FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan, states, “A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.” The Statement, however,does not specifically address how a creditor should recognize, measure, or display interest income on an impaired loan. Although Statement No. 114 does not specifically address how a financial institution should recognize, measure, or display interest income on an impaired loan, the Instructions for Preparation of Consolidated Reports of Condition and Income (call report instructions) published by the Federal Financial Institutions Examination Council indicate that impaired loans should normally be placed on nonaccrual status at the time they first become impaired and it is determined that full collection of principal and interest is not probable. Cash payments received on impaired loans that have been placed on nonaccrual status should be reported in accordance with the criteria for the cash basis recognition of income for nonaccrual loans.
Per the call report instructions, financial institutions should not accrue interest, amortize deferred net loan fees or costs, or accrete discount on any asset (a) which is maintained on a cash basis because of deterioration in the financial condition of the borrower, (b) for which payment in full of principal or interest is not expected, or (c) upon which 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.
There are limited situations, which are exceptions to this general rule, under which an asset need not be placed in nonaccrual status. However, any state statute, regulation, or rule that imposes more stringent standards for nonaccrual of interest takes precedence over the call report instructions.
While an asset is in nonaccrual status, some or all of the cash interest payments received may be treated as interest income on a cash basis as long as the remaining recorded investment in the asset (i.e., after charge-off of identified losses, if any) is deemed to be fully collectible. When recognition of interest income on a cash basis is appropriate, it should be handled in accordance with generally accepted accounting principles. One acceptable accounting practice involves allocating contractual interest payments among interest income, reduction of the recorded investment in the asset, and recovery of prior charge-offs. If this method is used, the amount of income that is recognized would be equal to that which would have been accrued on the asset's remaining recorded investment at the contractual rate.
A financial institution may also choose to account for the contractual interest in its entirety either as income, reduction of the recorded investment in the asset, or recovery of prior charge-offs, depending on the condition of the asset, consistent with its accounting policies for other financial reporting purposes.
Instructions for Preparation of Consolidated Reports of Condition and Income is available in full at http://www.ffiec.gov/PDF/FFIEC_forms/FFIEC031_041_200803_i.pdf.
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