• The filing of bankruptcy by the borrower.
• A formal restructuring of the loan’s terms to provide a concession.
• A notable decline in the borrower’s overall financial health or business operations.

Measuring the Impairment

Once a loan was identified as impaired, FASB 114 provided creditors with three distinct methods to measure the amount of the loss. The impairment amount was calculated as the difference between the loan’s recorded investment and the value determined by one of these methods. The recorded investment includes the outstanding principal balance, any accrued interest, and other related costs.

Present Value of Expected Future Cash Flows

The primary method involved calculating the present value of the loan’s expected future cash flows. A creditor would estimate the amount and timing of future cash collections and then discount them using the loan’s original effective interest rate. This requirement to use the original rate isolated the impact of the borrower’s credit deterioration from general movements in market interest rates.

Observable Market Price

As a practical expedient, a creditor could measure impairment based on the loan’s observable market price. This option was available only if an active and reasonably liquid market existed for the specific impaired loan. This method was often less complex than projecting cash flows but was limited by the availability of reliable market data.

Fair Value of Collateral

The third method was for loans that are “collateral-dependent,” meaning repayment is expected to be provided solely by the underlying collateral. In this situation, the impairment was measured as the difference between the recorded investment in the loan and the fair value of the collateral. If the collateral’s fair value was less than the recorded loan amount, that shortfall represented the impairment loss. This method was frequently used for asset-based lending where the primary source of repayment was tied directly to a specific asset.

Accounting and Disclosure Requirements

After measuring the impairment, the creditor was required to account for the loss in its financial statements. The impairment was recorded by establishing or increasing a valuation allowance, commonly known as the allowance for loan losses. This allowance is a contra-asset account that reduces the net carrying value of the loan on the balance sheet, with a corresponding charge to bad debt expense on the income statement.

The accounting entry would involve a debit to Bad Debt Expense and a credit to the Allowance for Loan Losses. Subsequent changes in the measured impairment, whether increases or decreases, were recorded through adjustments to this valuation allowance.

FASB 114 also mandated specific disclosures in the notes to the financial statements to provide transparency to investors and other stakeholders. Creditors were required to disclose the total recorded investment in loans identified as impaired and the corresponding amount of the allowance for credit losses related to those loans. Disclosures also had to include the creditor’s policy for recognizing interest income on impaired loans.

Financial statements also needed to present a detailed summary of the activity in the allowance for credit losses account for the period. This reconciliation would show:

• The beginning balance.
• The amount of bad debt expense recognized.
• Any write-offs of uncollectible loans against the allowance.
• Any recoveries of loans previously written off.

This level of detail provided users with insight into the credit quality of the loan portfolio.