Due to increased foreclosures resulting from the lingering effects of “The Great Recession,” financial institutions have been forced to become all too adept at accounting for real estate foreclosures or other real estate owned (OREO). Final guidance jointly issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in May 2014, addresses revenue recognition from contracts with customers. FASB’s version of this guidance took form as Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606).
ASU 2014-09 does away with industry-specific guidance related to the sale of real estate. As such, the guidance in Accounting Standards Codification (ASC) Subtopic 360-20, Real Estate Sales, will no longer be applicable to financial institutions’ sales of OREO unless the transaction is part of a sale-leaseback arrangement. Instead, these types of sales will be accounted for based on the guidance established in ASU 2014-09, which implements a principles-based approach to revenue recognition rather than the rigid guidance currently required by ASC Subtopic 360-20-55.
Background
At the time of foreclosure, ASC Topic 360, Property, Plant, and Equipment, requires a financial institution to record an asset for a foreclosed property based on the asset’s fair value, less estimated selling costs, establishing a new cost basis or carrying amount for the property. The difference between this new cost basis and the loan’s recorded amount (the outstanding loan balance at the time of foreclosure adjusted for any unamortized premium or discount and unamortized loan fees or costs, less any previous charge-offs, plus recorded accrued interest), is treated as an adjustment to the financial institution’s allowance for loan and lease losses.
Arguably, the most challenging aspect of accounting for OREO relates to the sale of such assets—more specifically, the gain recognition associated with these sales. ASC Subtopic 360-20 provides very rigid guidelines describing how to account for gains associated with the sale of OREO. Gains from such sales occur when the carrying amount of OREO is less than the sales price. The “Full Accrual Method”, which allows the entire gain to be recognized at the time the asset is sold, is to be used when: 1) the gain is determinable—i.e., the collectability of the sales price is reasonably assured or the amount that will not be collected can be estimated; and 2) the earnings process is virtually complete—i.e., the seller is not obliged to perform significant activities after the sale to earn the gain.
The full accrual method cannot be used when: 1) a sale is not consummated; 2) the buyer’s initial and continuing investments are not adequate to demonstrate a commitment to pay for the property; 3) the seller’s receivable is subject to future subordination; and 4) the seller has not transferred to the buyer the usual risks and rewards of ownership.
Generally, financial institutions meet the criteria for utilization of the full accrual method in sales where they are not specifically involved in the financing of the sale. When they are involved in the financing of the sale, they can still utilize the full accrual method as long as the buyer provides an adequate initial cash investment (which can range from 5% to 25% of the property’s selling price, depending on the type of property being sold— i.e. land, commercial and industrial property, multifamily residential property, etc.)—and all other previously mentioned criteria are met.
When the full accrual method cannot be utilized, one of the methods documented in ASC Subtopic 360-20 is to be utilized. These include the installment, cost recovery, reduced-profit, and deposit methods. As indicated previously, these methods have provided strict guidance to be followed if characteristics of the sale meet one of these method’s respective gain recognition criteria. The need for judgment is minimal.
What’s in Store with the New Revenue Recognition Standard
ASU 2014-09 indicates that an entity should recognize revenue to depict the transfer of promised goods or services to a customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In making this determination, an entity should apply the following five-step process:
- Identify the contract with the customer.
- Identify the performance obligation in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligation.
- Recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer.
When it comes to the sale of OREO, steps 1 through 4 seem fairly straight forward and easily identifiable. Step 5 requires some additional analysis. In determining whether a customer has obtained control of a promised asset and an entity has satisfied a performance obligation, the entity is to consider factors such as the following:
- The entity has a present right to payment for the asset.
- The customer has legal title to the asset.
- The entity has transferred physical possession of the asset.
- The customer has the significant risks and rewards of ownership of the asset.
- The customer has accepted the asset.
Generally, these criteria would be considered met for sales of OREO that are financed by the financial institution selling the property on the date the sales transaction is closed.
Before financial institutions get too excited about the potential ease of recognizing the gain on these types of transactions at closing, remember that it was previously stated that step 1 may seem fairly straight forward and easily identifiable. To some extent this is true; however, as part of identifying the contract with the customer, the financial institution must determine if it is probable that it will collect the consideration to which it is entitled in exchange for the goods or services provided to the customer.
This process requires the financial institution to consider the customer’s ability to repay the loan and requires a significant degree of judgment. Items to consider could include an analysis of the customer’s historical financial performance, collateral securing the loan as well as additional assets owned by the customer and, although no specific threshold is included in ASU 2014-09, the customer’s initial cash investment. If a financial institution determines that there are uncertainties in the customer’s ability to repay the loan, the contract is considered non-existent; therefore, the associated gain would not be recognized until the financial institution concludes that it is probable that the customer will be able to repay the loan.
The guidance established in ASU 2014-09 is currently effective for public entities for annual reporting periods beginning after December 15, 2016, and for all other entities beginning after December 15, 2017, including interim periods within each respective year. FASB’s Board is currently seeking comment on its proposal to extend these deadlines by one year. Additionally, financial institution regulatory bodies have yet to comment on the guidance established in ASU 2014-09.
If you would like more information about the new revenue recognition standard and its impact on your financial institution’s accounting methods, contact the experts listed below at PYA, (800) 270-9629.
