Other real estate owned (OREO), also referred to as other real estate (ORE) or real estate owned (REO), is a bank-owned asset that isn’t included with property, plant, and equipment (PP&E) and requires specialized accounting.
Decades-old guidance that many practitioners used during their careers to evaluate OREO transactions for sales treatment are no longer in place, and new processes and controls must be used to ensure proper conclusions are reached by selling institutions from the start.
An overview of key elements of the guidance follows.
Previous Accounting Guidance
Accounting guidance previously lived under Accounting Standards Codification (ASC) Topic 310-40 Troubled Debt Restructurings by Creditors, and ASC Topic 360-20, Property, Plant, and Equipment.
Under these topics, internally financed transfers of foreclosed real estate were evaluated for sales treatment qualification. This was primarily determined if the amount of initial consideration paid by the buyer was sufficient to meet the initial investment measurement standards, generally ranging from 10%–20%, depending on the nature of the asset. Such transactions were also evaluated for continuing involvement by the seller.
New Accounting Guidance Under ASC 606 for Sales of OREO
ASC Topic 610, Other Income and ASC Topic 606, Revenue from Contracts with Customers offer new sources of guidance.
ASC 606 Adoption
ASC 606 has been adopted by all public and nonpublic financial institutions; the preexisting prescriptive guidance requiring a specified down payment no longer applies.
In place of prescriptive guidance, principles requiring significant judgments now drive conclusions about whether internally financed transactions to transfer foreclosed real estate qualify as transfers and sales, and thus revenue recognition.
While some new concepts exist in ASC 606 that are relevant, such as elements of a contract and fixed versus variable consideration, many elements driving conclusions about revenue recognition mirror those principles used by institutions in the credit underwriting process to evaluate credit worthiness of potential borrowers.
However, this means significant judgment now enters the determination of whether an internally financed transfer of foreclosed real estate represents a sale.
Evaluating Whether a Sale of OREO Occurred
A financial institution will have a sale with full gain or loss recognition and derecognition of the OREO if the transaction meets ASC 606 requirements. The institution will continue reporting the OREO as an asset until it meets the requirements.
Several key judgments should be evaluated in each OREO transaction, including, but not limited to:
- If all elements of a contract are met
- If the buyer has the ability and intent to pay the contracted transaction price, particularly in circumstances involving minimal initial consideration
- If financing terms are reasonable and customary
- If there are other elements to the transaction that represent transferred consideration by either the seller or the buyer
- If initial consideration paid by the buyer or borrower originated from outside funds or from other credit facilities financed by the seller, such as an operating line of credit
Contractual Obligations and Controlling Financial Interest
Topic 606 enumerates the five steps of the revenue recognition process, and two of the more significant and interrelated elements related to transfers of foreclosed real estate.
That includes evaluating when both parties’ obligations will likely be met, and at what point the real estate transfer is when the seller has no financial interest in the property.
Circumstances that the seller should evaluate to determine the buyer’s intent and ability to meet their obligations under the contract can be broken into the following categories:
- Transactional considerations
- Borrower considerations
- Collateral considerations
Transactional elements to consider are:
- The amount, timing, and source of the initial down payment
- If any recourse provisions exist
- If there’s any contingent consideration
- If there were payments made by the buyer to third parties that would customarily be paid by the seller
Consider the borrower’s credit standing and the net worth, looking at liquidity and income in terms of amounts and stability.
The seller should consider the collateral of the property—its marketability, age, location, and other desirable qualities, and the amount and quality of the cash flow expected to be generated from it.
Think of the commercial substance of the transaction first, then the borrower’s intent and ability to satisfy contractual obligations.
Revenue can be recognized, in general, when it’s probable that the buyer will satisfy their obligations under the contract and there’s been a transfer of effective control of the property to the buyer.
Effective control usually will be shown with successful transfer of the title. However, if it’s unlikely that the borrower will perform their contractual obligations—pay the loan—and the seller retains a security interest in the property they can execute in a default, the presumption of effective control that would otherwise be met with physical transfer of the title may not be met.
As a result, significant documentation should be prepared by the seller to evaluate the borrower’s intent and ability to meet their contractual obligations.
Fixed Versus Variable Consideration
If a contract includes fixed and variable consideration, additional analysis must be performed by the selling institution to estimate the total consideration against which the carrying value of the foreclosed real estate transferred would be measured to determine the amount of gain or loss at the time of sale.
Additional Factors to Consider
Institutions can consider a variety of elements when evaluating internally financed sales of foreclosed real estate.
These factors didn’t require the same level of scrutiny under legacy accounting standards:
- Fixed and variable consideration
- Market value of the real estate
- If equity interests or beneficial interests are retained by the seller in the real estate
- If there are any ongoing obligations by the seller to maintain the property
- If the terms of the loan are below-market
- If related parties are involved in the transaction
Institutions selling foreclosed real estate have much to evaluate beyond the amount of the down payment provided by the buyer.
It’s important for accounting departments to also modify internal controls to prevent erroneous conclusions.
We’re Here to Help
If you have questions about new accounting guidance under ASC 606, contact your Moss Adams professional. You can also visit our Financial Services Practice page for more resources.