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Interest income on all loans is generally accrued and credited to interest income as it is earned using the interest method. The objective of the interest method is to recognize periodic interest income that reflects a constant effective yield on the recorded investment in the loan. In addition to the accrual of contractual interest, periodic interest reflects the amortization of deferred loan fees and costs and the amortization of any purchase discount or premium. However, the accrual of interest income has generally been suspended when the collection of interest is less than probable or the collection of any portion of the loan's principal is doubtful (i.e., a non-performing loan).
Our view is that recognition of interest income based on the contractual terms of the loan agreement should not continue while the loan is considered impaired because any such interest would not have been earned (i.e., the creditor does not expect to collect all of the interest (and principal) in accordance with the contractual terms of the loan agreement). If an impaired loan is purchased, then income recognition should be in accordance with ASC 310-30 (see ARM 3560.51 for further details).
Although ASC 310-10 does not address how a creditor should recognize, measure, or display interest income on an impaired loan, the guidance allows a creditor to use existing methods for recognizing interest income on impaired loans, including a cash basis method, a cost recovery method, or some combination of both. When applying these methods, an entity also needs to consider changes in the valuation allowance related to passage of time.
Changes to the ALLL related to passage of time
When the creditor recalculates the loan's impaired basis at the end of the reporting period, changes in the loan’s impaired basis due to the passage of time are reflected in the income statement using either the interest method or the bad-debt expense method, depending on the entity’s income recognition policy.
Interest method
The change in the present value of the loan is assessed to identify the changes due to passage of time and those which are due to changes in the amount or timing of expected future cash flows. The increase in present value attributable to the passage of time can be reported as interest income accrued on the net carrying amount of the loan. The change in present value (increase or decrease), if any, attributable to changes in the amount or timing of expected future cash flows can be reported as provision for credit losses or as a reduction in the amount of provision for credit losses that otherwise would be reported.
Bad-debt expense method
The entire change in present value (increase or decrease) can be reported as provision for credit losses or as a reduction in the amount of provision for credit losses that otherwise would be reported.
Accounting methods for recognizing income
In addition to accounting for the changes in ALLL due to passage of time, a creditor should account for the cash payments which are periodically received on the loans using either the cash basis method or the modified cost recovery method, depending on the entity’s income recognition policy.
Cash basis method
Under the cash basis method, payments of interest received by the creditor are recorded as interest income provided the amount does not exceed that which would have been earned at the historical effective interest rate. When the creditor recalculates the loan's impaired basis at the end of the reporting period, changes in the basis due to the passage of time are reflected in the income statement using either the interest method or the bad-debt expense method. The cash basis is the most prevalent method applied in practice today, and it has certain attractions. First, the amount of interest income recognizable in any one period is limited to the lesser of the amount of cash that is actually received or the product of multiplying the recorded investment in the loan by the loan's effective interest rate. Some accountants consider this to be a practical rule given the uncertainty that surrounds the timing and amount of future cash flows. Second, unlike the interest method, the total amount of interest recorded over the life of the loan does not exceed the amount of interest that is received in cash, assuming the loan's balance is fully recovered.
Modified cost recovery method
Under the modified cost recovery method, any interest or principal received is recorded as a direct reduction of the recorded investment in the loan. When the recorded investment has been fully collected, any additional amounts collected are recognized as interest income. When the creditor recalculates the loan's impaired basis at the end of the reporting period, changes in the basis due to the passage of time are reflected using either the interest method or the bad-debt expense method. Many financial institutions refer to this income recognition policy as the cost recovery method. We, however, refer to this method as the modified cost recovery method, since the cost recovery method utilized by institutions prior to ASC 310-10 did not reflect the concept of recognizing income by reducing the ALLL (i.e., crediting provision for credit losses) for the passage of time. Current practice is to generally apply this method when collection of the recorded balance of the loan is doubtful. This method seeks to avoid a situation where total interest income recorded over the life of the loan exceeds the amount of interest collected in cash. This method may result in the recorded investment being less than the present value of the loan.
The method of income recognition selected should be applied to all loans for which impairment is measured based on the present value, and should be applied consistently from one reporting period to the next.
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