'Impaired' vs. 'Impairment'

A credit union’s allowance for loan and lease losses reflects estimated credit losses in its loan portfolio. ALLL calculations and reserve levels have been under increased scrutiny in recent years, and compliance with Financial Accounting Standards Board guidance is of concern to many institutions’ risk management teams and senior executives, particularly as new guidance for a current expected credit loss model is expected to be released later this year.

According to the 2015 Sageworks Bank & Credit Union Examination survey, roughly one out of every six institutions polled was criticized by examiners for its ALLL calculation process. (It is important to note that this statistic includes all institutions surveyed – both credit unions and banks).

A common mistake credit unions make with their ALLL calculations is the distinction between the words “impaired” and “impairment.” These words, although seemingly similar, have very different meanings when it comes to ALLL.

According to the National Credit Union Administration’s Examiners Guide, “A loan is impaired when it is probable that a creditor (credit union) will be unable to collect all amounts due, including principal and interest, according to the contractual terms and schedules of the loan agreement.”

When preparing for the ALLL calculation, credit unions should begin identifying impaired loans by determining which characteristics best represent impaired loans within their portfolios. The most common characteristics include:

• non-accrual status,
• substandard risk ratings (or worse), as determined by the CU
• 60 days or more past due
• loan-to-value ratios outside limits set by the CU
• or those loans that have been subject to troubled debt restructuring.

Loans that have been restructured automatically fall into the impaired category per the NCUA statement, since the original contractual terms have already been altered. Non-accrual loans (those that are not generating the stated interest rate because of nonpayment from the borrower) are by nature non-performing and, therefore, can easily be defined as impaired.

Aside from non-accrual and TDR distinctions, institutions have the ability to determine additional characteristics from which to identify their impaired loans. Risk ratings and days past due are often used to identify loans that are deteriorating and should also be considered impaired. While risk ratings are often weighted on a credit union’s internal system, the institution should consider any “non-pass” loans, such as those categorized as watched or doubtful loans, as well as those already determined as a loss.

Once loans are identified as impaired, a credit union must then measure the impairment, the “measurement portion of the overall allowance for loan and lease losses attributable to individually impaired loans.”

One of three valuation methods can be used: present value of future cash flows, fair market value of collateral or loan pricing.

The ASC 310-10-35 guidance requires that, “[impaired loans] be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent.”

Many institutions test loans for impairment to decide whether the loans belong within ASC 310-10-35. If zero impairment is found, institutions then move the loans back within their homogeneous pools under ASC 450-20 and apply the associated loss rates. This practice is widely used, but is not in accordance with guidance. An impaired loan may have zero impairment once evaluated using one of the three valuation methods, but should remain under ASC 310-10-35. This loan is still considered impaired if it meets the criteria of an impaired loan. This zero impairment may occur for an individual loan that has sufficient collateral that could be quickly liquated in order to cover the loan balance.

A Q&A document published by NCUA addresses this specifically. The document adds, “However, before concluding that an impaired FAS 114 loan needs no associated loss allowance, an institution should determine and document that its measurement process was appropriate and that it considered all available and relevant information.”

As such, credit unions may want to re-evaluate loans with zero impairment to ensure proper considerations were made for valuation adjustments, such as selling costs, adjustments made for collectability and review of expected monthly payments. If, upon re-evaluation, a loan realistically has zero impairment then no allowance for loss is required.

Understanding the guidelines will help your institution more accurately comply and likely reduce criticism from auditors and regulators. Also, a well-documented ALLL process and calculation will help eliminate uncertainty during examinations.

Emily Bogan is a senior risk management consultant at Sageworks, where she provides guidance to financial institutions on the allowance for loan and lease losses calculation. Prior to joining Sageworks, Bogan served in various capacities at both large and regional-sized banks, from credit risk management to business intelligence.