For acquired pools of loans that are not accounted for under
ASC 310-30, the ALLL is determined using the guidance in
ASC 450. In looking to this guidance, an ALLL is established when losses have been incurred. The book value reflected on the balance sheet at a point in time will, generally, reflect the contractual amount of the loan less any ALLL. However, this may not always be the case in situations where loans are purchased at a premium or discount.
For example, assume a portfolio of homogenous loans with par value of $1,000 is purchased at $850. Under
ASC 805, the portfolio of loans is initially recorded at fair value of $850, resulting in an initial purchase discount of $150. The portfolio of loans is accreted from $850 to $1000 based on guidance in
ASC 310-20.
On day 2, the portfolio of loans will be subject to an entity's ALLL process, whereby the portfolio of loans will be subject to
ASC 450 at a pool level. Based on pool level cash flows and historical data, assume that an incurred loss of $100 is calculated. The question has often arisen as to whether (1) a pool level allowance should be established to reflect the $100 incurred loss or (2) whether no allowance for loan loss should be recorded, given that the par value ($1,000) less incurred loss of $100 is higher ($900) than the current book value ($850) given the initial purchase discount of $150.
ASC 450 is a balance sheet focused model and, consistent with other impairment models, contains a trigger to recognize impairment. As a result, we believe that no allowance will be recognized until the current book value is accreted past the level of incurred loss. In the fact pattern above, the portfolio of loans initially recognized at $850 will accrete up to $1,000. Assuming that the incurred loss on the portfolio above remains $100, an ALLL will be recorded when the portfolio is accreted past $900. This concept is often referred to as "accreting into impairment" and has been consistently used and accepted in practice. We also understand that this model has been discussed informally by the SEC staff and accepted based on the concepts above. While we believe the aforementioned approach is the most conventional and commonly accepted, we are aware of the SEC staff accepting certain other methodologies depending on the facts and circumstances.
The situation above becomes more complicated when dealing with portfolios of loans acquired at a premium. For example, assume a portfolio of homogenous loans with a par value of $1,000 is acquired at $1,150. The portfolio of loans is recorded at fair value, resulting in an initial purchase premium of $150 that will be amortized into income over the contractual life of the loans. When this portfolio of loans becomes subject to the entity's ALLL process, historical loss experience will result in an incurred loss being calculated for the portfolio of loans. As mentioned above,
ASC 450 is a balance sheet focused model. Therefore, the question has to come up as to whether the entire original purchase premium of $150 should be written off and an ALLL should be recorded to reflect the current incurred loss, therefore resulting in book value reflecting the par value of the loan less incurred loss.
We do not believe that the entire original purchase premium should be written off solely due to a portfolio of loans requiring an
ASC 450 allowance. Instead, we believe that an ALLL should be measured against the principal amount of the loan, and the premium should continue to be amortized into income, in accordance with
ASC 310-20, as the premium is expected to be received through future interest payments. With respect to the premium amount, we believe that, if an individual loan becomes impaired and, therefore, subject to
ASC 310-10-35, an entity should apply its provisions as stated, which could result in a portion of the premium being written off, as the expected cash flow calculation required under
ASC 310-10-35 takes into consideration the premium by using the loan's effective interest rate.