Due to the inherent risks in a credit-granting environment, it is probable that some loans will not be collected in full. A loan is impaired when it is likely, in the prevailing conditions, that a creditor will be unable to collect all amounts due (Principal and Interest) according to the original contractual terms of the loan agreement. The lender feels that there is no evidence to suggest that the debt could be collected based on the borrower’s financial and credit status.
In accordance with the rules of Generally Accepted Accounting Principles (GAAP), a lender must report the debt as impaired on any of its financial statements. This gives customers, investors and credit raters a complete picture of the lender’s financial standing. The amount of impairment can be calculated by subtracting the amount expected to be recovered on the loan from the initial book amount of the loan. For example, the original amount of a loan was $500,000. However, the lender expects to recover only $230,000. The impairment amount would then be $270,000.
It is important to look for early signs that indicate a loan may become impaired. Managing impaired loans requires special attention. When a loan becomes impaired, a lender can pursue either restructuring or foreclosure. In the case of Troubled Debt Restructuring, the creditor grants a concession to the debtor owing to economic or legal reasons related to the debtor’s financial difficulties. Such a concession may arise from a mutual agreement between the creditor and the debtor or it may be imposed by law or court. This may involve debt rescheduling and/or conversion of a portion of debt into equity.
Troubled Debt Restructuring gives a debtor more flexibility to meet loan payments. A debtor may obtain funds from sources other than the existing creditor in a troubled debt restructuring. A debt may be restructured due to a variety of circumstances. For example, if a creditor feels that the market rates have decreased and the debtor can borrow money elsewhere at a lower rate, he may reduce the effective rate. The lender’s objective, here, is to reduce the amount of impairment by recovering the largest possible amount from the borrower.
The second option for a lender is to foreclose on collateral to recover from impairment. The lender may, in fact, profit on the debt if the asset is valued higher than the impaired amount of the loan.