11Real Estate Investments, Real Estate Owned, and Other Foreclosed Assets – Audit and Accounting Guide – Depository and Lending Institutions

Chapter 11
Real Estate Investments, Real Estate Owned, and Other Foreclosed Assets

Introduction

11.01 Generally, the largest component of real estate owned (REO), also known as other real estate owned (OREO), by lenders is assets taken in full or partial settlement of troubled loans through foreclosure or receiving physical possession of real estate property collateralizing a loan. Real estate investments, real estate loans that qualify as investments in real estate, and premises that are no longer used in operations may also be included in REO.1 Once a bank obtains physical possession of the collateral, the real estate is included in REO. Physical possession of residential real estate property collateralizing a consumer mortgage loan occurs either when the creditor obtains legal title to the residential real estate property through foreclosure, even if the borrower has redemption rights whereby it can legally reclaim the real estate property for a period of time, or upon completion of a deed in lieu of foreclosure or similar legal agreement under which the borrower conveys all interest in the residential real estate property to the creditor to satisfy that loan. The deed in lieu of foreclosure or similar legal agreement is completed when agreed upon terms and conditions have been satisfied by both the borrower and the creditor. Furthermore, institutions may obtain assets other than real estate through foreclosure, and those assets also are addressed in this chapter.

Foreclosed Assets

11.02 Foreclosed assets include all assets received in full or partial satisfaction of a receivable and include real and personal property; equity interests in corporations, partnerships, and joint ventures; and beneficial interests in trusts.

Real Estate Investments

11.03 Some institutions make direct and indirect equity investments in real estate projects. Direct and indirect equity investment activities exclude OREO acquired in any manner for debts previously contracted and are limited by 12 USC 29 and Regulation H, 12 CFR Part 208.

Regulatory Matters

11.04 As explained in the entry foreclosed assets in the “Glossary” section of the Federal Financial Institutions Examination Council’s Instructions for Preparation of Consolidated Reports of Condition and Income, certain provisions of Statement of Position No. 92-3, Accounting for Foreclosed Assets, (rescinded with the issuance of FASB Statement No. 144, Accounting for the Impairment or Disposal of Long Lived Assets, [codified in FASB Accounting Standards Codification (ASC) 360, Property, Plant, and Equipment]) are not present in FASB ASC 360, but the application of these provisions represents prevalent practice in the banking industry and is consistent with safe and sound banking practices and the accounting objectives set forth in Section 37(a) of the Federal Deposit Insurance Act. These provisions have been incorporated into the entry foreclosed assets in the “Glossary” section of the Federal Financial Institutions Examination Council’s Instructions for Preparation of Consolidated Reports of Condition and Income. The instructions explain that

     for purposes of these reports, foreclosed assets include loans (other than residential real estate property collateralizing a consumer mortgage loan) where an institution, as creditor, has received physical possession of a borrower’s assets, regardless of whether formal foreclose proceedings take place. The timing of physical possession is also explained.

     when an institution receives a long-lived asset, such as real estate, from a borrower in full satisfaction of a loan, the long-lived asset is rebuttably presumed to be held for sale (HFS) and the institution shall initially measure this asset at its fair value less cost to sell. This fair value (less cost to sell, if applicable) of the asset received in full satisfaction of the loan becomes the “cost” of the asset. Cost to sell includes items like estimated sales commissions on the sale of the property.

     an asset received in partial satisfaction of a loan should be initially measured at its fair value less cost to sell and the recorded investment in the loan should be reduced by the fair value (less cost to sell, if applicable) of the asset at the time of restructuring, foreclosure, or repossession.

     after foreclosure, each foreclosed real estate asset (including any real estate for which the bank receives physical possession) 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. This determination must be made on an asset-by-asset basis.

11.05 Voluntary direct investments in real estate are generally limited for national banks, as described in Title 12 U.S. Code of Federal Regulations (CFR) Part 7.1000. State member banks may invest in real estate only with the prior approval of the Board of Governors of the Federal Reserve System (Federal Reserve) as described in Regulation H. Part 7.1000 also covers the allowable holding period for real estate. For REO acquired through foreclosure, the maximum allowable holding period is generally five years from the date of a bank receiving legal title, unencumbered by any redemption period applicable, to the property. For unoccupied premises (including unoccupied premises under operating or capital lease agreements) the maximum allowable holding period is generally five years, but the five-year disposal period is suspended during the time the bank had a valid sublease in place. A bank may request an extension not to exceed an additional five years, if (1) the institution has made a good faith attempt to dispose of the real estate within the five-year period, or (2) disposal within the five-year period would be detrimental to the institution. The holding period regulatory guidance applies to all OREO properties the bank holds legal title to, even if the property has been written down to a recorded amount of zero, and unoccupied real estate lease under capital or operating leases.

11.06 Foreclosure management. In July 2012, the Federal Reserve issued guidance to address a lender’s decision to discontinue foreclosure proceedings. The objective of the guidance is to emphasize the importance of appropriate risk management practices and controls in connection with a decision not to complete foreclosure proceedings after they have been initiated. Responsibilities of management include the following:

     Communication with borrowers. Supervised banking organizations should use all means possible to provide the previously described notification to affected borrowers, particularly those who prematurely vacated their homes based on the servicers’ initial communications regarding foreclosure actions.

     Notification to local authorities. Supervised banking organizations should ensure that their procedures include reasonable efforts to notify appropriate state or local government authorities of the organization’s decision not to pursue a foreclosure, including complying with applicable state or local government notification requirements.

     Obtaining and monitoring collateral values. Supervised banking organizations should have a process for obtaining the best practicable information on the collateral value of a residential property that may be subject to foreclosure and for updating this information on a regular basis.

Readers can access this guidance in Supervision and Regulation (SR) letter 12-11/Consumer Affairs (CA) letter 12-10, Guidance on a Lender’s Decision to Discontinue Foreclosure Proceedings, from the Federal Reserve website at www.federalreserve.gov.

11.07 In April 2013, the Federal Reserve issued guidance on sound business practices for residential mortgage servicing that Federal Reserve supervised financial institutions are expected to address in their collections, loss mitigation, and foreclosure processing functions. The guidance confirms the minimum standards that all regulated institutions are expected to adopt in prioritizing and handling borrowers’ files with imminent risk of foreclosure. These minimum review criteria are intended to ensure a level of consistency across servicers and should be used to determine whether a scheduled foreclosure sale should be postponed, suspended, or cancelled because of critical foreclosure defects in the borrower’s file. Readers can access this guidance in SR letter 13-9/CA letter 13-6, Minimum Standards for Prioritization and Handling Borrower Files with Imminent Scheduled Foreclosure Sale, from the Federal Reserve website at www.federalreserve.gov.

11.08 Disposal of problem assets through exchanges. In December 2011, the Federal Reserve issued SR letter 11-15, Disposal of Problem Assets through Exchanges. The guidance addresses the risks involved in asset exchanges, the associated risk management considerations for institutions, and the supervisory considerations for examiners. The guidance also provides a detailed example of an asset exchange transaction. The example highlights the potential risks associated specifically with transactions that may reduce problem assets in the short term but, because of a lack of appropriate, up-front due diligence, may result in heightened risks over the longer term. Readers can access the guidance in SR letter 11-15 from the Federal Reserve website at www.federalreserve.gov.

11.09 Rental of Residential OREO Properties. In April 2012, the Federal Reserve issued SR letter 12-5/CA letter 12-2, Policy Statement on Rental of Residential OREO Properties, (policy statement) to remind banking organizations and examiners that the Federal Reserve's regulations and policies permit the rental of OREO properties as part of an orderly disposition strategy within statutory and regulatory limits. The policy statement applies to state member banks, bank holding companies, nonbank subsidiaries of bank holding companies, savings and loan holding companies, nonthrift subsidiaries of savings and loan holding companies, and U.S. branches and agencies of foreign banking organizations (collectively, banking organizations).

11.10 While general policy of the Federal Reserve is that banking organizations should make good-faith efforts to dispose of OREO properties at the earliest practicable date, the policy statement indicates that banking organizations may rent one- to four-family residential OREO properties without having to demonstrate continuous active marketing of the properties, provided that suitable policies and procedures are followed.

11.11 Key risk management considerations for banking organizations that engage in the rental of residential OREO include compliance with holding-period requirements for OREO, compliance with landlord-tenant and associated requirements, and accounting for OREO assets in accordance with U.S. generally accepted accounting principles (GAAP). Residential OREO is typically treated as a substandard asset as defined by the interagency classification guidelines. However, residential properties with leases in place and demonstrated cash flow from rental operations sufficient to generate a reasonable rate of return should generally not be classified.

11.12 The policy statement also establishes specific supervisory expectations for banking organizations that undertake large-scale residential OREO rentals (generally, 50 properties or more available for rent). Such organizations should have formal policies and procedures governing the operation and administration of OREO rental activities, including property-specific rental plans, policies and procedures for compliance with applicable laws and regulations, a risk management framework, and oversight of third-party property managers. For more information, readers can access SR letter 12-5/CA letter 12-3 from the Federal Reserve website at www.federalreserve.gov.

11.13 OREO management. In June 2012, the Federal Reserve issued SR letter 12-10/CA letter 12-9, Questions and Answers for Federal Reserve-Regulated Institutions Related to the Management of Other Real Estate Owned (OREO), to clarify existing policies and promote prudent practices for the management of an institution’s OREO assets. Topics covered in the question and answer document include transferring an asset to OREO, reporting treatment and classification, appraisal concepts, ongoing property management, operational and legal issues, and sale and transfer of OREO. Readers can access SR letter 12-10/CA letter 12-9 from the Federal Reserve website at www.federalreserve.gov.

11.14 Appraisals. All OREO whether actively marketed or not actively marketed, should be reviewed quarterly and supported by appropriate policies, procedures, and documentation to support appraised value. Readers should refer to the discussion beginning in paragraph 8.63 of this guide for regulatory guidance addressing appraisals. A bank is required to monitor the appraisal value of each parcel of OREO property in accordance with GAAP and regulatory guidance. Further discussion on ongoing appraisal requirements for OREO can also be found in 12 (CFR) Part 34.85(a)(2).

11.15 Bank Accounting Advisory Series (BAAS). The Office of the Comptroller of the Currency’s BAAS is updated periodically to express the Office of the Chief Accountant’s current views on accounting topics of interest to national banks and federal savings associations. See further discussion of the BAAS in paragraph 7.82 of this guide. Topic 5A, “Other Real Estate Owned,” of the BAAS includes interpretations and responses related to OREO (for example, when a bank should derecognize a loan collateralized by property other than residential real estate, such as a commercial real estate loan and an auto loan.) In addition, Topic 2 A, “Troubled Debt Restructuring,” includes discussion on when discharged debt should not to be reported as OREO and classification and measurement guidance under GAAP for government guaranteed mortgage loans upon a bank’s foreclosure of the property that collateralizes the loan. Readers are encouraged to view this publication under the “Publications—Bank Management” page at www.occ.gov.

Accounting and Financial Reporting

Foreclosed Assets

11.16 FASB ASC 310-40-40 applies to the initial measurement of a foreclosed property (including when the creditor receives physical possession of the debtor’s assets, regardless of whether formal foreclosure proceedings take place). Paragraphs 2–3 of FASB ASC 310-40-40 provide that a creditor that receives real estate or other assets from a debtor in full satisfaction of a receivable should record the asset received at fair value at the time of the restructuring. If the long-lived asset received will be sold, those assets should be recorded at their fair value less cost to sell, as that term is used in FASB ASC 360-10-35-43. In addition, FASB ASC 310-40-35-7 provides that an asset received in partial satisfaction of a receivable combined with a modification of the debt should account for the asset received as prescribed in paragraphs 2–4 of FASB ASC 310-40-40 (fair value less cost to sell if the asset received will be sold) and reduce the recorded investment in the receivable by a corresponding amount.

11.17 Further, FASB ASC 310-40-40-6 explains that, except in the circumstances described in FASB ASC 310-40-40-6A (see paragraph 11.18), a troubled debt restructuring that is, in substance, a repossession or foreclosure by the creditor (that is, the creditor receives physical possession of the debtor's assets, regardless of whether formal foreclosure proceedings take place, or in which the creditor otherwise obtains one or more of the debtor's assets in place of all or part of the receivable) should be accounted for according to the provisions of FASB ASC 310-40-35-7 (see paragraph 11.16), paragraphs 2–4 of FASB ASC 310-40-40 (see paragraph 11.16), and if appropriate, FASB ASC 310-40-40-8. See paragraphs 7A–7B of FASB ASC 310-40-40 for the classification and measurement of certain government-guaranteed mortgage loans. For guidance on when a creditor should be considered to have received physical possession (resulting from an in substance repossession or foreclosure) of residential real estate properly collateralizing a consumer mortgage loan, see FASB ASC 310-40-55-10A.

11.18 The guidance in FASB ASC 310-40-40-7 (see paragraph 11.19) applies to initial measurement of a foreclosed property in a transaction having all of the following characteristics:

a.     A sale of real estate was financed by the seller.

b.     The buyer’s initial investment was not sufficient for recognition of profit under the full accrual method.

c.     The seller met the conditions of FASB ASC 970-605 to record a sale and recognized profit on the installment or cost recovery method.

d.     Subsequently, the buyer defaulted on the mortgage to the seller.

e.     The seller forecloses on the property.

f.     At the time of foreclosure, the fair value of the property is less than the seller’s gross receivable but greater than the seller’s net receivable, that is, the principal and interest receivable less the deferred profit on the sale and related allowances.

11.19 At the time of foreclosure, foreclosed property meeting the characteristics of FASB ASC 310-40-40-6A (see paragraph 11.18) should be recorded at the lower of the net amount of the receivable or fair value of the property, in accordance with FASB ASC 310-40-40-7. The net receivable assumes that the accrual of interest income on the financing, if any, is appropriate under the circumstances. FASB ASC 310, Receivables, would be applied to a foreclosure related to a sale accounted for under the full accrual method, and if appropriate, the repossessed property would be recorded at its fair value. The “Impairment and Disposal of Long-Lived Assets” subsections of FASB ASC 360-10 require a foreclosed asset that is newly acquired and that is classified as HFS to be recognized at the lower of its carrying value or fair value less cost to sell.

11.20 In accordance with paragraphs 7A–7B of FASB ASC 310-40-40, a guaranteed mortgage loan receivable should be derecognized and a separate other receivable be recognized upon foreclosure (that is, when a creditor receives physical possession of real estate property collateralizing a mortgage loan in accordance with the guidance in FASB ASC 310-40-40-6 (see paragraph 11.17) if the following conditions are met:

     The loan has a government guarantee that is not separable from the loan before foreclosure.

     At the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under the claim.

     At the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed.

Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor.

11.21 FASB ASC 310-10-35-32 establishes guidance on the accounting for loans when foreclosure is probable and requires that, regardless of the measurement method, a creditor should measure impairment based on the fair value of the collateral if the creditor determines that foreclosure is probable.

Financial Statement Presentation and Disclosure

11.22 FASB 310-10-45-3 requires that foreclosed and repossessed assets should be classified as a separate balance sheet amount or included in other assets in the balance sheet, with separate disclosures in the notes to the financial statements. Certain returned or repossessed assets, such as inventory, should not be classified separately if the assets subsequently are to be utilized by the entity in operations. In accordance with FASB ASC 310-10-50-11, an entity should also disclose the carrying amount of foreclosed residential real estate properties held at the reporting date as a result of obtaining physical possession in accordance with FASB ASC 310-40-40-6 (see paragraph 11.17) and FASB ASC 310-40-55-10A.

Accounting and Reporting for Long-Lived Assets to Be Disposed of by Sale

11.23 FASB ASC 360-10-05-4 states that the “Impairment or Disposal of Long-Lived Assets” subsections of FASB ASC 360-10 provide guidance for measurement of long-lived assets to be disposed of by sale and disclosures about the impairment or disposal of long-lived assets and disposals of individually significant components of an entity.

11.24 FASB ASC 360-10-45-9 states that a long-lived asset (disposal group) to be sold should be classified as HFS in the period in which all of the following criteria are met:

a.     Management, having the authority to approve the action, commits to a plan to sell the asset (disposal group).

b.     The asset (disposal group) is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets (disposal groups).

c.     An active program to locate a buyer and other actions required to complete the plan to sell the asset (disposal group) have been initiated.

d.     The sale of the asset (disposal group) is probable, and transfer of the asset (disposal group) is expected to qualify for recognition as a completed sale, within one year, except as permitted by FASB ASC 360-10-45-11.

e.     The asset (disposal group) is being actively marketed for sale at a price that is reasonable in relation to its current fair value. The price at which a long-lived asset (disposal group) is being marketed is indicative of whether the entity currently has the intent and ability to sell the asset (disposal group). A market price that is reasonable in relation to fair value indicates that the asset (disposal group) is available for immediate sale, whereas a market price in excess of fair value indicates that the asset (disposal group) is not available for immediate sale.

f.     Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

11.25 FASB ASC 360-10-45-10 states that if, at any time, the preceding criteria are no longer met (except as permitted by FASB ASC 360-10-45-11), a long-lived asset (disposal group) classified as HFS should be reclassified as held and used in accordance with FASB ASC 360-10-35-44.

11.26 FASB ASC 360-10-35-43 states that a long-lived asset (disposal group) classified as HFS should be measured at the lower of its carrying amount or fair value less cost to sell. If the asset (disposal group) is newly acquired, the carrying amount of the asset (disposal group) should be established based on its fair value less cost to sell at the acquisition date. A long-lived asset should not be depreciated (amortized) while it is classified as HFS. Interest and other expenses attributable to the liabilities of a disposal group classified as HFS should continue to be accrued.

11.27 A valuation allowance for a loan collateralized by a long- lived asset should not be carried over as a separate element of the cost basis for purposes of accounting for the long-lived asset under FASB ASC 360 after foreclosure, as stated in FASB ASC 310-40-40-10.

11.28 In accordance with FASB ASC 360-10-35-40, a loss should be recognized for any initial or subsequent write-down to fair value less cost to sell. A gain should be recognized for any subsequent increase in fair value less cost to sell, but not in excess of the cumulative loss previously recognized (for a write-down to fair value less cost to sell). The loss or gain should adjust only the carrying amount of a long-lived asset, whether classified as HFS individually or as part of a disposal group. A gain or loss not previously recognized that results from the sale of a long-lived asset (disposal group) should be recognized at the date of sale according to FASB ASC 360-10-40-5.

Financial Statement Presentation and Disclosure

11.29 FASB ASC 360-10-45-5 states that a gain or loss recognized on the sale of a long-lived asset (disposal group) that is not a discontinued operation should be included in income from continuing operations before income taxes in the income statement of a business entity. If a subtotal such as income from operations is presented, it should include the amounts of those gains or losses.

11.30 FASB ASC 360-10-45-14 states that a long-lived asset classified as HFS (but not qualifying for presentation as a discontinued operation in the statement of financial position in accordance with FASB ASC 205-20-45-10) should be presented separately in the statement of financial position of the current period. The assets and liabilities of a disposal group classified as HFS should be presented separately in the asset and liability sections, respectively, of the statement of financial position. Those assets and liabilities should not be offset and presented as a single amount. The major classes of assets and liabilities classified as HFS should be separately presented on the face of the statement of financial position or disclosed in the notes to the financial statements (see FASB ASC 360-10-50-3 in paragraph 11.31e ).

11.31 For any period in which a long-lived asset (disposal group) either has been disposed of or is classified as HFS (see FASB ASC 360-10-45-9 in paragraph 11.24), FASB ASC 360-10-50-3 states that an entity should disclose the following information in the notes to the financial statements:

a.     A description of the facts and circumstances leading to the disposal or expected disposal.

b.     The expected manner and timing of that disposal.

c.     The gain or loss recognized in accordance with paragraphs 37–45 of FASB ASC 360-10-35 and FASB ASC 360-10-40-5.

d.     If not separately presented on the face of the statement where net income is reported, the caption in the statement where net income is reported that includes the gain or loss.

e.     If not separately presented on the face of the statement of financial position, the carrying amounts of the major classes of assets and liabilities included as part of a disposal group classified as HFS. Any loss recognized on the disposal group classified as HFS in accordance with paragraphs 37–45 of FASB ASC 360-10-35 and FASB ASC 360-10-40-5 should not be allocated to the major classes of assets and liabilities of the disposal group.

f.     If applicable, the segment(s) in which the long-lived asset (disposal group) is reported under FASB ASC 280, Segment Reporting.

11.32 In addition to the disclosures in FASB ASC 360-10-50-3 (see paragraph 11.31), FASB ASC 360-10-50-3A states that if a long-lived asset (disposal group) includes an individually significant component of an entity that either has been disposed of or is classified as HFS (see FASB ASC 360-10-45-9 in paragraph 11.24) and does not qualify for presentation and disclosure as a discontinued operation (see FASB ASC 205-20 on discontinued operations), a public business entity and a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market should disclose the information in item (a). All other entities should disclose the information in item (b).

a.     For a public business entity and a not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market, both of the following:

1.     The pretax profit or loss of the individually significant component of an entity for the period in which it is disposed of or is classified as HFS and for all prior periods that are presented in the statement where net income is reported calculated in accordance with paragraphs 6–9 of FASB ASC 205-20-45

2.     If the individually significant component of an entity includes a noncontrolling interest, the pretax profit or loss attributable to the parent for the period in which it is disposed of or is classified as HFS and for all prior periods that are presented in the statement where net income is reported

b.     For all other entities, both of the following:

1.     The pretax profit or loss of the individually significant component of an entity for the period in which it is disposed of or is classified as HFS calculated in accordance with paragraphs 6–9 of FASB ASC 205-20-45

2.     If the individually significant component of an entity includes a noncontrolling interest, the pretax profit or loss attributable to the parent for the period in which it is disposed of or is classified as HFS

Accounting and Reporting for Long-Lived Assets to Be Held and Used

11.33 The “Impairment or Disposal of Long-Lived Assets” subsections of FASB ASC 360-10 provide guidance for recognition and measurement of the impairment of long-lived assets to be held and used.

11.34 Paragraphs 16–36 of FASB ASC 360-10-35 address how long-lived assets or asset groups that are intended to be held and used in an entity’s business should be reviewed for impairment. FASB ASC 360-10-35-21 requires that a long-lived asset (asset group) be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group), as stated in FASB ASC 360-10-35-17. That assessment should be based on the carrying amount of the asset (asset group) at the date it is tested for recoverability, whether in use (see FASB ASC 360-10-35-33) or under development (see FASB ASC 360-10-35-34). In accordance with FASB ASC 360-10-35-29, estimates of future cash flows used to test recoverability of a long-lived asset (asset group) should include only the future cash flows (cash inflows less associated cash outflows) that are directly associated with and that are expected to arise as a direct result of the use and eventual disposition of the asset (asset group). Those estimates should exclude interest charges that will be recognized as an expense when incurred.

11.35 FASB ASC 360-10-35-17 goes on to state that an impairment loss should be recognized only if the carrying amount of the long-lived asset (asset group) is not recoverable and exceeds its fair value. An impairment loss should be measured as the amount by which the carrying amount of the long-lived asset (asset group) exceeds its fair value. Paragraphs 23–25 of FASB ASC 360-10-35 provide guidance on grouping long-lived assets classified as held and used.

11.36 When a long-lived asset (asset group) is tested for recoverability, FASB ASC 360-10-35-22 states that it also may be necessary to review depreciation estimates and methods as required by FASB ASC 250, Accounting Changes and Error Corrections, or the amortization period as required by FASB ASC 350, Intangibles—Goodwill and Other. Paragraphs 17–20 of FASB ASC 250-10-45 and FASB ASC 250-10-50-4 address the accounting for changes in accounting estimates, including changes in the method of depreciation, amortization, and depletion. Paragraphs 1–5 of FASB 350-30-35 address the determination of the useful life of an intangible asset. Any revision to the remaining useful life of a long-lived asset resulting from that review also should be considered in developing estimates of future cash flows used to test the asset (asset group) for recoverability (see paragraphs 31–32 of FASB ASC 360-10-35). However, any change in the accounting method for the asset resulting from that review should be made only after applying FASB ASC 360-10.

11.37 If an impairment loss is recognized, the adjusted carrying amount of a long-lived asset should be its new cost basis according to FASB ASC 360-10-35-20. For a depreciable long-lived asset, the new cost basis should be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited.

Financial Statement Presentation and Disclosure

11.38 In accordance with FASB ASC 360-10-45-4, an impairment loss recognized for a long-lived asset (asset group) to be held and used should be included in income from continuing operations before income taxes in the income statement of a business entity. If a subtotal such as income from operations is presented, it should include the amount of that loss.

11.39 As required by FASB ASC 360-10-50-2, the following information should be disclosed in the notes to the financial statements that include the period in which an impairment loss is recognized:

a.     A description of the impaired long-lived asset (asset group) and the facts and circumstances leading to the impairment

b.     If not separately presented on the face of the statement, the amount of the impairment loss and the caption in the income statement that includes that loss

c.     The method or methods for determining fair value (whether based on a quoted market price, prices for similar assets, or another valuation technique)

d.     If applicable, the segment in which the impaired long-lived asset (asset group) is reported under FASB ASC 280

Real Estate Investments

11.40 The “General” subsections of FASB ASC 970, Real Estate—General, provide accounting guidance concerning various forms of real estate investments. FASB ASC contains several topics for real estate due to differing accounting treatment for various real estate subindustries.

11.41 The “Acquisition, Development, and Construction” subsections of FASB ASC 310-10 provide guidance for determining whether a lender should account for an acquisition, development, and construction (ADC) arrangement as a loan or as an investment in real estate or a joint venture. The FASB ASC glossary defines an acquisition, development, and construction arrangement as an arrangement in which a lender, usually a financial institution, participates in expected residual profit from the sale or refinancing of property. In an ADC arrangement in which the lender participates in expected residual profit, in addition to the lender’s participation in expected residual profit, FASB ASC 310-10-25-19 outlines certain characteristics that would suggest that the risks and rewards of the arrangement are similar to those associated with an investment in real estate or joint venture.

Financial Statement Presentation and Disclosure

11.42 FASB ASC 310-10-45-15 states that ADC arrangements accounted for as investments in real estate or joint ventures should be combined and reported in the balance sheet separately from those ADC arrangements accounted for as loans.

Sale of Real Estate Assets6

11.43 FASB ASC 360-20 establishes standards for recognition of profit on all real estate sales transactions, other than retail land sales, without regard to the nature of the seller’s business.

11.44 FASB ASC 360-20-40 presents the real estate derecognition guidance primarily from the perspective of the profit recognition upon a sale. This guidance addresses various conditions that may or may not result in derecognition of the real estate asset (and related profit or loss recognition, if any). The six primary methods of accounting for sales transactions are full accrual, installment, percentage-of-completion, reduced profit, cost recovery, and deposit. If an institution is selling discrete real estate projects, it may need to consider whether the projects would be considered a disposal of a component of an entity that represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results and accordingly may need to be reported as a discontinued operation in accordance with paragraphs 1A–5 of FASB ASC 205-20-45. Other guidance on accounting for real estate sales that may apply includes FASB ASC 970-360 and FASB ASC 840-40.

Development Costs

11.45 The “Real Estate Project Costs” subsections in FASB ASC 970-10 establish accounting and reporting standards for ADC, selling, and rental costs associated with real estate projects, as stated in FASB ASC 970-10-05-6. Project costs clearly associated with the ADC of a real estate project should be capitalized as a cost of that project, according to FASB ASC 970-360-25-2.

11.46 Payments to obtain an option to acquire real property should be capitalized as incurred, as stated in FASB ASC 970-340-25-3. All other costs related to a property that are incurred before the entity acquires the property, or before the entity obtains an option to acquire it, should be capitalized if all of the following conditions are met and otherwise should be charged to expense as incurred:

a.     The costs are directly identifiable with the specific property.

b.     The costs would be capitalized if the property were already acquired.

c.     Acquisition of the property or of an option to acquire the property is probable (that is, likely to occur). This condition requires that the prospective purchaser is actively seeking to acquire the property and has the ability to finance or obtain financing for the acquisition and that there is no indication that the property is not available for sale.

11.47 Paragraphs 8–12 of FASB ASC 970-340-25 address the accounting for costs incurred on real estate for property taxes and insurance, costs of amenities, and incidental operations. Costs incurred on real estate for property taxes and insurance should be capitalized as property cost only during periods in which activities necessary to get the property ready for its intended use are in progress. Accounting for costs of amenities should be based on management's plans for the amenities in accordance with the criteria stated in FASB ASC 970-340-25-9. Incremental revenues from incidental operations in excess of incremental costs of incidental operations should be accounted for as a reduction of capitalized project costs.

11.48 The capitalized costs of real estate projects should be assigned to individual components of the project based on specific identification, as stated in FASB ASC 970-360-30-1. If specific identification is not practical, capitalized costs should be allocated as follows:

a.     Land costs and all other common costs, including the costs of amenities to be allocated as common costs per paragraphs 9–11 of FASB ASC 970-340-25 (before construction), should be allocated to each land parcel benefited. Allocation should be based on the relative fair value before construction.

b.     Construction costs should be allocated to individual units in the phase on the basis of relative sales values of each unit.

If allocation based on relative values is also impractical, costs should be allocated based on area methods (for example, square footage) or other value methods as appropriate under the circumstances.

Allocation of Income and Equity Among Parties to a Joint Venture

11.49 If a real estate investment is made through a joint venture arrangement, a formal agreement generally exists that specifies key terms, such as profit or loss allocations, cash distribution, and capital infusion provisions. The terms of these agreements may affect the institution's investment valuation and, accordingly, are considered in the investment evaluation process.

11.50 According to FASB ASC 970-323-35-16, joint venture agreements may designate different allocations among the investor for any of the following:

a.     Profits and losses

b.     Specified costs and expenses

c.     Distributions of cash from operations

d.     Distributions of cash proceeds from liquidation

11.51 FASB ASC 970-323-35-17 states that accounting by the investors for their equity in the venture's earnings under such agreements requires careful consideration of substance over form and consideration of the underlying values, as discussed in FASB ASC 970-323-35-10. Specified profit and loss allocation ratios should not be used to determine an investor's equity in venture earnings if the allocation of cash distributions and liquidating distributions are determined on some other basis.

11.52 If a specified allocation has no substance (for example, all depreciation is to be allocated to one partner but all cash distributions, including proceeds from the sale of real estate, are shared equally by all partners), it should be ignored. The agreement should be analyzed to determine how changes in net assets of the venture will affect cash payments to investors over the venture's life and at liquidation.

11.53 The institution should consider whether it is appropriate to allocate to other partners losses in excess of their capital contributions or whether the institution should record losses in excess of its own investment, including loans and advances. Items that may affect the institution's decision are (a) the financial strength of the partners, (b) the type of partners (general versus limited) and the partners' legal requirement to fund losses, (c) the fair value of the real estate, and (d) the type of losses being incurred (cash or book). Paragraphs 2–11 of FASB ASC 970-323-35 provide guidance on investor accounting for losses in such circumstances.

11.54 FASB ASC 970-810 provides guidance on consolidation matters incremental to the real estate industry. FASB ASC 970-810-25-2 states that a noncontrolling investor in a general partnership should account for its investment by the equity method and should be guided by the provisions of FASB ASC 323, Investments—Equity Method and Joint Ventures. A controlling investor should account for its investment under the principles of accounting applicable to investments in subsidiaries. For guidance on determining control held by an investor, see paragraphs 1–2 of FASB ASC 970-810-25. For guidance on determining whether a general partner should consolidate a limited partnership or apply the equity method of accounting to its interests in the limited partnership, see FASB ASC 970-810-25-3.9

Auditing10

Objectives

11.55 The primary objectives of audit procedures in the real estate investments, REO, and other foreclosed assets area are to obtain sufficient appropriate evidence that

a.     the assets exist, are properly recorded, and are owned by the institution;

b.     the assets are properly classified, described, and disclosed in the financial statements;

c.     adequate provisions have been made for impairment, if any, of the assets;

d.     depreciation expense, where applicable and other revenues and expenses related to real estate assets are properly allocated and reported;

e.     sales of assets, including the recognition of gains and losses, have been recognized; and

f.     appropriate disclosures have been made.

Planning

11.56 In accordance with AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatements,11 the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement (as described in chapter 5, “Audit Considerations and Certain Financial Reporting Matters,” of this guide). In obtaining that understanding, the auditor might consider the following factors related to real estate investments, REO, and other foreclosed assets that may indicate higher inherent risk in this area:

     Adverse environmental or economic conditions that may affect real estate markets and the values and liquidity of properties or other assets

     Significant losses on past sales of REO or other foreclosed assets

     Complex real estate assets

     Sales, financed by the institution, of REO or other foreclosed assets

     Lack of experienced real estate staff

     High concentrations of real estate or other assets in a particular geographic area

     Significant fluctuations in the amount and number of foreclosures or in-substance foreclosures

     Inexperienced internal appraisal personnel or the use of low-quality or outdated appraisals

     Appraisals in unstable market conditions

Internal Control Over Financial Reporting and Possible Tests of Controls

11.57 AU-C section 315 addresses the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements through understanding the entity and its environment, including the entity’s internal control. Paragraphs .13–.14 of AU-C section 315 state that the auditor should obtain an understanding of internal control relevant to the audit (such as, individually significant real estate in-vestments, REO and other foreclosed assets) and, in doing so, should evaluate the design of those controls and determine whether they have been implemented by performing procedures in addition to inquiry of the entity’s personnel. (See chapter 5 of this guide for further discussion of the components of internal control.) To provide a basis for designing and performing further audit procedures, paragraph .26 of AU-C section 315 states that the auditor should identify and assess the risks of material misstatement at the financial statement level and the relevant assertion level for classes of transactions, account balances, and disclosures.

11.58 Inherent risk is often high for foreclosed assets and ADC arrangements because of the high degree of subjectivity involved in determining real estate values and the classification of ADC arrangements. However, with a high level of inherent risk in the real estate area, the auditor would often conclude that for most of the assertions it is more effective or efficient to assess control risk at the maximum and plan a primarily substantive approach, involving a selection of major real estate assets for detailed review.

11.59 AU-C section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained, addresses the auditor’s responsibility to design and implement responses to the risks of material misstatement identified and assessed by the auditor in accordance with AU-C section 315 and to evaluate the audit evidence obtained in an audit of financial statements.

11.60 In accordance with paragraph .08 of AU-C section 330, the auditor should design and perform tests of controls to obtain sufficient appropriate audit evidence about the operating effectiveness of relevant controls if (a) the auditor’s assessment of risks of material misstatement at the relevant assertion level includes an expectation that the controls are operating effectively or (b) substantive procedures alone do not provide sufficient appropriate audit evidence at the relevant assertion level. Internal control over financial reporting of real estate investments, REO, and other foreclosed assets may include

     written policies and procedures, including those that address

     frequency of appraisals and selection and qualifications of appraisers;

     disbursement of funds and capitalization of costs;

     review and monitoring of marketing efforts;

     nature and amount of facilitating financing;

     revenue recognition;

     estimates of cost to sell; and

     capitalization of interest.

     proper authorizations for specific transactions.

     periodic reviews of balances, fair values, realizable values, and policies by persons specified in management's written policy.

     accounting for dispositions, including whether derecognition (sale) and profit recognition are appropriate.

Substantive Tests

11.61 Irrespective of the assessed risks of material misstatement, paragraph .18 of AU-C section 330 states that the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure, which for a financial institution would include real estate investments, REO, and other foreclosed assets. In accordance with paragraph .A45 of AU-C section 330, this requirement reflects the facts that (a) the auditor’s assessment of risk is judgmental and may not identify all risks of material misstatement and (b) inherent limitations to internal control exist, including management override.

11.62 Other REO and real estate investments. Obtaining audit evidence about the carrying amount of foreclosed assets (fair values) and real estate investments (including loans that qualify as real estate investments) may involve a review of appraisals, feasibility studies, forecasts, sales contracts or lease commitments, and information concerning the track record of the developer. Being aware of the involvement of related parties may contribute to the design of audit procedures used by the auditor. To obtain appropriate audit evidence of progress to completion under a real estate investment or other real estate project, the auditor may also decide to perform an on-site inspection of certain properties.

11.63 Substantive tests of other real estate and real estate investments generally focus on the valuation assertion; however, tests of the other assertions should also be considered. For example, evidence about the completeness assertion may be obtained through the auditor's testing of loans. In addition, the auditor should consider testing the propriety of gains and losses on real estate sales and capitalized interest and other holding costs. The auditor may also evaluate appraisals performed close to a period end that may not be timely processed and included in the entity’s records.

11.64 Estimates of the fair value of real estate assets are necessary to account for such assets. AU-C section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosure, addresses the auditor’s responsibilities related to accounting estimates, including fair value accounting estimates and related disclosures, in an audit of financial statements. Specifically, it expands on how AU-C section 315, AU-C section 330, and other relevant AU-C sections are to be applied with regard to accounting estimates. It also includes requirements and guidance related to misstatements of individual accounting estimates and indicators of possible management bias.

11.65 Many fair values will be based on valuations by independent appraisers. In applying audit procedures to real estate, the auditor often relies on representations of independent experts, particularly appraisers and construction consultants, to assist in the assessment of real estate values. AU-C section 500, Audit Evidence, addresses the auditor's use of the work of an individual or organization possessing expertise in a field other than accounting or auditing whose work in that field is used by the entity to assist the entity in preparing the financial statements (defined as a management's specialist).

11.66 If information to be used as audit evidence has been prepared using the work of a management’s specialist, paragraph .08 of AU-C section 500 states that the auditor should, to the extent necessary, taking into account the significance of that specialist’s work for the auditor’s purposes,

a.     evaluate the competence, capabilities, and objectivity of that specialist;

b.     obtain an understanding of the work of that specialist; and

c.     evaluate the appropriateness of that specialist’s work as audit evidence for the relevant assertion.

11.67 Information regarding the competence, capabilities, and objectivity of a management’s specialist may come from a variety of sources, such as knowledge of that specialist’s qualifications, membership in a professional body or industry association, license to practice, or other forms of external recognition (a listing of additional sources is addressed in paragraph .A39 of AU-C section 500). Further application and explanatory material regarding the reliability of information produced by a management’s specialist is addressed in paragraphs .A35–.A49 of AU-C section 500.

11.68 As addressed in the preceding paragraphs, independent appraisals may be considered acceptable audit evidence. The quality of appraisals varies, however, and, in some instances, the auditor may have reason to believe certain assumptions underlying appraisals are unrealistic. Some matters that should be considered by the auditor when evaluating an appraisal are

     a rise or decline in a particular market area not reflected in an appraisal may warrant that additional procedures, or perhaps a new appraisal, be performed;

     if the date of appraisal is substantially earlier than the audit date, a rise or decline in a particular market area between the two dates may warrant a new appraisal or the performance of additional procedures;

     appraised values should be based on current market conditions and must be discounted for costs to complete and sell; and

     the estimated selling prices should reflect the expectations of a sale in the reasonably near future — not in an indefinite future period.

11.69 In periods of declining real estate values, management might consider implementing policies and procedures that address

     its process for evaluating appraisals that are not as of the balance sheet date to determine whether an adjustment to the appraised value is needed to reflect declines in fair value that are not reflected in the appraisals.

     circumstances in which an updated appraisal should be obtained and the process for obtaining an updated appraisal.

Depending on materiality and level of inherent risk the auditor may also engage its own experts to review appraisals obtained by management or perform independent appraisals of collateral.

11.70 Because of time and cost considerations, an institution may use various approaches to estimate value without using the services of an independent appraiser. In evaluating internally derived valuation data, the auditor should understand the methods and assumptions used and the qualifications of the individual performing the evaluation and should be aware of inherent subjective determinations in estimating value that may be significant to the valuation process. The auditor should consider the reasonableness of the assumptions and approach used and should test the information underlying the valuation. Further, the auditor may decide to engage an appraiser independent of the institution to test the institution's internally derived valuation. Despite the existence of an appraisal, in certain situations the auditor may wish to physically observe properties for the stage of completion, for deterioration, or for estimating the extent of occupancy.

11.71 The auditor should also evaluate whether significant real estate transactions qualify as sales in conformity with criteria set forth in FASB ASC 360-20-40.

11.72 Other foreclosed assets. The procedures discussed previously may be applied to other foreclosed assets to the extent that the auditor deems necessary.

Notes

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