In good economic times, we need to use the foreclosure rules much less often than when times are tougher. However, it’s important to know the ins and outs of the accounting treatment for OREO in order to properly report them in financial statements and regulatory reports.
In general, the accounting and reporting standards for foreclosed real estate are set forth in Financial Accounting Standards Board Accounting Standards Codification (ASC) Topic 310-40, [Accounting for] Troubled Debt Restructurings by Creditors, and ASC Topic 360-10-35, [Accounting for the] Impairment or Disposal of Long-Lived Assets.
Acquisition
Foreclosed real estate received in full or partial satisfaction of a loan should be recorded at the fair value less costs to sell the property at the time of foreclosure. This amount becomes the new cost basis of the asset. Costs to sell are the incremental direct costs to transact a sale, which include broker commissions, legal and title transfer fees, and closing costs that must be incurred before legal title can be transferred.
The rationale for recording foreclosures and asset transfers at fair value is that they are not merely reversals of the original loans. They are distinct transactions between borrowers and lenders that represent exchanges of loans for other assets. The fair value of a foreclosed asset is used to establish an exchange price for recording the transaction.
Holding period
After foreclosure, each foreclosed real estate asset must be carried at the lower of (1) the fair value of the asset minus the estimated costs to sell the asset or (2) the "cost" of the asset (i.e., the amount at which the acquisition of the asset was recorded, as described above). This determination must be made on an asset-by-asset basis. If the fair value of a foreclosed real estate asset minus the estimated costs to sell the asset is less than the asset's cost, under the regulatory guidance, the deficiency must be recognized as a valuation allowance against the asset which is created through a charge to expense.
The cost of repairs or physical improvements to a foreclosed asset should be capitalized if they significantly increase the fair value of the asset. Otherwise, they should be expensed as incurred.
Disposition period
The new source of accounting guidance for sales of foreclosed real estate is ASC Topic 610, Other Income, and ASC Topic 606, Revenue from Contracts with Customers. Under guidance, which includes all transactions in which the seller provides financing to the buyer of real estate, an institution will recognize the entire gain or loss, if any, and derecognize the OREO at the time of sale if the transaction meets certain requirements of the Topic 606. Otherwise, an institution will generally record any payments received as a deposit liability to the buyer and continue reporting the OREO as an asset at the time of transaction.
If you have questions on the new rules, give us a call. Please contact Tracy Harding or Janice Latulippe.
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