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FAS 115 (Impairment Accounting) for Dummies.

“Begin from where you are” - Anonymous.

fas115b

Flavor Flave Banking Corporation based in Far Far Away,  originated a loan as follows:

  • Principal amount $380,000
  • Interest Rate is 10%
  • Annual Contractual Payments is $61,845
  • Trade & Settlement Date is 1/1/2006
  • Maturity Date is 12/31/2015
  • Net Loan Origination Cost Charged to customer is 7,600
  • Therefore, net cash outflow on day zero is ($380,000 - 7,600 = 372,400)

This loan is classified as available for sale. Per guidance in FAS 115, certain debt and equity securities classified as available-for-sale should be reported at fair value with unrealized changes in fair value excluded from earnings.

Requirements & Assumptions:

  • Calculate the book value/carrying value of the loan as of 12/31/2010.
  • Two quarters prior to period ended 12/31/2010, the fair value of the loan was significantly less than the book value.
  • The borrower’s credit rating has been downgraded from AAA to CCC in the last six months (CCC is less than investment grade based on S&P ratings)
  • Flavor Flave Banking Corporation considers these two events as other than temporary impairments (OTTI)

Based on the calculations in the attached MS Excel workbook, the amortized cost basis as of 12/31/2010 is $231,631.77.

In order to calculate the fair value of the the loan as of 12/31/2010 we need the following information:

The fair value of the loan is the net present value of the remaining future cashflow stream from the date the OTTI event occured.

The projected LIBOR yield curve (Hypothetical) is as follows:

12/31/2011 - 14%
12/31/2012 - 15%
12/31/2013 - 16%
12/31/2014 - 17%
12/31/2015 - 18%

The remaining future cashflow stream are as follows:

12/31/2011 - 61, 845
12/31/2012 - 61, 845
12/31/2013 - 61, 845

12/31/2014 - 61, 845

12/31/2015 - 61, 845

  Bfix  =  Sigma Ke^( -riti ) + Le^( -rntn )

Where
K = Fixed payment made on each payment date
L = Notional principal in swap agreement
ti = time until maturity (over the life of the swap)
ri = LIBOR zero rate corresponding to maturity ti
e = exponential

Bfix = 61, 845e^(-0.14*12/12) + 61, 845e^(-0.15*24/12) +  61, 845 e^(-0.16*36/12) 

+  61, 845e^(-0.17*48/12) +61, 845e^(-0.18*60/12)


Bfix =53,765.46 + 45,815.90 + 38,268.66 + 31,331.73 +25,144.30  =$194,326.05

The amount of the OTTI impairment is therefore, the amount by which the fair value  is less than the book/carrying value as follows:

231,631.77 - 194,326.05 = $37,305.72

*The FV was calculated using continuous compounding method…..discrete compounding method may be more appropriate in certain cases.  Evaluate your situation on a case by case basis.

FAS 115 (para. 16)  states that for individual securities classified as either available-for-sale or held-to-maturity, an enterprise shall determine whether a decline in fair value below the amortized cost basis is other than temporary. For example, if it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred.  If the decline in fair value is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value as a new cost basis and the amount of the write-down shall be included in earnings (that is, accounted for as a realized loss). The new cost basis shall not be changed for subsequent recoveries in fair value. Subsequent increases in the fair value of available-for-sale securities shall be included in the separate component of equity pursuant to paragraph 13; subsequent decreases in fair value, if not an other-than-temporary impairment, also shall be included in the separate component of equity.

Accounting Entries to Record OTTI Impairment:

Dr  Earnings      $37,305.72

Cr Loan (asset account)    $37,305.72

(To record OTTI impairment on a loan/asset)

Balance Sheet Presentation:

Loan - Book Value     —     $231,631.77

Less: Impairment —        ($37,305.72)

Net Value —                    $194,326.05

NOTE: This is a rather simplistic example.  We will deal with a more robust example in the near future .  We will also discuss FAS 65 LOCOM in the future and also talk about how to calculate your loan loss provisions using the expected loss approach.

Bibliography:

NOTE ON TREATMENT OF ISSUANCE COST PER GUIDANCE IN PARAGRAPH A41 OF FAS 159:

“A41. The Board considered whether to provide guidance on how reported interest should be determined for receivables and payables reported at fair value pursuant to the fair value option. The Board noted that the issue of determining interest when financial assets and financial liabilities are measured at fair value is not new and would best be resolved in a different project. During its redeliberations, the Board affirmed that the fair value option project does not address methods for recognizing and measuring the amount of interest and dividend income and that an entity should provide a description indicating how interest and dividends are measured and reported in the income statement. However, the Board clarified that origination fees and costs related to items for which the fair value option is elected should be expensed as incurred. No amendment to FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, is required because that Statement does not apply to loans measured at fair value with changes reported in earnings.”

NOTE: Thanks to our partners at Blackinsey & Company for providing the solution.  Blackinsey & Company is a top tier strategy & management consulting outfit based in Washington, DC.  This was created under creative commons and is copyleft.  The interpretations and analysis presented in this article are purely for pedagogical exercise and Black Herald cannot be held responsible for any error of commission or omission.  Thanks for visiting our website.  You are always welcome :) .

If you like this article check out:

FAS 91 for Dummies and stay tuned for the following:

  • FAS 133 for Dummies
  • FAS 91 for Dummies (Sample with Prepayments)
  • FIN 46 for Dummies
  • FAS 115 for Dummies
  • FAS 123(R) For Dummies