Understanding the Accounting Treatment when a Debtor Enters into a Loan Modification Agreement with its Financial Institution
June 04, 2020
By Steven Heumann
On March 22, 2020, financial institution regulators released guidance for financial institutions and their customers in response to the COVID-19 pandemic titled Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus. Specifically, this guidance encourages financial institutions to work prudently with borrowers and to describe the agencies’ interpretation of how current accounting rules under accounting principles generally accepted in the United States (U.S. GAAP) apply to certain COVID-19-related loan modifications. The agencies have confirmed with staff of the Financial Accounting Standards Board (FASB) that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief, are not troubled debt restructurings (TDRs). This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant.
Then on April 7, 2020, financial institution regulators released an update to the earlier guidance titled, Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus (Revised). Included in the update was that on March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was signed into law. In addition, the revised Interagency Statement clarifies the interaction between the March 22, 2020, Interagency Statement and section 4013 of the CARES Act, Temporary Relief from Troubled Debt Restructurings (section 4013), as well as the agencies’ views on consumer protection considerations and accounting and reporting considerations for loan modifications.
Both Interagency Statements focus on the accounting for the creditor (the financial institution who is making the loan), which is addressed in ASC 310-40, Receivables—Troubled Debt Restructurings by Creditors. However, neither of the Interagency Statements provide any guidance on the accounting treatment from a debtor’s perspective.
So let’s discuss the accounting implications from the debtor’s/company’s perspective when their debt loan agreements have been modified. There is no change under U.S. GAAP in the accounting guidance from a debtor’s perspective. For a debtor, under U.S. GAAP, they must first determine if the modification is considered a TDR. If it is not a TDR, the company must then determine if it is a modification or an extinguishment. As discussed later below, the accounting treatment is different between a modification and an extinguishment.
The Definition of a TDR:
Based on ASC 470-60, Troubled Debt Restructurings by Debtors, a modification is determined to be a TDR if the debtor is experiencing financial difficulty and has received a concession from the lender. A lender is considered granting a concession when the effective borrowing rate on the restructured debt is less than the effective borrowing rate on the original debt. The effective borrowing rate of the restructured debt is calculated by solving for the discount rate that equates the present value of the cash flows under terms of the restructured debt to the current carrying amount of the original debt. The revised Interagency Statement discusses interest rate concessions, payment deferrals, or loan extensions. Accordingly, these would be considered a concessions provided by a financial institution (lender). Determining whether modifications to a debt agreement constitute a TDR, so care should be taken when analyzing and concluding upon this.
What Is the Accounting for a TDR?
The accounting for a TDR depends on the type of restructuring. For purposes of this article, we are going to focus on modifications that result in a TDR. This restructuring type is accounted prospectively. The accounting depends on the future undiscounted cash flows generated under the restructured debt as follows:
- If the future undiscounted cash flows required under the restructured debt are greater than the net carrying amount of the original debt prior to the restructuring, then no gain or loss are recognized and there is no adjustment to the carrying amount of the debt. A new effective interest rate is established based on the carrying value of the original debt and the revised cash flows.
- If the future undiscounted cash flows required under the restructured debt are less than the net carrying amount of the original debt prior to the restructuring, a gain is recognized by the debtor equal to the carrying amount of the debt in excess of future cash payments. Subsequently, all cash receipts and payments under the terms of the restructured debt agreement, whether designated as interest or as face amount, reduce the carrying amount of the debt and no interest expense is recognized.
Accounting for Modifications or Extinguishments not Considered a TDR
Companies have to follow ASC 470-50, Modifications and Extinguishments. Under ASC 470-50, modifications and exchanges that are not considered TDRs are accounted for as either (1) an extinguishment (if the terms are substantially different) or (2) a modification. Substantially different means that if the present value of the cash flows under the terms of the new debt instrument is at least 10% different from the present value of the remaining cash flows under the terms of the original instrument (commonly referred to as the “10% cash flow test”). Below is a summary of the accounting treatment between an extinguishment and a modification:
- If the present value of the cash flows under the terms of new debt instrument is at least 10% different from the present value of the remaining cash flows under the terms of the original debt instrument, the debtor accounts for the transaction as a debt extinguishment. The original debt is derecognized and the new debt is recorded at fair value, with the difference recognized as an extinguishment gain or loss. New fees paid to or received from the existing lender are included in the calculation of the gain or loss. New costs incurred with third parties directly related to the modification (such as legal fees) are capitalized as deferred debt issuance costs associated with the new debt and amortized over term of new debt using the effective interest method. Previously deferred fees relating to the existing debt are included in calculation of gain or loss.
- If the present value of the cash flows under the terms of the new debt instrument is less than 10% from the present value of the remaining cash flows under the terms of the original debt instrument, the debtor would account for the transaction as a debt modification. New fees paid to or received from the existing lender are reflected as additional debt discount and amortized as an adjustment of interest expense over the remaining term of the exchanged or modified debt using the effective interest method. New costs incurred with third parties directly related to the modification (such as legal fees) are expensed as incurred. Previously deferred fees related to the existing debt are amortized as an adjustment of interest expense over remaining term of exchanged or modified debt using the effective interest method.
In the wake of the COVID-19 outbreak, many financial institutions are modifying loan terms for the benefit of the debtor. As a result, these modifications may or may not significantly change the subsequent cash flows of the debtor, which impacts the determination on whether the accounting treatment is either a TDR, a modification or a debt extinguishment