While OREO is not a new concept for financial institutions, from 2020 to 2024, OREO foreclosure transactions were relatively infrequent. A recent rise in the number of distressed properties and quicker asset dispositions has led to consistent double-digit increases in year-over-year foreclosure auction activity.
As a result, it is important for financial institution leadership to revisit guidance on how to accurately categorize and report OREO assets’ fair value, on-going valuation, and any income or loss resulting from a sale. If your institution has OREO on the books, this article is for you.
Accounting for transfer into OREO
OREO is generally considered to be acquired when the institution receives possession (physical possession or control) of foreclosed or repossessed property. In general terms, for residential real estate, the loan commonly should be classified as OREO once a Sherriff Sale is completed, even if there is a redemption period. Legal definitions of when possession or control is considered to transfer can also vary by state. The value of the property must be initially recorded at its fair value, less estimated costs to sell the property at the time it is moved into OREO. Any reductions in the loan balance at transfer are recorded as a charge-off to the allowance for credit losses (ACL). This adjusted “fair value” amount becomes the asset’s new cost basis. If the fair value of the assets exceeds the loan balance, a gain could be recognized. Therefore, it is prudent to challenge the assumptions used in determining the fair value to ensure that a gain truly does exist.
Accounting for the sale of OREO
Developed by the Financial Accounting Standards Board (FASB), Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers, was effective for non-public companies in 2019, providing clearer accounting guidance to evaluate and report foreclosed properties. However, as noted above, from 2020 to 2024, OREO foreclosure transactions were relatively infrequent, so many institutions did not need to regularly evaluate these transactions under ASC Topic 606.
When an OREO property is sold, the financial institution must evaluate the transaction under the five steps of ASC 606, to ensure the transaction meets the requirements to be considered a sale. It is important to evaluate the buyer’s ability to pay the agreed upon sales price. If full consideration is received from the buyer and all security interest is transferred at the time of the sale, then revenue and any gain or loss can generally be recorded at the time of the sale. If the sale is internally financed and there is uncertainty about the buyer’s ability to repay, then it is possible that the gain or loss will not be recorded at the time of the sale.
No two sales are the same, so it is important that each sale is evaluated individually under ASC 606.The bottom line
- Accurate initial valuation of a foreclosed or repossessed property is critical to accurate accounting at the time the property is deemed to be acquired and subsequent reporting.
- An institution can recognize the entire gain or loss of an OREO sale only when control of the property fully transfers to the buyer, such as through a duly recorded title transfer.
- If an institution provides the buyer with financing but retains significant continuing involvement or does not pass full control of the OREO asset to the buyer, then the transaction may not qualify for “sale accounting” and payments are treated as a deposit liability until sale criteria are met.
Key Consideration of Board Oversight
As part of their overall oversight and discussions of OREO, directors may consider the following questions:
- Who is responsible for transactions in this area and does the accounting team have insight into the activity?
- What types of valuations are being obtained and frequency to ensure it is truly reflective of current market value?
- Are we seeing an increase in OREO because of isolated situations, or is it an early indicator of broader credit deterioration?
- Have our policies, people, systems, controls and third-party resources kept pace with the increase in OREO activity.
OREO accounting requirements can be complex. We can streamline valuations and advise your institution on the development and implementation of accurate accounting processes and controls. Contact Kevin Frank at [email protected] or 989-797-8346 for more information.