New Guidance and Clarification on Troubled Debt Restructuring

Few borrowers have come through the economic downturn unscathed. Some are more battered and bruised than others, but one of the consistent consequences of the recession has been a dramatic increase in the volume of loan modifications for borrowers.

The Financial Accounting Standards Board (FASB) noted divergence in practice when determining which loan modifications constitute a troubled debt restructuring (TDR).

FASB issued an exposure draft in October 2010, and in April 2011, it issued Accounting Standards Update (ASU) No. 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.

Possible Impact on Financial Statements

When implemented, ASU 2011-02 will change how some financial institutions evaluate whether a loan modification constitutes a TDR. Since U.S. GAAP requires a specific impairment-measurement method and disclosures for receivables that are part of a TDR, the new standard could have a significant impact on the financial statements of some lenders.

FASB has stated that ASU 2011-02 was issued to help provide clarity when determining whether a creditor has granted a "concession" and whether a debtor is experiencing "financial difficulty," for purposes of determining whether a loan modification constitutes a TDR.

Under the updated standard, a loan modification is considered to be a TDR when the creditor, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider.

Two conditions must be present for a loan modification to be considered a TDR:

The creditor must grant a concession, and
The borrower must be experiencing financial difficulty

Clarification of Concessions

ASU 2011-02 clarifies guidance on whether the creditor has granted a concession. Indicators that a concession has been granted may include:

If the borrower does not otherwise have access to funds at a market rate for debt with similar risk characteristics as the restructured debt. This means that the borrower wouldn’t normally qualify for the same financing terms elsewhere.
A temporary or permanent increase in the interest rate as a result of a restructuring could still be considered a concession granted by the lender if the new interest rate is still below the market interest rate for new debt with similar risk characteristics.
More than insignificant payment delays. When considered together, these factors may indicate insignificant payment delays that do not constitute a TDR:
- The amount of the restructured payments subject to the delay is insignificant relative to the unpaid principal or collateral value of the debt, and will result in an insignificant shortfall in the contractual amount due.
- The delay in timing of the restructured payment period is insignificant relative to the frequency of payments due under the debt, the debt’s original contractual maturity or the debt’s original expected duration.

In the past, a delay in payment of 60 to 90 days could be considered insignificant. Now an institution must look at the frequency of payments and the term of each delay. A 90-day delay may be considered more significant on a loan with a two-year term than on a loan with a 30-year term.

If the debt was already restructured and is now being restructured again, the creditor should consider the cumulative effect of the past restructurings when determining whether the most recent delay in payment is insignificant. This is important because the creditor may have determined that the original payment delay was insignificant and has therefore not reported it as a TDR. However, if the borrower needs to extend the payment period again or requires additional payment delays, the cumulative effect may now be considered significant and needs to be reported as a TDR.

Examples of a creditor’s evaluation about whether a delay in payment resulting from a restructuring is insignificant are included in the ASU, which can be found on the FASB website.

Clarification of Financial Difficulty

ASU 2011-02 clarifies guidance on whether the debtor is experiencing financial difficulties. The following conditions may be considered indications of financial difficulty by the borrower:

A borrower may have financial difficulty, even though the borrower is in default on other loans, but not currently in payment default with your financial institution
The borrower is currently delinquent on any of its debt (within or outside of the financial institution). An institution may have knowledge of derogatory credit information that could impact the borrower’s ability to pay the debt in the foreseeable future.
The borrower has declared or is in the process of declaring bankruptcy.
There is substantial doubt as to whether the borrower will continue to be a going concern.
The borrower has securities that have been delisted, are in the process of being delisted or are under threat of being delisted from an exchange.
The institution forecasts that the borrower’s cash flows will be insufficient to service existing debt for the foreseeable future.
Without the current modification, the borrower cannot obtain funds from other sources at the same rate as a nontroubled borrower (i.e., if the borrower wouldn’t normally qualify for the same financing terms elsewhere).

Financial institutions will have to look at the borrower’s financial condition and ability to pay which should entail:

Gathering current financial statements or records
Pulling a credit report
Performing or reviewing forecasts or projections

In theory, if the restructuring is outside of the institution’s current policies and outside of industry guidelines (i.e., terms, rates, loan-to-values, etc.), then it most likely would be considered a TDR.

Effective Interest Rate Test

The ASU also precludes an institution from using the borrower’s effective interest rate test (as defined in Accounting Standards Codification (ASC) 470-60-55-10) in determining whether a restructuring constitutes a TDR. Even if an institution has used this test in the past, it is no longer a valid method for determining the nature of a restructuring.

Effective Date

ASU 2011-02 is effective for nonpublic entities for annual periods ending on or after Dec. 15, 2012, and should be applied retroactively to the beginning of the annual period of adoption. In order to accurately identify and report TDRs, as well as capture annual TDR activity for year end disclosures, private institutions should apply the new guidance starting on Jan. 1, 2012 (for institutions with a December 31 fiscal year end). Early adoption is permitted.

Early communication between the accounting and lending departments and proper documentation of conclusions are the best ways to ensure that all loans that have been modified have been evaluated for inclusion as a TDR. This will help ensure accurate reporting of interim and year-end earnings, and examiners and investors can have continued confidence in the financial reporting of financial institutions as they address the needs of the current financial environment.

Disclaimers

If you would like to be removed from our mailing list, please e-mail us.