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Título: BAAS 2013
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Office of the
Comptroller of the Currency
Washington, DC 20219

Bank Accounting
Advisory Series

September 2013

Message From the Chief Accountant
I am pleased to present the Office of the Chief Accountant’s September 2013 edition of the
Bank Accounting Advisory Series (BAAS). The BAAS expresses the office’s current views
on accounting topics relevant to national banks and federal savings associations (collectively,
banks). We hope that you find this publication useful.

UPDATE

NEW

The following questions have been added or revised in this edition:
Topic 2A

Troubled Debt Restructurings

Question 39

Topic 2G

Acquired Loans

Question 9

Topic 4

Allowance for Loan and Lease Losses

Question 53

Topic 5A

Other Real Estate Owned

Questions 35-36

Topic 9A

Transfers of Financial Assets and Servicing

Questions 15-17

Topic 11D

Fair Value Accounting

Question 9

Topic 1A

Investments in Debt and Equity Securities

Questions 4 and 14

Topic 2A

Troubled Debt Restructurings

Questions 4-5, 25, 32 and 38

Topic 2B

Nonaccrual Loans

Question 3

Topic 2G

Acquired Loans

Questions 5 and 8

Topic 3A

Lease Classification and Accounting

Question 9

Topic 4

Allowance for Loan and Lease Losses

Question 29

Topic 5A

Other Real Estate Owned

Questions 4 and 6

Topic 8A

Sales of Stock

Question 1

Topic 9A

Transfers of Financial Assets and Servicing

Questions 3 and 8

Topic 10C

Push-Down Accounting

Questions 1 and 11

This edition also incorporates FASB Accounting Standards Updates that have become
effective through September 2013. As part of our annual review process, some additional
existing entries have been fine-tuned.
On July 9, 2013, the OCC approved a new regulatory capital rule. The new rule becomes
effective January 1, 2014, for advanced approaches banks and January 1, 2015, for all other
banks. This edition of the BAAS does not include any new or revised questions to reflect
changes in the new regulatory capital rule.
Banks and others are reminded that the BAAS does not represent official rules or regulations
of the OCC. Rather, the BAAS represents the OCC’s Office of the Chief Accountant’s
interpretations of generally accepted accounting principles and regulatory guidance based
on the facts and circumstances presented. Nevertheless, banks that deviate from these stated
interpretations may be required to justify those departures to the OCC.
Kathy Murphy
Office of the Comptroller of the Currency
Chief Accountant
Office of the Comptroller of the Currency

BAAS September 2013

| i

Contents


Message From the Chief Accountant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i

Topic 1

Investment Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1



1A. Investments in Debt and Equity Securities. . . . . . . . . . . . . . . . . . . . . . . . 1



1B. Other-Than-Temporary Impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Topic 2

Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21



2A. Troubled Debt Restructurings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21



2B. Nonaccrual Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44



2C. Commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60



2D. Origination Fees and Costs (Including Premiums and Discounts) . . . . . 66



2E. Loans Held for Sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71



2F. Loan Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82



2G. Acquired Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

Topic 3

Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92



3A. Lease Classification and Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . 92



3B. Sale-Leaseback Transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96



3C. Lease Cancellations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

Topic 4

Allowance for Loan and Lease Losses . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Topic 5

OREO and Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128



5A. Other Real Estate Owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128



5B. Life Insurance and Related Deferred Compensation . . . . . . . . . . . . . . 144



5C. Miscellaneous Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

Topic 6

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153



6A. Contingencies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

Topic 7

Income Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156



7A. Deferred Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156



7B. Tax Sharing Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162



7C. Marginal Income Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164

ii

| Office of the Comptroller of the Currency

BAAS September 2013

Topic 8

Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166



8A. Sales of Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166



8B. Quasi-Reorganizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167



8C. Employee Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168

Topic 9

Income and Expense Recognition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169



9A. Transfers of Financial Assets and Servicing . . . . . . . . . . . . . . . . . . . . . 169



9B. Credit Card Affinity Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178



9C. Organization Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

Topic 10

Acquisitions, Corporate Reorganizations, and Consolidations . . . . . . 181



10A. Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181



10B. Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189



10C. Push-Down Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195



10D. Corporate Reorganizations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201



10E. Related-Party Transactions (Other Than Reorganizations) . . . . . . . . . 203

Topic 11

Miscellaneous Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207



11A. Asset Disposition Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207



11B. Hedging Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208



11C. Financial Statement Presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . 209



11D. Fair Value Accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

Appendixes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216


Appendix A. Commonly Used Acronyms . . . . . . . . . . . . . . . . . . . . . . . . . 216



Appendix B. Commonly Used Pre-Codification References . . . . . . . . . . . 218



Appendix C. Commonly Used FASB Codification References . . . . . . . . . 223

Office of the Comptroller of the Currency

BAAS September 2013

| iii

INVESTMENT SECURITIES

Topic 1

1A. Investments in Debt and Equity Securities

Investment Securities
1A. Investments in Debt and Equity Securities
Facts Under ASC 320, banks must classify their investment securities in one

of three categories: HTM, AFS, or trading. Securities categorized as HTM are
reported at amortized cost, while AFS and trading securities are reported at fair
value. Banks include the net unrealized holding gains and losses on AFS securities
in AOCI, net of applicable taxes, rather than as part of the bank’s net income
(loss). Banks do not include, however, the net unrealized holding gains and
losses attributable to AFS debt securities in their calculation of Tier 1 capital. Net
unrealized holding gains and losses on trading securities are reported immediately
in net income.

Question 1
Should the net unrealized holding gains and losses on AFS debt securities be included
in the calculation of a bank’s lending limit?

Staff Response
The net unrealized holding gains and losses attributable to AFS debt securities do not
affect the computation of a bank’s legal lending limit (i.e., the amount that a bank
may legally lend to one customer). This limit is based on an institution’s Tier 1 and
Tier 2 capital, adjusted to include the portion of the ALLL that was excluded for
capital purposes.

Question 2
How should a bank account for the unrealized gains or losses on investments
denominated in a foreign currency?

Staff Response
The net unrealized holding gains and losses on AFS investments denominated in a
foreign currency should be excluded from net income and reported in AOCI. The
entire unrealized gain or loss, including both of the portions related to interest rate
and foreign currency rate changes, is accounted for as an unrealized holding gain or
loss and reported in the separate component of stockholders’ equity. Therefore, the
income statement effect of foreign currency gains and losses is deferred until the
security is sold.
The gain or loss attributable to changes in foreign currency exchange rates, however,
would be recognized in income, if the investment is categorized as HTM. Banks
should follow the accounting guidance provided in ASC 830 for such investments.

Office of the Comptroller of the Currency

BAAS September 2013

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INVESTMENT SECURITIES

1A. Investments in Debt and Equity Securities

Question 3
What is the appropriate accounting for transfers between investment categories?

Staff Response
In accordance with ASC 320-10-35, transfers between investment categories are
accounted for as follows:


HTM to AFS—The unrealized holding gain or loss at the date of the transfer shall
be recognized in AOCI, net of applicable taxes.



AFS to HTM—The unrealized holding gain or loss at the date of transfer shall
continue to be reported in AOCI but shall be amortized over the remaining life
of the security as a yield adjustment. This amortization of the unrealized holding
gain or loss will offset the effect on income of amortization of the related premium or discount (see question 4).



All transfers to the trading category—The unrealized gain or loss at the date of
transfer, net of applicable taxes, shall be recognized in earnings immediately.



All transfers from the trading category—The unrealized gain or loss at the date
of transfer will have already been recognized in earnings and shall not be reversed.

Facts A bank purchased a $100 million bond on December 31, 20X1, at par. The
bond matures on December 31, 20X6. Initially, the bond was classified as AFS.
On December 31, 20X2, the bank decides it intends to hold the bond until maturity
and transfers the security to the HTM portfolio. The fair value of the security
on the date of transfer is $92 million. There has been no other than temporary
impairment recognized to date, including credit-related impairment.

UPDATE

Question 4
How should the bank account for the transfer?

Staff Response
In accordance with ASC 320-10-35-10, at the date of transfer, the bank should record
the security at its fair value, $92 million, which becomes the security’s amortized
cost. The $8 million unrealized holding loss on the date of transfer is not recognized
in net income but remains in AOCI. In addition, an unaccreted discount of $8 million
offsets the security’s face amount of $100 million, so the security is reported at its
fair value ($92 million) when transferred.
Under ASC 320-10-35-16, the $8 million discount is accreted to interest income
over the remaining life of the security. In accordance with ASC 320-10-35-10d, the
unrealized loss amount in AOCI is amortized simultaneously against interest income.
Those entries offset or mitigate each other.

2

| Office of the Comptroller of the Currency

BAAS September 2013

INVESTMENT SECURITIES

1A. Investments in Debt and Equity Securities

For regulatory capital purposes, the unamortized AOCI related to the security is
treated in the same manner as an AFS debt security.

Question 5
Do any restrictions exist on the types of securities that may be placed in the HTM
category?

Staff Response
Generally, there are few restrictions on how bank management chooses to allocate
the securities in their portfolio among the investment categories. ASC 320 requires
that a security, such as an IO strip, not be accounted for as HTM, if it can be prepaid
contractually or otherwise settled, so that its holder would not recover substantially
all of its recorded investment.
Additionally, an institution may not include a convertible debt security as HTM.
Convertible debt bears a lower interest rate than an equivalent security without such
a feature, because it provides the owner with potential benefits from stock price
appreciation. Use of this feature, however, requires the owner to dispose of the debt
security prior to maturity. Accordingly, the acquisition of such a security implies that
the owner does not intend to hold it to maturity.
No restrictions prevent a bank from pledging HTM securities as collateral for a loan.
A bank may also pledge HTM securities in a repurchase agreement if the agreement
is not effectively a sale in accordance with ASC 860.

Question 6
How should banks account for investments in mutual funds under ASC 320?

Staff Response
By investing in a mutual fund, the bank gives up the ability to control whether the
underlying securities are held to maturity. Therefore, at acquisition, the bank must
evaluate whether the investment should be classified as trading or AFS. A mutual
fund bought principally for sale in the near term should be classified as a trading
investment. For a mutual fund that is not bought principally for sale in the near term,
a bank may elect to classify the fund as trading or AFS at the time of purchase. Net
unrealized holding gains and losses on trading investments are included in income,
while net unrealized holding gains and losses on AFS investments are included in
AOCI until they are realized.

Question 7
How should gains and losses be reported when the mutual fund investments are sold?

Staff Response
Realized gains and losses should be included in determining net income for the
period in which they occur. They should be recorded as “Other noninterest income”
Office of the Comptroller of the Currency

BAAS September 2013

| 3

INVESTMENT SECURITIES

1A. Investments in Debt and Equity Securities

or “Other noninterest expense,” as appropriate, in the call report. If mutual fund
investments classified as AFS are sold, the component in AOCI should be adjusted to
remove any previously included amounts applicable to them.

Question 8
When may a bank sell HTM securities and not “taint” the portfolio?

Staff Response
ASC 320 establishes the following “safe harbors” under which HTM securities may
be sold without tainting the entire portfolio:


Evidence of a significant deterioration in the issuer’s creditworthiness.



A change in the tax law that eliminates or reduces the tax-exempt status of interest on the debt security (but not a change in tax rates).



A major business combination or disposition that necessitates the sale of the
securities to maintain the bank’s existing interest rate risk position or credit risk
policy.



A change in statutory or regulatory requirements that significantly modifies either
the definition or level of permissible investments that may be held.



A significant increase in industry-wide regulatory capital requirements that
causes the bank to downsize.



A significant increase in the risk weights of debt securities for risk-based capital
purposes.

There is also a limited exclusion for certain unusual events.

Question 9
What are the ramifications of selling debt securities that have been classified as HTM
and that do not meet any of the safe harbor exemptions set forth in question 8?

Staff Response
A sale outside of the safe harbor exemptions would taint the portfolio. Once a
portfolio is tainted, all remaining securities in the existing HTM portfolio must be
transferred to the AFS category. In addition, future purchases of securities must
be classified as AFS. Consistent with the views of the Securities and Exchange
Commission, the prohibition from using HTM will apply for a two-year period.
Because AFS securities are carried at fair value in the financial statements, the
transfer of tainted HTM securities would result in an unrealized holding gain or
loss, net of applicable taxes, at the date of transfer. The unrealized holding gain or
loss should be included in AOCI, a separate component of stockholders’ equity.
Amounts included in AOCI, however, are excluded in the determination of the bank’s
regulatory capital.

4

| Office of the Comptroller of the Currency

BAAS September 2013

INVESTMENT SECURITIES

1A. Investments in Debt and Equity Securities

In addition, ASC 320 requires certain disclosures for sales or transfers of securities
out of the HTM category. Specifically, the amortized cost, realized or unrealized gain
or loss, and circumstances leading to the sale or transfer of HTM securities must be
disclosed in the bank’s financial statements. For call report purposes, the amortized
cost of securities sold or transferred from the HTM category should be included on
Schedule RC-B, Memoranda.

Facts A bank sells a portion of its investment securities that were included in the

HTM portfolio. The securities were sold to gain additional liquidity.

Question 10
Would this sale of securities from the HTM portfolio taint the remaining securities in
the portfolio?

Staff Response
Yes. Except for the safe harbor exceptions stated in question 8, transfers out of the
HTM portfolio taint the portfolio. Sales for liquidity reasons are excluded from the
ASC 320 safe harbor exceptions. As a result, the HTM portfolio would be considered
tainted as of the sale date.

Facts In anticipation of converting from a taxable corporation to Subchapter S

status, a bank sells some tax-exempt municipal securities that had been included in
the HTM portion of the investment portfolio. The bank sold the securities because
it no longer benefits from the tax-free status of the municipal securities, and the
individual shareholders do not need the tax-exempt income.

Question 11
Does the sale of these securities taint the entire HTM portfolio?

Staff Response
Yes, selling securities from the HTM portfolio because of a change in tax status of the
bank to Subchapter S is not one of the safe harbor exceptions included in ASC 320.
Although ASC 320 does provide an exception for changes in tax law that eliminate or
reduce the tax-exempt status of interest, this exception does not extend to changes in
the tax status of the bank. Accordingly, the HTM portfolio is tainted.
This change resembles a change in tax rates more than a change in tax law. Therefore,
it is not covered by the safe harbor exceptions in ASC 320.

Facts A bank purchases trust preferred securities using its legal lending limit

authority.

Office of the Comptroller of the Currency

BAAS September 2013

| 5

INVESTMENT SECURITIES

1A. Investments in Debt and Equity Securities

Question 12
Should these securities be reported as loans or securities on the bank’s financial
statements?

Staff Response
The trust preferred securities should be classified and reported as securities on the
bank’s financial statements, including call reports. The legal means for acquiring
the security is not relevant for the accounting treatment. The financial statement
classification is governed by GAAP, not the legal authority under which the assets are
purchased. The trust preferred securities are debt securities subject to the accounting
requirements of ASC 320.

Facts In 20X1 Bank A purchased $10 million of the 30-year capital securities
of the Trust of Bank B (trust preferred securities). These securities have a fixed
distribution (interest) rate, quarterly payment dates, and a fixed maturity date.
In accordance with ASC 320, Bank A has classified these assets as AFS debt
securities.
The Trust exists for the sole purpose of investing in junior subordinated deferrable
interest debentures of Bank B. Accordingly, the ability of the Trust to pay the
quarterly distribution is based solely on Bank B’s ability to pay interest on the
debentures. Interest on the debentures is paid quarterly, unless deferred by Bank
B. The agreements allow Bank B to defer interest payments on the debentures for
a period of up to 20 consecutive quarters without creating a legal default. If the
interest payments on the debentures are deferred, the distribution payments on the
capital securities are also deferred, without creating a legal default. The payments,
however, are cumulative.
During 20X4, Bank B began experiencing financial difficulties. Accordingly, in
June 20X4, Bank B announced that the interest payment on the debentures and
the Trust’s distribution payment on the capital securities scheduled for July 31
would be deferred. These payments will be deferred for the last two quarters of
20X4. Resumption of payments in 20X5 is dependent upon Bank B returning to
profitable operations. Further, the capital securities are publicly traded and selling
at a discount in excess of 25 percent of par value.

Question 13
Should the accrual of interest income be discontinued on a debt type security (trust
preferred) that is not paying scheduled interest payments but is not in legal default
according to the terms of the instrument?

6

| Office of the Comptroller of the Currency

BAAS September 2013

INVESTMENT SECURITIES

1A. Investments in Debt and Equity Securities

Staff Response
Bank A should discontinue the accrual of income on its investment in the Trust’s
capital securities and include the securities as a nonaccrual asset on Schedule RC-N
of the call report. Previously accrued interest should be reversed.
The glossary instructions to the call report set forth the criteria for placing an asset
on nonaccrual status. Two of those criteria are: (1) principal or interest has been in
default for a period of 90 days or more unless the asset is both well secured and in the
process of collection or (2) full payment of principal and interest is not expected.
For the first criteria, both the 20X4 third and fourth quarter distribution (interest)
payments will not be made because of the financial condition and operating losses
of Bank B. Payments may resume in 20X5 but only if Bank B becomes profitable.
Accordingly, there is no assurance that Bank A will receive these or future payments.
While it is true that a legal default has not occurred, the staff believes that interest
should not be accrued on an asset that is impaired or when the financial condition of
the borrower is troubled.
Although the nonaccrual policies of the banking agencies are not codified in GAAP,
they are followed by financial institutions in the preparation of their financial
statements. This has resulted in these policies being considered an element of GAAP
even though not specifically included in the accounting literature.
Further, this 30-year debt investment is classified by Bank A as AFS and is currently
trading at a substantial discount from par. Therefore, in addition to the uncertainty
about the collection of the income, concern exists about recovery of the principal.

Question 14

UPDATE

Does the decline in value in the trust preferred securities raise any other issues?

Staff Response
The issue of whether the impairment in the trust preferred securities should be
considered OTTI must be addressed. If, upon evaluation, the impairment of the
securities is determined to be other-than-temporary, an impairment loss must be
recognized. The impact of the write-down on net income will depend on several
factors. See Topic 1B. Other-Than-Temporary Impairment for further discussion of
OTTI.

Facts A bank affected by major-category hurricanes (category 4 storms such

as Hurricanes Katrina and Rita) sells investment securities that were classified as
HTM to meet its liquidity needs.

Question 15
Will the bank’s intent to hold other investment securities to maturity be questioned?

Office of the Comptroller of the Currency

BAAS September 2013

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INVESTMENT SECURITIES

1A. Investments in Debt and Equity Securities

Staff Response
Under normal circumstances, the sale of any HTM investment would call into
question a bank’s intent to hold its remaining HTM investments to maturity. ASC
320-10-25 indicates that events that are isolated, nonrecurring, and unusual for the
reporting enterprise that could not be reasonably anticipated, however, may cause
an enterprise to sell or transfer an HTM security without necessarily calling into
question its intent to hold other HTM debt securities to maturity. ASC 320-10-25
specifically states that extremely remote disaster scenarios should not be anticipated
by an entity in deciding whether it has the positive intent and ability to hold a debt
security to maturity. Accordingly, in this situation the sale of any HTM investment
security would not necessarily call into question the bank’s intent to hold its
remaining HTM investment securities until maturity.

Facts A bank uses the cost method to account for its interest in Company A,
a credit card payment intermediary. Company A restructures its legal form by
converting from a mutual company to a stock company (demutualization). The
bank receives restricted stock and may also receive cash in the future. Pending
litigation related to Company A will affect the value realized of the restricted
stock. Each mutual company owner has a proportional obligation for the litigation
based on the member by-laws. It is determined that at the date of the restructuring
the member by-laws were modified such that each mutual company owner’s
(including the bank’s) proportional share is subject to ASC 460.
Question 16
May a bank record the stock received upon the restructuring at fair value?

Staff Response
No. Although GAAP does not directly address this specific type of transaction, ASC
325-20-30 provides guidance for certain nonmonetary exchanges of cost method
investments. In accordance with that standard, the bank should record the stock
received at the bank’s historical cost, which may be zero.
The OCA staff notes that nonmonetary transactions within the scope of ASC 845
generally are recorded at fair value. This transaction, however, is not within the scope
of that standard, because the transfer does not meet the definition of an exchange.
Reciprocal transfers of nonmonetary assets are considered exchanges only if the
transferor has no substantial continuing involvement in the transferred asset, such
that the usual risk and rewards of ownership of the asset are transferred. The pending
litigation constitutes substantial continuing involvement; therefore, the transfer does
not meet the definition of an exchange.
ASC 325-30 provides guidance on the accounting for the demutualization of a mutual
insurance company. Stock received in a demutualization within the scope of that
standard should be recognized at fair value. The scope of ASC 325-30 is limited,

8

| Office of the Comptroller of the Currency

BAAS September 2013

INVESTMENT SECURITIES

1A. Investments in Debt and Equity Securities

however, to the demutualization of mutual insurance companies and should not be
applied to this transaction by analogy. As such, in the absence of guidance within
GAAP specific to this particular transaction, the staff believes it is most appropriate to
account for this transaction in accordance with ASC 325-20-30 at historical cost (as
discussed previously).

Question 17
What accounting literature should the bank follow when recording the obligation for
the pending litigation?

Staff Response
A bank should record, in accordance with ASC 460, the fair value of its proportionate
share of all pending litigation as of the day the guarantee exists. In the event that, at
the inception of the guarantee, the bank must recognize a liability under ASC 450 for
the related contingent loss, the liability to be initially recognized for that guarantee
must be the greater of the amount that satisfies the fair-value objective as discussed in
ASC 460 or the contingent liability amount required to be recognized by ASC 450.

Question 18
Should the pending litigation be recorded at the bank level for call report purposes?

Staff Response
Yes. The liability for the litigation expense should be recorded at the bank level
primarily because it is a result of bank activity. In this situation, the member banks
have been liable for litigation since the mutual company’s formation, and the banks
have been the beneficiaries of related card fee income.

Question 19
What happens if the holding company legally assumes the litigation obligation
without compensation from the subsidiary bank?

Staff Response
The transfer of the liability should be measured at fair value, with a corresponding
noncash capital contribution from the holding company. Recording this intercompany
transfer at fair value is consistent with arms-length, standalone financial reporting and
is not inconsistent with GAAP.

Facts A few months later, Company A has an IPO. Approximately one-fourth of
the restricted stock is redeemed for cash, which results in significant gains for the
existing stockholders. In certain instances the cash was distributed to the holding
company rather than the bank. In addition, some of the IPO proceeds are retained
in an escrow account to cover the pending litigation. The bank has considered the
escrow account in recalculating its ASC 460 liability. The bank also retains its
remaining restricted stock.

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1B. Other-Than-Temporary Impairment

Question 20
Should the gain related to the receipt of cash from the IPO be recorded at the bank
level for call report purposes?

Staff Response
Yes, assuming a transfer at fair value has not already occurred and been documented
between the bank and holding company. Any benefit received by the holding
company because of a bank activity should be reflected at the bank. Therefore, cash
received by the holding company on the bank’s behalf (and not immediately passed
on to the bank) should be reflected as a dividend to the bank holding company
from the bank. If the bank transfers the stock to its holding company, the call report
requires the transfer to be recorded at fair value.

Question 21
Should the establishment (funding) of the escrow account be recorded at the bank
level for call report purposes?

Staff Response
As noted in question 18, the litigation expense and liability should be recorded at the
bank level primarily because it is a result of bank activity. The amount allocated to
the escrow account should also be recorded at the entity where the litigation expense
is recorded.

1B. Other-Than-Temporary Impairment
Question 1
What is OTTI?

Staff Response
An investment is impaired if the fair value is less than the amortized cost. ASC 320
requires institutions to determine whether the investment is other-than-temporarily
impaired. OTTI may occur when the investor does not expect to recover the entire
cost basis of the security. As a holder of an investment in a debt or equity security
for which changes in fair value are not regularly recognized in earnings (such as
securities classified as AFS and HTM), the bank must determine whether to recognize
a loss in earnings when the investment is impaired.

Question 2
Does other-than-temporary mean permanent?

Staff Response
No. The staff believes that the FASB consciously chose the phrase “other-thantemporary” because FASB did not intend that the test be “permanent impairment,” as
has been used elsewhere in the accounting literature. Specific facts and circumstances
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INVESTMENT SECURITIES

1B. Other-Than-Temporary Impairment

dictate whether OTTI recognition is appropriate. Therefore, this determination should
be made on a case-by-case basis. The staff believes that “other-than-temporary”
should be viewed differently than the absolute assurance that “permanent”
impairment implies. This response is consistent with ASC 320-10-S99.

Question 3
What factors indicate that impairment may be other-than-temporary for an equity
security classified as AFS?

Staff Response


ASC 320-10-S99 and AICPA Statement on Auditing Standards No. 92, “Auditing
Derivative Instruments, Hedging Activities and Investments in Debt Securities”
provide criteria that is helpful in making the OTTI assessment. There are several
factors to consider that, individually or in combination, may indicate an OTTI of
an AFS equity security has occurred, including length of time and extent to which
fair value has been less than cost.



Financial condition, industry environment, and near-term prospects of the issuer.



Downgrades of the security by rating agencies.



Intent and ability of the bank to hold the security for a period of time sufficient to
allow for any anticipated recovery in fair value.

Question 4
What factors indicate that impairment may be other-than-temporary for a debt
security classified as AFS or HTM?

Staff Response
In certain cases, the OTTI determination for a debt security will be straightforward.
For example, impairment would generally be considered other than temporary if the


investor has the intent to sell,



investor more likely than not will be required to sell prior to the anticipated recovery, or



issuer of the security defaults.

Outside of these situations, management must evaluate impairment based on the
specific facts and circumstances surrounding the security. The following are examples
of factors that should be considered for debt securities, as described in ASC 320. This
list is not meant to be all inclusive. Some factors are


the length of time and the extent to which the fair value has been less than the
amortized cost basis.

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1B. Other-Than-Temporary Impairment



adverse conditions specifically related to the security, an industry, or a geographic
area (for example, changes in the financial condition of the issuer of the security,
or in the case of an asset-backed debt security, in the financial condition of the
underlying loan obligors).



the historical and implied volatility of the fair value of the security.



the payment structure of the debt security (for example, nontraditional loan
terms) and the likelihood of the issuer being able to make payments that increase
in the future.



failure of the issuer of the security to make scheduled interest or principal payments.



any changes to the rating of the security by a rating agency.

• recoveries or additional declines in fair value subsequent to the balance sheet
date.

Question 5
What additional expectations exist for bank management in the assessment and
documentation of OTTI?

Staff Response
Banks should consider the following when evaluating and documenting whether
impairment is other-than-temporary:

12



Banks should apply a systematic methodology for identifying and evaluating fair
value declines below cost that includes the documentation of all factors considered.



Once a security is in an unrealized loss position, banks must consider all available evidence relating to the realizable value of the security and assess whether
the decline in value is other-than-temporary.



The longer the security has been impaired and the greater the decline in value, the
more robust the documentation should be to support a conclusion of only temporary impairment and not OTTI.



Banks should not infer that securities with declines of less than one year are not
other-than-temporarily impaired or that declines of greater than one year are
automatically other-than-temporarily impaired. An other-than-temporary decline
could occur within a very short time, and/or a decline in excess of a year might
still be temporary.



An investor’s intent to hold an equity security indefinitely would not, by itself,
permit an investor to avoid recognizing OTTI.



A market price recovery that cannot reasonably be expected to occur within an
acceptable forecast period should not be included in the assessment of recoverability.

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INVESTMENT SECURITIES



1B. Other-Than-Temporary Impairment

In the case of an equity security for which an entity asserted its intent to hold
until recovery or a debt security an entity did not intend to sell, facts and circumstances surrounding the sale of a security at a loss should be considered in determining whether the hold-to-recovery assertion remains valid for other securities
in the portfolio. That is, the bank’s previous assertion is not automatically invalidated.

Question 6
May impairment of a debt security be deemed other-than-temporary even if the bank
has not made a decision to sell the security?

Staff Response
Yes. ASC 320-10-35-33 states that an investor should recognize an impairment loss
when the impairment is deemed other-than-temporary even if a decision to sell the
security has not been made.

Facts A bank holds an equity security whose fair value is less than amortized

cost. Bank management has determined, based on facts and circumstances, that the
decline in fair value is other-than-temporary.

Question 7
How should the bank record OTTI for the equity security?

Staff Response
The bank recognizes a loss in earnings equal to the entire difference between the
security’s cost basis and its fair value at the balance sheet date. The fair value of the
security becomes the new amortized cost basis, and net income is not adjusted for
subsequent recoveries in fair value of the instrument.

Facts Using the same facts as for question 7, assume the asset is a debt security

rather than an equity security.

Question 8
How should the bank record OTTI for the debt security?

Staff Response
It depends. If the bank intends to sell the debt security or if it is more likely than not
the bank will be required to sell the debt security before recovery of its amortized cost
basis, the bank should recognize a loss in earnings for the entire difference between
the security’s amortized cost basis and its fair value at the balance sheet date.

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1B. Other-Than-Temporary Impairment

If the bank does not intend to sell the debt security and it is not likely that the bank
will be required to sell the security before recovery of its amortized cost basis, the
bank shall separate the decline in value into the following two components:


The amount representing the credit loss (also referred to as the credit component).



The amount related to all other factors (also referred to as the noncredit component).

The amount of OTTI related to the credit component shall be recognized in earnings.
The amount of the OTTI related to the noncredit component shall be recognized in
AOCI, net of applicable taxes.
The previous amortized cost basis less the OTTI impairment recognized in earnings
shall become the new amortized cost basis of the investment. Subsequent recoveries
in fair value of the debt security will not be reflected in net income. The amortized
cost basis of the impaired debt security, however, will be adjusted for accretion and
amortization as described in question 15 included in this topic.

Question 9
How should a bank calculate the credit component of the OTTI for a debt security?

Staff Response
ASC 320-10-35-33D states that one way to estimate the credit component of the
OTTI would be to consider the impairment methodology described in ASC 31010-35. In general, ASC 310-10-35 measures impairment as the excess of the asset’s
recorded balance over the present value of expected future cash flows discounted at
the asset’s effective interest rate. Other methodologies may be used if they represent
reasonable measurements of credit impairment.

Question 10
Beneficial interests in securitized financial assets that are not of high credit quality
are accounted for in accordance with ASC 325-40. What is meant by securitized
financial assets that are “not of high credit quality”?

Staff Response
The SEC staff has concluded that securitized financial assets that are “not of high
credit quality” are those securitized financial assets rated below AA. The OCA staff
does not object to the SEC staff’s interpretation; however, banks should be alert to
updated guidance in light of recent regulatory reform efforts,
ASC 325-40 provides examples of the securities that are of “high credit quality,”
which specifically include: securities that are guaranteed by the U.S. government,
its agencies, or other creditworthy guarantors, and loans or securities that are
collateralized to ensure that the possibility of credit loss is remote. As such, it appears
the standard only intended assets to be deemed “of high quality” when the likelihood

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1B. Other-Than-Temporary Impairment

of loss was remote. Based on review of the rating definitions, an AA rating is defined
as “the obligor’s capacity to meet its financial commitment on the obligation is very
strong,” which appears to be consistent with the intent of the standard when using the
“high credit quality” terminology.
Also, the rating definition for an investment-grade rating of BBB is that of an
“obligation that exhibits adequate protection parameters but that under adverse
economic conditions or changing circumstances is likely to lead to a weakened
capacity of the obligor to meet its financial commitment on the obligation.” The SEC
staff’s position is that an investment-grade rating of BBB is not consistent with the
intent of the standard when using “high credit quality” terminology.

Question 11
Is there a different OTTI measurement for beneficial interests in securitized financial
assets that meet the scope of ASC 325-40 and thus are “not of high credit quality”
and can be contractually prepaid or settled so that the investor does not recover
substantially all of the recorded investment?

Staff Response
No. Institutions with beneficial interests in securitized financial assets within the
scope of ASC 325-40 should apply the OTTI measurement framework prescribed in
ASC 320-10-35-18.

Question 12
If OTTI measurements now follow the requirements of ASC 320-10-35, why is there
still a need for ASC 325-40?

Staff Response
ASC 325-40 is needed because guidance on interest income recognition remains
applicable.

Question 13
When evaluating market prices, is it a valid argument that markets are performing
irrationally and need time to recover before assessing fair value and OTTI?

Staff Response
No. Bank management is required to account for certain securities at fair value
and assess OTTI on a quarterly basis for call report purposes. Bank management
must estimate fair value by using observable market data to the extent available or
otherwise make assumptions that a market participant would use in assessing fair
value as required by ASC 820-10.
As explained in ASC 820-10, fair value is the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. In other words, fair value is the price that would
be received to sell an asset (exit price) as opposed to the price that would be paid
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INVESTMENT SECURITIES

1B. Other-Than-Temporary Impairment

to purchase an asset (entry price). This exit price should be based on the price that
would be received in the bank’s principal market for selling that asset. The principal
market is the market the bank has historically sold into with the greatest volume. If
the bank does not have a principal market for selling that asset, the exit price should
assume the asset is sold into the most advantageous market. The most advantageous
market is the market in which the bank would receive the most value, considering the
transaction costs in the respective markets. Additional guidance is provided in ASC
820-10-35-51 to assist in the determination of fair value when markets are inactive,
when the level of activity has declined, and when transactions are not orderly. These
concepts are discussed further in Topic 11D.

Question 14
How is OTTI reflected in a bank’s financial statements and call reports?

Staff Response
In the income statement, banks must present the total amount of OTTI that has been
recorded during the period, the portion of the loss recognized in AOCI, and the
portion of loss recognized in earnings. As an example, the following presentation
may be made:
Total OTTI losses
Portion of loss recognized in AOCI
Net impairment loss recognized in earnings

$ XXX
(XX)
$ XXX

Additionally, when reporting the total amount of AOCI, the bank must disclose the
amount related to AFS securities and the total amount related to HTM securities.

Question 15
After an OTTI loss has been recorded for a debt security, the security has a new cost
basis. How is the debt security accounted for in subsequent periods?

Staff Response
The subsequent accounting for a debt security with OTTI depends on whether it is
classified as HTM or AFS.
For HTM securities, the amount of OTTI recorded in AOCI should be accreted
from AOCI to the amortized cost of the security. This transaction does not affect
net income. Accretion of amount in AOCI will continue until the security is sold,
matures, or suffers additional OTTI.
For AFS securities, subsequent increases or decreases in fair value will be reflected in
AOCI, as long as the decreases are not further OTTI losses. The difference between
the new cost basis of the AFS debt security and the cash flows expected to be
collected will be accreted into interest income as long as the security is not placed on
nonaccrual. (See question 16.)

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INVESTMENT SECURITIES

1B. Other-Than-Temporary Impairment

Question 16
When should a bank place a debt security on nonaccrual status and therefore not
accrete or amortize the discount or reduced premium created through the OTTI writedown?

Staff Response
GAAP does not address when a holder of a debt security would place a debt security
on nonaccrual status or how to subsequently report income on a nonaccrual debt
security. Banks should apply its nonaccrual policies and regulatory guidance in
determining when a debt security should be placed on nonaccrual status.

Facts A bank owned a corporate debt security of ABC Corp. and carried the

investment in its AFS portfolio. ABC Corp. filed for bankruptcy, at which time the
bank recorded OTTI through earnings to write down the value of the security to
$0, because the bank determined that the full decline in fair value was related to
credit. Several years later, ABC Corp. emerged from bankruptcy and issued new
debt to its prior bondholders.

Question 17
How should the bank account for the receipt of the restructured debt instrument?

Staff Response
Guidance regarding a creditor’s accounting for a modification or exchange of debt
instruments is addressed in ASC 310-20-35, which requires that the restructured debt
be accounted for as new debt if the following two criteria are met:


The new debt’s effective yield is at least equal to the effective yield for a comparable debt with similar collection risks not involved in a restructure.



The modifications to the original debt are more than minor.

ASC 310-20-35 provides that a modification is considered more than minor if the
present value of the cash flows of the new debt is at least 10 percent different from
the present value of the remaining cash flows of the original debt.
If both criteria noted above have been met, the restructured debt would be accounted
for as a new debt arrangement with the new bond recorded initially at fair value.
If both criteria are not met, the restructured debt would not be accounted for as a new
debt arrangement. Therefore, no adjustment would be made to the carrying amount,
because the new bond would be considered a continuation of the existing one.

Question 18
If the reissued bond distributed by ABC Corp. qualifies as new debt under ASC 32010-35, how should the bank account for the exchange?

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INVESTMENT SECURITIES

1B. Other-Than-Temporary Impairment

Staff Response
The bank should record the new bond in its investment portfolio at its current fair
value, which results in the recognition of income through current earnings.

Facts A bank holds a debt security that has an amortized cost basis of $100 and

is currently trading in the active market at $70. The bank determined that the debt
security is other-than-temporary impaired in accordance with GAAP, as of the
reporting date. The fair value as of the reporting date is the market quote of $70.
The bank holds approximately 25 percent of the entire debt security issuance. The
sale of the bank’s holdings would affect the market pricing on the debt securities,
because of the market’s inability to readily absorb the volume of securities being
traded.

Question 19
Based on liquidity, may the bank consider the volume of securities being held in the
determination of fair value?

Staff Response
No. Consistent with ASC 820-10, the best evidence of fair value is quoted market
prices in an active market. Although the sale of the bank’s holdings could affect the
market pricing, an adjustment of fair value or a reserve for liquidity against a security
is not permitted under GAAP when the security trades in an active market.

Facts Two severe hurricanes, Hurricane Katrina and Hurricane Rita (the

hurricanes), caused severe damage to certain Gulf Coast areas late in the third
quarter of 2005.

Question 20
How should banks holding municipal bonds from issuers in the areas of a major
hurricane (a category 4 storm such as Hurricanes Katrina and Rita) on which fair
value is less than the amortized cost, assess these bonds for OTTI to prepare their
quarterly call reports?

Staff Response
Under GAAP, when the fair value of a municipal bond has declined below its
amortized cost, the bank holding the bond must assess whether the decline represents
an “other-than-temporary” impairment and, if so, write the cost basis of the municipal
bond down to fair value. When making the OTTI assessment, banks should apply
relevant OTTI guidance, including ASC 320-10-35.
In this regard, if a bank decided prior to the end of the quarter that it would sell a
municipal bond after quarter-end and management did not expect the fair value of the

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1B. Other-Than-Temporary Impairment

bond, which is less than its amortized cost, to recover prior to the expected time of
sale, a write-down for OTTI should be recognized in earnings in the bank’s quarterly
financial statements. Otherwise, management should consider all information
available prior to filing this report when assessing hurricane-affected municipal
bonds for OTTI. If the bank determined the impairment on the bond was other-thantemporary, but it did not intend to sell the bond and it was not likely it would be
required to sell the bond, the portion of the decrease in value attributed to credit loss
should be recognized in earnings, and the change related to all other factors (i.e., the
non-credit component) should be recognized in AOCI, net of applicable taxes.
In each subsequent reporting period, banks should continue to assess whether any
declines in fair value below amortized cost of these municipal bonds are other-thantemporary.

Question 21
Should banks record OTTI on mortgage-backed securities with subprime exposure or
other affected securities when there are adverse market conditions?

Staff Response
Measuring and recording OTTI is based on the specific facts and circumstances.
Consistent with OTTI guidance, the staff believes that banks should review their
securities portfolios at each reporting date and determine if write-downs are required
in the current period. For example, if the bank determines that the cause of the decline
in a security’s value is a result of a ratings downgrade attributable to significant
credit problems with the issuer, generally that decline would be considered other than
temporary, and that loss should be recorded in the current period.

Question 22
There are securities in the market that mirror a debt instrument but have no maturity
date, such as FNMA and FHLMC perpetual preferred stock issues. Are there any
special OTTI considerations for these types of securities (i.e., equity securities)?

Staff Response
One important consideration in an OTTI analysis is the existence of a maturity
date. Because equity securities do not have a maturity date, bank management must
determine the period over which they expect the fair value to recover and they must
have the ability and intent to hold the equity securities for a reasonable period of time
to allow for the forecasted recovery of fair value. These time frames are typically
of a shorter duration. Recently the SEC stated that because of the challenges with
assessing OTTI for perpetual preferred securities, it would not object to “applying
an impairment model (including an anticipated recovery period) similar to a debt
security.” This treatment may only be applied if there has been no evidence of
deterioration in credit of the issuer. Note that this does not affect the balance sheet
classification of the securities.

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INVESTMENT SECURITIES

1B. Other-Than-Temporary Impairment

Because any market depreciation represents an unrealized loss on a marketable
equity security, the unrealized loss is required to be deducted from Tier 1 capital. In
addition, the OTTI write-down also affects earnings.

Question 23
How does one determine whether a fair value adjustment to an IO strip represents
OTTI?

Staff Response
Institutions should follow the guidance in ASC 320-10-35-18 to determine whether
fair value adjustments incurred on an IO strip are considered to be other than
temporary. If the timing and amount of cash flows is not sufficient to recover the
cost basis of the IO, OTTI is considered to have occurred and the IO strip should be
written down to fair value.

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LOANS

Topic 2

2A. Troubled Debt Restructurings

Loans
2A. Troubled Debt Restructurings
Question 1
What is a TDR?

Staff Response
Under GAAP, a modification of a loan’s terms constitutes a TDR if the creditor
for economic or legal reasons related to the debtor’s financial difficulties grants a
concession to the debtor that it would not otherwise consider. The concession could
either stem from an agreement between the creditor and the debtor or be imposed by
law or a court. This guidance is included in ASC 310-40.
Not all modifications of loan terms, however, automatically result in a TDR.
For example, if the modified terms are consistent with market conditions and
representative of terms the borrower could obtain in the open market, the restructured
loan is not categorized as a TDR. If, however, a concession (e.g., below-market
interest rate, forgiving principal, or previously accrued interest) is granted based on
the borrower’s financial difficulty, the TDR designation is appropriate.
If a modification meets the definition of a TDR in accordance with ASC 310-40-35,
the specific accounting set forth in ASC 310-10-35 must be followed. Banks should
have policies and procedures in place to evaluate loan modifications for the TDR
designation.
With the exception of loans accounted for at fair value under the fair-value option,
the TDR accounting rules apply to all types of restructured loans held for investment,
including retail loans. Loans held for investment in a portfolio do not include loans
accounted for as held for sale in accordance with ASC 310.

Question 2
What are some examples of modifications that may represent TDRs?

Staff Response
ASC 310-40-15-9 provides the following examples of modifications that may
represent TDRs:


Reduction (absolute or contingent) of the stated interest rate for the remaining
original life of the debt.



Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk.



Reduction (absolute or contingent) of the face amount or maturity amount of the
debt as stated in the instrument or other agreement.



Reduction (absolute or contingent) of accrued interest.

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2A. Troubled Debt Restructurings

Said another way, the modification is a TDR if the borrower cannot go to another
lender and qualify for and obtain a loan with similar modified terms.

Question 3
How should a bank evaluate TDR loans for impairment?

Staff Response
Loans whose terms have been modified in TDR transactions should be evaluated
for impairment in accordance with ASC 310-10-35. This includes loans that were
originally not subject to that standard prior to the restructuring, such as individual
loans that were included in a large group of smaller-balance, homogeneous loans
collectively evaluated for impairment (i.e., retail loans).
A loan is impaired when, based on current information and events, it is probable
that an institution will be unable to collect all amounts due, according to the original
contractual terms of the loan agreement. Usually, a commercial restructured troubled
loan that had been individually evaluated under ASC 310-10-35 would already have
been identified as impaired, because the borrower’s financial difficulties existed
before the formal restructuring.
For a restructured troubled loan, all amounts due according to the contractual
terms means the contractual terms specified by the original loan agreement, not
the contractual terms in the restructuring agreement. Therefore, if impairment is
measured using an estimate of the expected future cash flows, the interest rate used
to calculate the present value of those cash flows is based on the original effective
interest rate on the loan, and not the rate specified in the restructuring agreement. The
original effective interest rate is the original contractual interest rate adjusted for any
net deferred loan fees or cost or any premium or discount existing at the origination
or acqu isition of the loan and not the rate specified in the restructuring agreement.

UPDATE

LOANS

Facts Borrower A cannot service his $100,000 loan from the bank because of his
financial difficulties. On June 1, the loan is restructured, with interest of 5 percent
payable annually for the first two years and a final payment of $105,000 (principal
plus interest at 5 percent) required at the end of the third year. The 5 percent
interest rate is below the current market rate of 12 percent for new customers
meeting the bank’s underwriting criteria. Borrower A is expected to make two
interest-only payments of $5,000 each and, due to continued poor performance, a
final payment of $95,000.
The present value of the expected payments under the restructured terms,
discounted at 10 percent (the original effective interest rate), is approximately
$80,000. The loan is neither collateral dependent nor has an observable market
price.

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2A. Troubled Debt Restructurings

Question 4
How should a bank account for this restructuring?

UPDATE

Staff Response
This modification of terms should be accounted for as a TDR in accordance with
ASC 310-40. Given the facts and circumstances, impairment should be measured
in accordance with ASC 310-10-35 based on the present value of the expected
future cash flows discounted at the effective interest rate of the original loan. In this
example, the measure of impairment is the difference of approximately $20,000
between the present value of the expected payments (approximately $80,000) of the
restructured loan, discounted at the loan’s original effective interest rate, and the
recorded investment ($100,000) in the loan.

Facts Consider the same facts as question 4, except that Borrower A transfers

the collateral to a new borrower (Borrower B) not related to Borrower A. The bank
accepts Borrower B as the new debtor. The loan with Borrower B provides for
interest-only payments of 5 percent for two years and a final payment of $105,000
(principal plus interest at 5 percent) at the end of the third year. The fair value of
the loan, discounted at a current market interest rate of 12 percent, is $83,200.
UPDATE

LOANS

Question 5
How should a bank account for this restructuring?

Staff Response
ASC 310-40-40 requires that the receipt of a loan from a new borrower be accounted
for as an exchange of assets. Accordingly, the asset received (new loan) is recorded at
its fair value ($83,200 in this example). In question 4, which involves a modification
of terms, the impairment is recorded through a valuation allowance, whereas here
a loss of $16,800 (i.e., the $100,000 recorded investment in the old loan less the
$83,200 fair value of the new loan), to the extent it is not offset against valuation
allowance, is recognized in earnings.

Facts A bank makes a construction loan to a real estate developer. The loan

is secured by a project of new homes. The developer is experiencing financial
difficulty and has defaulted on the construction loan. To assist him in selling the
homes, the bank agrees to give the home buyers permanent financing at a rate that
is below the market rate being charged to other new home buyers.

Question 6
Must a loss be recorded on the permanent loan financings?

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Staff Response
Yes. The bank is granting a concession it would not have allowed otherwise,
because of the developer’s financial condition. Therefore, this transaction is a TDR.
Furthermore, it represents an exchange of assets. The permanent loans provided to
the home buyers must be recorded at their fair value. The difference between fair
value and recorded value in the loan satisfied is charged to the ALLL.

Facts Assume that the real estate developer described in question 6 has not yet
defaulted on the construction loan. He is in technical compliance with the loan
terms. Because of the general problems within the local real estate market and
specific ones affecting this developer, however, the bank agrees to give the home
buyers permanent financing at below-market rates.
Question 7
Must a loss be recorded on these permanent loan financings?

Staff Response
Yes. Even though the loan is not in default, the staff believes that the concession was
granted because of the developer’s financial difficulties. ASC 310-40-15-20 states
that a creditor may conclude that a debtor is experiencing financial difficulty even
though he is not currently in payment default.
Therefore, this restructuring would be accounted for as an exchange of assets under
the provisions of ASC 310-40. Again, the permanent loans provided to the home
buyers must be recorded at their fair value.

Facts A borrower owes the bank $100,000. The debt is restructured because of
the borrower’s precarious financial position and inability to service the debt. In
satisfaction of the debt, the bank accepts preferred stock of the borrower with a
face value of $10,000 but with only a nominal market value. The bank agrees to
reduce the interest rate from 10 percent to 5 percent on the remaining $90,000 of
debt. The present value of the combined principal and interest payments due over
the next five years, discounted at the effective interest rate in the original loan
agreement, is $79,000.
Question 8
How should the bank account for this transaction?

Staff Response
Securities (either equity or debt) received in exchange for cancellation or reduction
of a troubled loan should be recorded at fair value. The recorded amount of the
debt ($100,000) is reduced by the fair value of the preferred stock received. Any

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impairment in the remaining recorded balance of the restructured loan would be
measured according to the requirements of ASC 310. In this case, if the securities
have a fair value of $1,000, the remaining loan balance of $99,000 would be
compared with the present value of the expected future payments, discounted at
the effective interest rate in the original loan agreement. An allowance of $20,000
is established through a provision for loan and lease losses. This represents the
difference between the recorded balance ($99,000) and the present value of the
expected future payments ($79,000), discounted at 10 percent (the original effective
interest rate).

Facts A $10 million loan is secured by income-producing real estate. Cash flows
are sufficient to service only a $9 million loan at a current market rate of interest.
The loan is on nonaccrual. The bank restructures the loan by splitting it into two
separate notes. Note A is for $9 million. It is collateral dependent and carries a
current market rate of interest. Note B is for $1 million and carries a below-market
rate of interest. The bank charges off all of Note B but does not forgive it.
Question 9
May the bank return Note A to accrual status?

Staff Response
Yes, but only if all of the following conditions are met:


The restructuring qualifies as a TDR as defined by ASC 310-40. In this case, the
transaction is a TDR, because the bank granted a concession it would not consider normally, a below-market rate of interest on Note B.



The partial loan charge-off is supported by a good faith credit evaluation of the
loan(s). The charge-off should also be recorded before or at the time of the restructuring. A partial charge-off may be recorded only if the bank has performed a
credit analysis and determined that a portion of the loan is uncollectible.



The ultimate collectibility of all amounts contractually due on Note A is not in
doubt. If such doubt exists, the loan should not be returned to accrual status.



There is a period of satisfactory payment performance by the borrower (either immediately before or after the restructuring) before the loan (Note A) is returned to
accrual status.

If any of these conditions is not met, or the terms of the restructuring lack economic
substance, the restructured loan should continue to be accounted for and reported as a
nonaccrual loan.

Question 10
What constitutes a period of satisfactory performance by the borrower?

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Staff Response
ASC 942-310-35 requires some period of performance for loans to troubled
countries. The staff generally believes this guidance should also apply to domestic
loans. Accordingly, the bank normally may not return Note A to accrual status until or
unless this period of performance is demonstrated, except as described in question 11.
Neither ASC 942-310-35 nor regulatory policy, however, specify a particular period
of performance. This will depend on the individual facts and circumstances of each
case. Generally, we believe this period would be at least six months for a monthly
amortizing loan.
Accordingly, if the borrower was materially delinquent on payments prior to
the restructure but shows potential capacity to meet the restructured terms, the
loan would likely continue to be recognized as nonaccrual until the borrower has
demonstrated a reasonable period of performance; again, generally at least six months
(removing doubt as to ultimate collection of principal and interest in full).
If the borrower does not perform under the restructured terms, the TDR probably was
not appropriately structured, and it should be recognized as nonaccrual. In this case
the decision regarding accrual status would be based solely on a determination of
whether full collection of principal and interest is in doubt.

Question 11
The previous response indicates that performance is required before a formally
restructured loan may be returned to accrual status. When may a restructured loan be
returned to accrual status without performance?

Staff Response
The staff continues to believe that evidence of performance under the restructured
terms is one of the most important considerations in assessing the likelihood of full
collectibility of the restructured principal and interest. In rare situations, however, the
TDR may coincide with another event that indicates a significant improvement in the
borrower’s financial condition and ability to repay. These might include substantial
new leases in a troubled real estate project, significant new sources of business
revenues (i.e., new contracts), and significant new equity contributed from a source
not financed from the bank. A preponderance of this type of evidence could obviate
the need for performance or lessen the period of performance needed to assure
ultimate collectibility of the loan.

Question 12
Given that evidence of performance under the restructured terms will likely be relied
upon to determine whether to place a TDR on accrual status, may performance prior
to the restructuring be considered?

Staff Response
Performance prior to the restructuring should be considered in assessing whether the
borrower can meet the restructured terms. Often the restructured terms reflect the

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level of debt service that the borrower has already been making. If this is the case,
and the borrower will likely be able to continue this level of performance and fully
repay the new contractual amounts due, continued performance after the restructuring
may not be necessary before the loan is returned to accrual status.

Question 13
How would the absence of an interest rate concession on Note B affect the accrual
status of Note A?

Staff Response
If the bank does not grant an interest rate concession on Note B nor make any other
concessions, the restructuring would not qualify as a TDR. Accordingly, ASC 310-40
would not apply.
In substance, the bank has merely charged down its $10 million loan by $1 million,
leaving a $9 million recorded loan balance. The remaining balance should be
accounted for and reported as a nonaccrual loan. Partial charge-off of a loan does not
provide a sufficient basis by itself for restoring the loan to accrual status.
Furthermore, the bank should record loan payments as principal reductions as long
as any doubt remains about the ultimate collectibility of the recorded loan balance.
When that doubt no longer exists, interest payments may be recorded as interest
income on the cash basis.

Question 14
Assume the bank forgives Note B. How would that affect the accounting treatment?

Staff Response
Forgiving debt is a form of concession to the borrower. Therefore, a restructuring
that includes the forgiveness of debt would qualify as a TDR and ASC 310-40 would
apply. It is not necessary to forgive debt for ASC 310-40 to apply, as long as some
other concession is made.

Question 15
Assume that Note B was not charged off but was on nonaccrual. How would that
affect the accrual status and call report TDR disclosure for Note A?

Staff Response
When a loan is restructured into two or more notes in a TDR, the restructured loans
should be evaluated separately. Because the restructured loans are supported by
the same source of repayment, however, both would be reported as nonaccrual.
Additionally, because the interest rate on Note B was below a market rate, both notes
would be reported in the TDR disclosures on the call report.

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Facts Assume, as discussed in question 15, that Note B was not charged off prior

to or at the time of restructuring. Also, expected cash flows will not be sufficient to
repay Notes A and B at a market rate. The cash flows would be sufficient to repay
Note A at a market rate.

Question 16
When appropriate allowances, if necessary, have been established for Note B, would
Note A be reported as an accruing market-rate loan and Note B as nonaccrual?

Staff Response
No. Even after a TDR, two separate recorded balances, supported by the same source
of repayment, should not be treated differently for nonaccrual or TDR disclosure. All
loans must be disclosed as nonaccrual, unless the combined contractual balance and
the interest contractually due are expected to be collected in full.

Facts A bank negotiates a TDR on a partially charged-off real estate loan.

The borrower has been unable to make contractually owed payments, sell the
underlying collateral at a price sufficient to repay the obligation fully, or refinance
the loan. The bank grants a concession in the form of a reduced contractual interest
rate. In the restructuring, the bank splits the loan into two notes that require final
payment in five years. The bank believes that market conditions will improve by
the time the loan matures, enabling a sale or refinancing at a price sufficient to
repay the restructured obligation in full. The original interest rate was 9 percent.
Note A carries a 9 percent contractual interest rate. Note B, equal to the chargedoff portion, carries a 0 percent rate. Note A requires that interest be paid each
year at a rate of 5 percent, with the difference between the contractual rate of 9
percent and the payment rate of 5 percent capitalized. The capitalized interest and
all principal are due at maturity. Additionally, interest on the capitalized interest
compounds at the 9 percent rate to maturity.

Question 17
If the borrower makes the interest payments at 5 percent as scheduled, may Note A be
on accrual status?

Staff Response
No. The terms of the restructured loan allow for the deferral of principal payments
and capitalization of a portion of the contractual interest requirements. Accordingly,
these terms place undue reliance on the balloon payment for a substantial portion of
the obligation.
Generally, capitalization of interest is precluded when the creditworthiness of the
borrower is in question. Other considerations about the appropriateness of interest
capitalization are
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whether interest capitalization was included in the original loan terms to compensate for a planned temporary lack of borrower cash flow.



whether similar loan terms can be obtained from other lenders.

In a TDR, the answer to each consideration is presumed to be negative. First, the
bank, in dealing with a troubled borrower, must overcome the doubt associated with
the borrower’s inability to meet the previous contractual terms. To do this, objective
and persuasive evidence must exist for the timing and amount of future payments of
the capitalized interest.
In this case, the repayment of the capitalized interest is deferred contractually until
the underlying loan is refinanced or sold. A refinancing, or sale at a price adequate
to repay the loan, was not possible at the time of restructuring. The bank has offered
no objective evidence to remove the doubt about repayment that existed prior to
the restructuring. It is relying solely on a presumption that market conditions will
improve and enable the borrower to repay the principal and capitalized interest.
Accordingly, the timing and collectibility of future payments of this capitalized
interest are uncertain.
Second, the temporary lack of cash flow is generally the reason for a TDR. Thus,
capitalization of interest was not provided for in the original loan terms. Finally,
the concession was granted, because of the borrower’s inability to find other market
financing to repay the original loan.
Some loans, such as this example, are restructured to reduce periodic payments
by deferring principal payments, increasing the amortization term relative to the
loan term, and/or substantially reducing or eliminating the rate at which interest
contractually due is periodically paid. These provisions create or increase the balloon
payment significantly. Sole reliance on those types of payments does not overcome
the doubt as to full collectibility that existed prior to the restructuring. Other evidence
should exist to support the probability of collection before return to accrual status.
In this example, the conditions for capitalization of interest were not met, and sole
reliance for the full repayment was placed on the sale/refinancing. Accordingly, Note
A should be maintained on nonaccrual status. To the extent that the recorded principal
remains collectible, interest may be recognized on a cash basis.

Facts A bank restructures a loan by forgiving a portion of the loan principal due
and charging it off. Additionally, the bank requires that, should the borrower’s
financial condition recover, the borrower pay a sum in addition to the principal and
interest due under the restructured terms.
Question 18
For the restructured loan to be eligible for return to accrual status, must the contingent
payment also be deemed fully collectible?

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Staff Response
No. Contingent cash payments should not be considered in assessing the collectibility
of amounts contractually due under the restructured terms.

Facts A $10 million loan is secured by income-producing real estate. As a result

of a previous $1 million charge-off, the recorded balance is $9 million. Cash flows
are sufficient to service only $9 million of debt at a current market rate of interest.
The loan is classified as nonaccrual and is restructured. The bank protects its
collateral position, however, by restructuring the loan into two separate payment
“tranches,” rather than two separate notes. Tranche A requires $9 million in
principal payments and carries a current market rate of interest. Tranche B requires
$1 million in principal payments and carries a below-market rate of interest.

Question 19
May the bank return Tranche A to accrual status?

Staff Response
The use of one note with two payment tranches, instead of two separate notes, does
not prevent Tranche A from being returned to accrual status, as long as it meets the
conditions set forth in the staff response to question 9.

Facts A bank has a commercial real estate loan secured by a shopping center.

The loan, which was originated 13 years ago, provides for a 30-year amortization
with interest at the prime rate plus 2 percent. Two financially capable guarantors, A
and B, each guarantee 25 percent of the debt.
The shopping center lost its anchor tenant two years ago and is not generating
sufficient cash flow to service the debt. The guarantors have been providing funds
to make up the shortfall. Because of the decrease in the cash flow, the borrower
and guarantors asked the bank to modify the loan agreement. The bank agrees to
reduce the interest rate to prime, and in return, both guarantors agreed to increase
their guarantee from 25 percent to 40 percent each. The guarantors are financially
able to support this guarantee. Even with the increased guarantee, however, the
borrower could not have obtained similar financing from other sources at this rate.
The fair value of the shopping center is approximately 90 percent of the current
loan balance.

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Question 20
Should the debt modification be reported as a TDR because only the interest rate was
reduced?

Staff Response
ASC 310-40 states that a restructuring of a debt is a TDR if a creditor, for economic
or legal reasons related to the debtor’s financial difficulties, grants a concession that
it would not otherwise consider. This may include a reduction of the stated interest
rate for the remaining original life of the debt. No single characteristic or factor taken
alone, however, determines whether a modification is a TDR.
The following factors, although not all inclusive, may indicate the debtor is
experiencing financial difficulties:


Default or, in the absence of a modification, default in the foreseeable future



Bankruptcy



Doubt as to whether the debtor will continue as a going concern



De-listing of securities



Insufficient cash flows to service the debt



Inability to obtain funds from other sources at a market rate for similar debt to a
non-troubled borrower

In this case, the borrower was experiencing financial difficulties, because the primary
source of repayment (cash flows from the shopping center) was insufficient to service
the debt, without reliance on the guarantors. Further, it was determined that the
borrower could not have obtained similar financing from other sources at this rate,
even with the increase in the guarantee percentage. The capacity of the guarantor
to support this debt may receive favorable consideration when determining loan
classification or allowance provisions. Because the borrower was deemed to be
experiencing financial difficulties and the bank granted an interest rate concession it
normally would not have given, however, this restructuring would be considered a
TDR.

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Facts A bank made a $95 million term loan with a maturity of June 2006 to a

power company in 2001. The loan was secured by all of the PP&E of the power
plants and had an estimated fair value of $98 million. Under the terms of the note,
periodic interest payments were required. Principal payments were based on a
cash-flow formula.
The power plants did not generate sufficient cash flows in 2002 or 2003 to fully
service the interest payments. The parent company of the power company funded
the deficiencies in 2002 and 2003. In April 2004, the power company failed to
make the required interest payment because of its inability to generate sufficient
cash flows. Principal payments, based on the contractual cash-flow formula, had
not been required in any period between 2001 and 2004.
In July 2004, the parent paid $10 million of the principal, plus all outstanding
interest and fees, thereby bringing the loan fully current. This reduced the
outstanding loan balance from $95 million to $85 million. The loan was then
restructured and the remaining $85 million was split into two notes.
• Note A is for $45 million, with interest at current market rates. Periodic interest
payments are required, and the principal is due at maturity in 2010. The bank
received a first lien on the collateral. The bank maintained this note on accrual
status.
• Note B is for $40 million, with interest at current market rates capitalized into the
loan balance. All principal and interest is due at maturity in 2010. The bank received a second lien on the collateral. This loan was placed on nonaccrual status.
The parent agreed to inject $4 million in new equity into the power company in
July 2005 and July 2006 to pay the required interest on Note A for two years.
While the company continues to experience net losses in 2005, it is expected that
cash flows will be sufficient to cover interest by the third quarter of 2006. Further,
the parent has indicated that it will continue to cover interest payments on Note A
until the company can generate sufficient cash flows. In addition, the fair value of
the collateral is estimated at $98 million, exceeding the combined amount of the
restructured notes by approximately $13 million.

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Question 21
Should this restructuring be accounted for as a TDR?

Staff Response
Yes. ASC 310-40 states that the restructuring of a debt is a TDR if a creditor for
economic or legal reasons related to the debtor’s financial difficulties grants a
concession that it would not otherwise consider. The company was experiencing
financial difficulties, as demonstrated by the default on the interest payments. Further,
while there was no forgiveness of interest or principal, a concession was granted by
extending the maturity date and agreeing to capitalize interest on Note B.

Question 22
Should both Notes A and B be on a nonaccrual status?

Staff Response
Not necessarily. While the nonaccrual rules would normally require that both notes
be on nonaccrual status, Note A has a unique structure and financial backing that
distinguishes it from most restructured loans. Although both notes are supported
by the same cash flows and secured by the same collateral, these unique structural
differences result in different conclusions for each note regarding the appropriateness
of interest accrual. These structural differences also result in a different conclusion
than was reached in certain of the previous examples in this topic.
The parent paid $10 million (plus interest and fees) to bring all past-due amounts
current and has demonstrated the intent and ability to continue to support the power
company by its commitment to inject $4 million capital into the company in 2005 and
2006. The parent also indicated that additional financial support would be provided,
as necessary. This capital injection and future support is sufficient to meet all
required payments on Note A. Further, the previous actions of the parent sufficiently
demonstrate its intent to support the borrowing. In addition, after the $10 million
payment by the parent, the collateral value exceeds all current outstanding balances
by approximately $13 million and exceeds the balance of Note A by approximately
$53 million. Based on these factors, the collection of all principal and interest is
deemed reasonably assured for Note A. Accordingly, accrual status is appropriate for
Note A.

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Facts A borrower has a revolving line of credit of $35 million that is fully drawn

and a term loan in the amount of $28 million with the bank. Payments are current
but the loans are in default because of major financial covenant violations. Further,
there is serious concern regarding the borrower’s ability to continue to make
payments in accordance with the terms of the loans. Accordingly, both loans have
been placed on a nonaccrual status.
The credit line is restructured into a new revolving line of credit of the same
amount at an interest rate of prime plus 3 percent. The rate and terms are
considered to be at market terms and do not involve a concession. Further, the line
of credit is considered to be both fully collectible and fully secured.
The term loan is restructured into two new term loans, Loan X and Loan Y.
Loan X matures in three years and has an interest rate of the prime rate plus 3
percent. It requires periodic principal payments during the second and third years
and a balloon payment at maturity. The repayment structure is not uncommon for
this type of loan and is considered to be at market terms. Repayment capacity and
collateral are considered sufficient to assure repayment of the loan.

The second loan, Loan Y, provides for a below-market interest rate. It also matures
in three years but does not require principal or interest payments until maturity.
The terms of this loan are considered concessionary, because of the below market
interest rate and the repayment terms. Accordingly, the restructuring of the original
term loan is considered a TDR. Further, given that the borrower’s repayment
capacity and collateral are considered inadequate to repay any portion of this loan,
the loan is deemed uncollectible and should be charged off.
After a sufficient period of satisfactory payment performance on the revolving line
of credit and Loan X, the lender expects to return those two loans to accrual status.

Question 23
What factors should be considered before returning the revolving line of credit and
Loan X to accrual status?

Staff Response
This restructuring would be analyzed using the A/B structure described in the
previous examples. In this case, the collectibility of the revolving line and Loan X is
not in doubt, and Loan Y is the uncollectible charged-off portion.
Consistent with the previous question 10, the revolving line of credit and Loan
X may be returned to accrual status when there has been a period of satisfactory
payment performance by the borrower. In this situation, however, Loan X does not
require principal payments during the first year. Accordingly, consideration should
be given to whether the borrower can continue making the required payments of
principal and interest after the first year.

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Question 24
Does the revolving line of credit and Loan X have to be senior to Loan Y (i.e., a
senior/subordinated structure) for the performing loans to be returned to accrual
status?

Staff Response
No, a senior/subordinated structure is not required for the revolving line of credit and
Loan X to be returned to accrual status.

Question 25

UPDATE

LOANS

How should any payments received on Loan Y, the charged-off loan, be accounted
for?

Staff Response
Recoveries related to Loan Y would not be recorded until the recorded loans (the
revolving line and Loan X) are either paid off or returned to accrual status. Until then,
any payments received for Loan Y would be applied to the revolving line of credit
and Loan X.

Question 26
What is the impact on the ALLL determination under ASC 310-10-35 for TDR loans?

Staff Response
ASC 310-40 requires all TDRs, both retail and commercial transactions, to be
evaluated for impairment in accordance with ASC 310-10-35. Given the financial
difficulties of these borrowers, material impairment (i.e., additional ALLL provisions)
is possible.
When measuring impairment on an individual basis under ASC 310-10-35, a bank
must choose one of the following methods:


The present value of expected future cash flows discounted at the loan’s effective
interest rate (i.e., the contractual interest rate adjusted for any net deferred loan
fees or costs, premium, or discount existing at the origination or acquisition of the
loan);



The loan’s observable market price; or



The fair value of the collateral, if the loan is collateral dependent.

ASC 310-10-35 requires that if a loan’s contractual interest rate varies based on
subsequent changes in an independent factor, such as an index or rate (for example,
the prime rate, the LIBOR, or the U.S. Treasury bill rate weekly average), the loan’s
effective interest rate may be calculated based on the factor as it changes over the life
of the loan or be fixed at the rate in effect at the date the loan meets the impairment
criterion. This method used shall be applied consistently for such loans. Further,
projections of future changes in the factor should not be considered when determining
the effective interest rate or estimate of expected future cash flows.
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For most retail loan TDRs, the present value of expected future cash flows or the
fair value of collateral methods (if the loan is collateral dependent) will be used to
calculate impairment, because an observable market price for a loan is usually not
available. If impairment is measured using an estimate of the expected future cash
flows, the interest rate used to discount the cash flows (i.e., present value) is based
on the original effective interest rate on the loan and not the rate specified in the
restructuring agreement. If the present value of the modified terms is less than the
recorded investment in the loan, bank management must include the difference in
their ALLL analysis.
For practical reasons and as allowed in ASC 310-10-35, pools of smaller-balance
homogeneous TDRs (generally retail loans) could be reviewed on a pooled basis.
Some impaired loans have risk characteristics unique to an individual borrower,
and the bank should apply one of the three measurement methods noted above on a
loan-by-loan basis. Some impaired loans, however, may have risk characteristics in
common with other impaired loans. A bank may aggregate those loans and may use
historical statistics, such as average recovery period and average amount recovered,
along with a composite, effective interest rate to measure impairment of those loans.
In certain circumstances, grouping retail TDR loans together to measure impairment
may help banks arrive at the best estimate of expected future cash flows.

Question 27
Can a TDR to be collateral dependent immediately following the loan modification
(on day 1)?

Staff Response
Yes, a TDR can be collateral dependent at the time of or immediately after the loan
modification. A loan is collateral dependent if repayment of the loan is expected to
be provided solely by the underlying collateral and there are no other available and
reliable sources of repayment. A modified loan requiring only a nominal monthly
payment from the borrower with no support that the borrower can repay the recorded
loan balance may result in a loan that ultimately is repaid only through the liquidation
of the underlying collateral. Management judgment of a borrower’s specific facts and
circumstances is required to determine if this is the case.
If the facts and circumstances indicate that the borrower does not have the ability
to repay the modified loan or if the terms of the loan are based on future, uncertain
events, the loan may be deemed collateral dependent at the time of modification.
As the critical terms of the modified loan (such as repayment of the recorded loan
balance) extend over longer periods of time, there is more uncertainty in estimating
the timing and amount of cash flows associated with the loan and if the borrower
does not have the current capacity to repay the recorded loan balance, the likelihood
of the loan being collateral dependent increases.
If the TDR is determined to be collateral dependent, the amount of confirmed loss
(i.e., the amount deemed uncollectible) should be charged against the ALLL in a
timely manner.
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Question 28
Is it possible to have a group of originated loans or acquired loans that were not
impaired at acquisition in which the entire pool is deemed to be collateral dependent
at the time of TDR modification?

Staff Response
It is possible to have a pool of impaired residential mortgage loans that is collateral
dependent at the time of TDR modification. As each new TDR is underwritten and
executed, the loan must be reviewed for collateral dependency. If the impaired loan
is determined to be collateral dependent at the time of the modification, the loan
may be placed in a pool of other collateral-dependent loans that share similar risk
characteristics. In that case, the pool of loans may be collateral dependent. If the
collateral-dependent determination is not made at the time of the modification on a
loan-by-loan basis or the loan pools do not sufficiently segment collateral dependent
loans from those that are not collateral dependent, it is not appropriate to deem the
entire pool of loans as collateral dependent. The loan pool must be further segmented
to properly account for the collateral-dependent loans separately from other loans in
the pool that are not collateral dependent.

Question 29
How is the ALLL amount for TDRs established under ASC 310-10-35?

Staff Response
If the ASC 310-10-35 measurement of a TDR is less than the recorded investment in
the loan, impairment is typically recognized by adjusting the existing ALLL for the
difference with a corresponding charge to “Provision for loan and lease losses.”

Question 30
Should retail loans that are TDRs be placed on nonaccrual status and reported on call
report Schedule RC-N?

Staff Response
It depends. If the bank does not expect payment in full of both principal and interest,
then the loan may be put on nonaccrual status. If the loan is carried on nonaccrual
status, it is reported in RC-N. Banks may apply other alternative methods of
evaluation, however, for retail loans to assure that the bank’s net income is not
materially overstated. For example, banks may establish an “interest and fee” contra
asset or valuation allowance against the accrued interest receivable reported in other
assets. If that method is used, the loans would not be included as nonaccrual loans
in RC-N, but the methods being used should assure that the bank is not overstating
interest income. If the loans are not placed on nonaccrual status, however, and are
past due 30 days or more and still accruing under their modified terms, they should be
included in RC-N in the appropriate past-due column (i.e., 30 through 89 days or 90
days or more, as appropriate).
Office of the Comptroller of the Currency

BAAS September 2013 | 37

LOANS

2A. Troubled Debt Restructurings

Facts In 2005, a 2/28 hybrid ARM loan is made to a borrower with an initial

rate of 5 percent and a scheduled reset to LIBOR plus 2 percent as of September
1, 2007. In August 2007, while the loan is still at the initial rate of 5 percent, the
lender becomes aware that the borrower cannot make payments at the reset rate.
As of August 2007, LIBOR is 6 percent, so the loan’s interest rate is expected
to increase to 8 percent. Because of the borrower’s financial difficulty, the bank
agrees to modify the terms of the loan at a fixed rate of 6 percent until maturity,
which is below the current market rate for a loan in this risk category.

Question 31
Is it acceptable for the bank to use the 5 percent initial rate as the effective interest
rate to calculate the present value of the modified terms of this loan?

Staff Response
No. The impairment analysis as required by ASC 310-10-35 should reflect the
“concession” made (i.e., the lost interest), because this interest rate modification
results in the loan being considered a TDR. The effective interest rate for calculating
the present value of the modified terms is not the 5 percent initial rate. Instead, the
effective interest rate should be a blend of the 5 percent rate over the term of the
initial period and the scheduled 8 percent reset rate for the remaining 28 years of
the loan. In addition, shortcut methods may be used for the original effective rate
calculation that may not result in a material difference from the blended rate (e.g., a
bank may decide to use the full reset rate of 8 percent).
With respect to the reset rate, ASC 310-10-35 does not allow projected changes in the
independent factor, in this case LIBOR, to be considered in calculating the effective
interest rate; thus, the 8 percent rate during the reset period is the current LIBOR, 6
percent, plus 2 percent.

38

| Office of the Comptroller of the Currency

BAAS September 2013

2A. Troubled Debt Restructurings

Facts Bank X has a fixed-rate mortgage from Borrower A in its held-for-

investment portfolio. Borrower A’s mortgage is part of a portfolio of mortgages
that are evaluated collectively for impairment and for which an ALLL has been
established, even though no specific loan has been identified as impaired. Borrower
A is having difficulty making payments. Bank X has determined that it is in the
bank’s best interest to modify Borrower A’s loan by lowering the interest rate from
7 percent to 6 percent. The 6 percent rate is below the market interest rate the bank
would typically charge a borrower with similar credit risk as Borrower A. The
lower interest rate results in contractual payments of $603.40 per month. Because
of Borrower A’s financial difficulties and the interest-rate concession granted
by Bank X, the loan is a TDR and subject to ASC 310-10-35 for impairment
measurement. The terms of the original loan and the modified loan are as follows:

UPDATE

LOANS

Original loan terms

Modified loan terms

Payment: $665.12

Payment: $603.40

Interest rate: 7%

Interest rate: 6%

Remaining term: 27 years

Remaining term: 27 years

Loan balance: $96,700

Loan balance: $96,700

One approach to develop the best estimate of expected future cash flows would be
to incorporate default and prepayment assumptions that would be relevant to an
aggregated pool of loans with risk characteristics similar to the restructured loan.
In addition, the analysis may incorporate uncertainty about the timing and amount
of borrower payments. Bank X incorporates these assumptions in its cash flow
analysis and expects to receive approximately $580 per month for the remaining
term of the loan. Present value of the expected future cash flows discounted at the
original effective interest rate is approximately $84,300. For simplicity, recorded
investment in the loan at the time of the TDR equals the loan balance of $96,700,
and the treatment of any accrued interest receivable is not considered in this
example.

Question 32
How is the impairment calculated?

Staff Response
The present value of the modified loan’s expected cash flows discounted at the
original effective interest rate is approximately $84,300, which is less than the
recorded investment in the loan of $96,700. The difference of approximately $12,400
is the measurement of impairment at the time of the restructuring as required by ASC
310-10-35.

Office of the Comptroller of the Currency

BAAS September 2013 | 39

LOANS

2A. Troubled Debt Restructurings

Facts A borrower has a first lien residential mortgage with Bank A and a second

lien residential mortgage with Bank B. Bank A modified the borrower’s first lien
mortgage through a TDR. At the time the first lien mortgage is modified with Bank
A, the borrower is current on his second lien mortgage with Bank B. Bank B has
not modified the borrower’s loan.

Question 33
How should Bank B account for the second lien mortgage under ASC 310-10 after
the first lien mortgage was modified?

Staff Response
ASC 310-10-35 specifically scopes out large groups of smaller-balance homogeneous
loans that are collectively evaluated for impairment. Those loans may include but
are not limited to credit card, residential mortgage, and consumer installment loans.
As a result, residential mortgage loans are generally evaluated for impairment as
part of a group of homogenous loans under ASC 450-20. The only time a residential
mortgage loan is required to be analyzed for impairment under ASC 310-10-35
is when the residential mortgage loan is modified and classified as a TDR. In the
scenario described above, Bank B will include the second lien mortgage loan in its
allowance methodology under ASC 450-20; the second loan has not been modified
and is therefore not a TDR subject to ASC 310-10-35.
In addition, while the borrower’s first lien mortgage has been modified by Bank A,
Bank B may not be aware of this action. When Bank B does become aware of a first
lien modification, however, Bank B should recognize that the second lien mortgage
loan borrower is facing financial difficulties and that the second lien mortgage has
different risk characteristics than other second lien mortgage loans that have not had
their first lien mortgage modified or are not suffering financial difficulties. Following
the modification of the first lien mortgage, Bank B should consider segmenting the
loan into a different ASC 450-20 group that reflects the increased risk associated with
this loan. Alternatively, the bank may consider applying additional environmental or
qualitative factors to this loan pool to reflect the different risk characteristics.

Facts A bank’s short-term modification (i.e., 12 months or less) program delays

payments for troubled borrowers. Because the modifications are short term, the
bank concludes the delay in payment is insignificant.

Question 34
Is the bank’s basis for concluding the delay in payments is insignificant appropriate?

Staff Response
No. It is not appropriate to conclude the delay in payments is insignificant simply
because the modification is short term (i.e., 12 months or less). Rather, the bank

40

| Office of the Comptroller of the Currency

BAAS September 2013

LOANS

2A. Troubled Debt Restructurings

must collectively consider the following factors, which may indicate the delay is
insignificant:


The amount of the restructured payments subject to the delay is insignificant relative to the unpaid principal or collateral value of the debt and will result in an
insignificant shortfall in the contractual amount due.



The delay in timing of the restructuring payments period is insignificant relative
to any one of the following:
— The frequency of payments due under the debt
— The debt’s original contractual maturity
— The debt’s original expected duration

Facts A bank originated an SFR mortgage that is HFI. At origination, the
borrower’s income was the primary source of repayment and the underlying
collateral was the secondary source of repayment. There is no other source of
repayment.
The borrower files for Chapter 7 bankruptcy. The bankruptcy court discharges
the borrower’s obligation to the bank and the borrower does not reaffirm the
debt. Accordingly, after the bankruptcy proceedings are completed, the bank’s
only recourse is to take possession of the collateral. Therefore, if the bank does
not receive contractual mortgage payments, it can foreclose on the property, but
the bank cannot pursue the borrower personally for any deficiencies. Even if
the borrower has been making payments, the borrower’s continued ability and
willingness to make voluntary payments is uncertain.

Question 35
How should the bank report the discharged debt in the call report?

Staff Response
The discharged debt should be reported as a loan in the call report. The call report
instructions glossary states that a loan is generally an extension of credit resulting
from direct negotiations between a lender and a borrower. That definition is consistent
with GAAP, which defines a loan as a contractual right to receive money on demand
or on fixed or determinable dates and is recognized as an asset in the creditor’s
statement of financial position. The discharge of a secured debt does not eliminate
the bank’s contractual right to receive money on demand or on fixed or determinable
dates; only the debtor’s personal liability on the debt has been eliminated.
The discharged debt should not be reported as OREO because the bank does not have
physical possession or legal title to the collateral (see Topic 5A, question 2).

Office of the Comptroller of the Currency

BAAS September 2013 | 41

2A. Troubled Debt Restructurings

Question 36
Is the loan a TDR?

Staff Response
Yes. A restructuring constitutes a TDR if a concession is granted for economic or
legal reasons related to the borrower’s financial difficulties. The bankruptcy filing
indicates the borrower is experiencing financial distress (see question 20) and the
release of the borrower’s personal liability as ordered by the bankruptcy court is a
concession.
ASC 310-40-15-6 states that a concession can be imposed by a law or court.
Additionally, ASC 310-40-15-10 specifically states that TDRs consummated under
reorganization, arrangement, or other provisions of the Federal Bankruptcy Act
or other federal statutes are within the scope of 310-40. Therefore, the bankruptcy
court’s discharge of the borrower’s debt is a concession for the purpose of
determining whether the restructured loan is a TDR.

Question 37
How should the bank account for the TDR?

Staff Response
The restructured loan is collateral dependent. The bank should, therefore, establish
an ALLL in accordance with ASC 310-10 and charge-off the excess of the loan’s
carrying amount over the fair value of the collateral as uncollectible and the bank
should place the remaining balance on nonaccrual. The bankruptcy court “removed”
the borrower (the primary source of repayment) from responsibility to continue
to make payments called for by the original loan agreement. As such, the TDR is
collateral dependent because repayment depends solely on the collateral.

Facts A bank modifies a secured loan in a TDR and measures impairment using
the present value of the expected future cash flows discounted at the loan’s original
effective interest rate because the loan is not collateral dependent. The modified
contractual terms require a balloon payment at maturity. The current collateral
value is less than the scheduled balloon payment.
UPDATE

LOANS

Question 38
Is it appropriate for the bank to presume the borrower will be able to repay or
refinance at maturity?

Staff Response
No. When a contractual balloon payment is required at maturity under the modified
terms of a TDR loan that is not collateral dependent, significant uncertainty may exist
regarding the troubled borrower’s ability to refinance or repay the debt at maturity.
In accordance with ASC 310-10-35-26, when estimating expected future cash

42

| Office of the Comptroller of the Currency

BAAS September 2013

2A. Troubled Debt Restructurings

UPDATE

flows for impairment measurement purposes, the bank should consider all available
evidence, with greater weight given to evidence that can be verified objectively.
When no sources of cash flows are reasonably expected to be available to support the
assumption that the borrower will be able to repay or refinance the secured loan at
maturity, an acceptable approach for estimating expected future cash flows can be to
base the expected payment at maturity on the current fair value of the collateral, less
estimated costs to sell.
The fair value of the collateral should be supported by a current appraisal or other
similar timely evaluation. Using the fair value of the collateral, less selling costs,
in lieu of the balloon payment due at maturity, does not suggest a 100 percent
probability of default at renewal. Rather, using the fair value recognizes the value
inherent in the collateral to satisfy repayment should refinancing efforts prove
unsuccessful.
However, if the contractual balloon payment at maturity is lower than the fair value of
the collateral, less estimated costs to sell, the balloon payment amount should be used
as the final cash flow in the impairment analysis since there is no collateral deficiency.

Facts A bank modifies a loan to a borrower in a TDR. The bank incurs certain

costs directly related to the modification, including appraisal costs. The bank
charges the borrower a general fee for the modification and adds the fee to the
modified loan balance.

Question 39
NEW

LOANS

How should the bank account for these direct costs incurred in a TDR and for the
modification fee charged to the borrower?

Staff Response
Consistent with ASC 310-40-25-1, OCC staff believes that the bank should expense
the appraisal and other direct costs associated with the TDR when incurred. Likewise,
consistent with ASC 310-20-35-12, the bank should apply the fee received in
connection with the TDR to reduce the recorded investment in the loan. Thus, the
bank should defer recognition of the fee income associated with the TDR.

Office of the Comptroller of the Currency

BAAS September 2013 | 43

LOANS

2B. Nonaccrual Loans

2B. Nonaccrual Loans
Facts The bank made an equipment loan and advanced funds in the form of an

operating loan. Both loans have been placed on nonaccrual status, and a portion
of the equipment loan has been charged off. The loan balances are classified, and
doubt as to full collectibility of principal and interest exists.

Question 1
May a portion of the payments made on these loans be applied to interest income?

Staff Response
No. Interest income should not be recognized. The call report instructions require
that, when doubt exists about the ultimate collectibility of principal, wholly or
partially, payments received on a nonaccrual loan must be applied to reduce principal
to the extent necessary to eliminate such doubt.
Placing a loan in a nonaccrual status does not necessarily indicate that the principal is
uncollectible, but it generally warrants revaluation. In this situation, because of doubt
of collectibility, recognition of interest income is not appropriate.

Facts Assume the same facts as in question 1, except that cash flow projections
support the borrower’s repayment of the operating loan in the upcoming year.
Collectibility of the equipment loan is in doubt, however, because of the
borrower’s inability to service the loan and insufficient collateral values.
Question 2
May the bank accrue interest on the operating loan, even though the equipment loan
remains on nonaccrual status?

Staff Response
Loans should be evaluated individually. The borrower’s total exposure must be
considered, however, before concluding that doubt has been removed over the
collectibility of either loan. Additionally, the analysis should consider a time period
beyond the first year.
Projections indicate that the borrower will be able to service only one of the loans
for one year. Therefore, doubt still exists about total borrower exposure over the long
term. Accordingly, interest recognition generally is inappropriate.

44

| Office of the Comptroller of the Currency

BAAS September 2013

2B. Nonaccrual Loans

Facts The bank has placed a loan on nonaccrual and charged the loan down

to the estimated collateral value. The remaining principal has been classified as
substandard because of the borrower’s historical nonperformance or an event of
default (e.g., covenant violation, significant credit event) and questionable ability
to meet future repayment terms.

Question 3
Because the collateral value is sufficient to cover the remaining recorded investment
(after charge-off), may interest payments be recognized as income on a cash basis?

Staff Response

UPDATE

LOANS

Initial cash-basis income recognition would not be appropriate without a credit
analysis and documentation to support the borrower’s repayment capacity. In
determining the accounting for individual payments on a nonaccrual loan, the
bank must evaluate the loan to determine whether doubt exists about the ultimate
collectability of the recorded investment. If collectability of the recorded investment
in the loan is in doubt, any payment received in a nonaccrual loan should be applied
to reduce the recorded investment to the extent necessary to eliminate such doubt.
The overall creditworthiness of the borrower and the underlying collateral values
should be considered when making this determination. For example, doubt about
collectability of troubled loans often exists when regular payments have not been
made or with an event of default, even when a loan is fully collateralized. In general,
collateral values are not sufficient, by themselves, to eliminate the issue of ultimate
collectability of the recorded investment in the loan, especially when there is not a
high degree of confidence in the accuracy of the estimated collateral value. Without a
credit analysis and documentation to support the borrower’s capacity to repay, there
should be sufficient collateral margin before the bank can conclude that doubt has
been eliminated.
When the bank can demonstrate that doubt about the ultimate collectability of the
recorded investment no longer exists, subsequent interest payments received may
be recorded as interest income on a cash basis. Banks may record the receipt of the
contractual interest payment on a partially charged-off loan by allocating the payment
among interest income, reduction of principal, and recovery of prior charge-offs.
Banks may also choose to report the receipt of this contractual interest in its entirety
as either interest income, reduction of principal, or recovery of prior charge-offs,
depending on the condition of the loan, consistent with their accounting policies that
conform to GAAP.  

Facts A loan is currently on nonaccrual status as a result of being delinquent
in principal and interest payments for a period exceeding 90 days. The estimated
uncollectible portion of the loan has been charged off. The remaining balance is
expected to be collected.
Office of the Comptroller of the Currency

BAAS September 2013 | 45


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