What Was FAS 114 for Impaired Loans?

Statement of Financial Accounting Standards No. 114 (FAS 114) was a directive from the Financial Accounting Standards Board (FASB) that created a uniform method for creditors to account for impaired loans. The standard was designed to eliminate inconsistencies in how lenders identified and measured losses on loans where the full collection of principal and interest was no longer expected. This guidance applied to a wide array of loans and was a component of U.S. Generally Accepted Accounting Principles (GAAP) for many years.

Scope and Impairment Triggers

FAS 114 was directed toward loans that were evaluated for impairment on an individual basis, which included large commercial or industrial loans. The standard excluded large groups of smaller, similar loans that are evaluated for impairment collectively, such as residential mortgages, credit card balances, and consumer installment loans. Also outside its scope were loans measured at fair value, leases, and certain debt securities.

Impairment was recognized when it became “probable” that the creditor would not be able to collect all amounts due according to the loan’s original contractual terms, including both principal and interest. In this context, “probable” indicated that the future event of non-collection was likely to occur.

An insignificant delay or a minor shortfall in a payment did not automatically render a loan impaired. A loan was not considered impaired if the lender expected to collect all amounts due, including any interest that accrued during a period of payment delay. The standard also applied to loans modified in a troubled debt restructuring, making the restructuring itself a trigger for impairment analysis.

Measurement of Impairment

Once a loan was identified as impaired, FAS 114 provided creditors with three methods to measure the loss. The primary method involved calculating the present value of the loan’s expected future cash flows. These projected cash flows were then discounted using the loan’s original effective interest rate. This method focused on the deterioration of credit quality and did not reflect changes in general market interest rates.

As a practical alternative, a creditor could measure the impairment based on the loan’s observable market price, if an active market for that specific loan existed. This provided a direct, market-based valuation of the impaired asset and was often simpler than projecting and discounting future cash flows.

The third method was based on the fair value of the loan’s collateral, but only if the loan was “collateral-dependent,” meaning repayment was expected to be provided solely by the underlying collateral. If a creditor determined that foreclosure was probable, using the collateral’s fair value to measure impairment became mandatory. For example, if a commercial loan with a balance of $1 million was impaired and the collateral’s fair value was $800,000, the impairment loss would be $200,000, factoring in any costs to sell.

Recognition and Disclosure

After measuring the impairment, the creditor recognized the loss in its financial statements. The calculated impairment amount was recorded as a charge to the bad debt expense account on the income statement. This amount was also credited to the allowance for loan losses, a contra-asset account that reduces the total reported value of loans on the balance sheet.

FAS 114 also mandated specific disclosures in the notes to the financial statements to provide transparency to investors. Creditors were required to disclose:

• The total recorded investment in all loans identified as impaired and the corresponding balance in the allowance for credit losses.
• An analysis of the activity within the allowance for credit losses account, showing a reconciliation from the beginning to the ending balance.
• The creditor’s policy for recognizing interest income on these impaired loans.
• The amount of interest income recognized on impaired loans and how much cash was received for each period presented.

The Shift to CECL

The FAS 114 model is now obsolete and has been superseded by a new standard under ASC 326 known as the Current Expected Credit Losses (CECL) model. This new standard was developed in response to criticisms that the old model recognized losses “too little, too late,” a weakness highlighted by the 2008 financial crisis.

The primary change introduced by CECL is the shift from an “incurred loss” model to an “expected loss” model. Under FAS 114, an impairment loss was not recognized until it was probable that a loss had already been incurred. This backward-looking approach often delayed the recognition of credit losses until a borrower was significantly delinquent.

In contrast, the CECL model is forward-looking. It requires entities to estimate and record expected credit losses for the entire life of a loan from its origination or acquisition. This calculation must consider past events, current conditions, and reasonable and supportable forecasts of future economic conditions, forcing an earlier recognition of credit losses.

The move to CECL also eliminated the specific accounting model for troubled debt restructurings (TDRs). Previously, designating a loan modification as a TDR was a trigger for impairment. Under the new guidance, this designation has been removed, and modifications for borrowers experiencing financial difficulty are assessed under a general framework.