Organizations looking to amend the terms of their financing arrangements need to address common financial reporting complexities for debt modifications.
Even with many of the worst predictions for 2023 not having yet come to fruition, significant uncertainties continue to loom on the economic horizon. While many hope the Federal Reserve (Fed) navigates a “soft landing,” which would include bringing down inflation while avoiding a downturn of the economy, significant headwinds continue to cause uncertainty about the Fed’s ultimate decisions and resulting impacts. Aside from these policy matters, labor shortages and more recent strikes stand to threaten an already fragile supply chain, which would have ripple effects into many sectors. Real estate is not immune – decreasing occupancy rates in certain asset classes, coupled with volatility in interest rates, lead to tighter capital markets and lenders who today might view certain investments different from how they viewed those investments a few short years ago.
What this means for real estate
Because of these factors, real estate organizations should expect a higher-than-normal volume of loan modifications throughout the next six to 12 months:
- Some commercial property owners might need to modify existing loan terms to alleviate financial distress, which could include agreeing to revised terms that defer or forgive certain principal and interest payments, reducing the stated interest rate, or changing debt covenants or collateral requirements, among other things.
- Other owners or companies that are on solid footing might modify their debt arrangements to procure additional financing for development, acquisitions, or other strategic initiatives.
- Still others might prioritize refinancing because of uncertainty about the future direction of interest rates.
Why debt modification accounting is complex
The accounting rules governing debt modifications are notoriously complex, and failure to apply the rules correctly can lead to material errors. Notably, an entity’s accounting for a debt modification often relies heavily on specific facts and circumstances of the transaction. That is, certain scenarios are inherently more difficult to account for than others. The following complexities of debt modification accounting are prone to error:
1. Debt modifications involving multiple lenders
When a borrowing arrangement involves multiple lenders, accounting for the modification is done on a lender-by-lender basis (for example, in a syndicated loan scenario). Frequently, commercial real estate loans are structured as syndicated loans; consequently, entities need to be aware of the loan structure and lender parties of the old and revised debt when accounting for a debt modification in order to avoid inadvertently analyzing the debt modification in the aggregate instead of on a lender-by-lender basis.
2. Debt modifications involving multiple instrument types
Modifications of borrowing arrangements that involve multiple instruments – such as term loans, revolving lines of credit, and warrants – can require a complex assessment of the correct unit of analysis and the appropriate accounting framework.
One challenging scenario that we see frequently in practice is when credit arrangements include both term loans and revolving credit arrangements while also involving multiple lenders. The accounting guidance outlines separate models for troubled debt restructurings (TDRs) as well as for nontroubled modifications to term loans and revolving credit loans, but it does not explain how a borrower would account for a modification of a credit facility that contains multiple instrument types and multiple lenders. Given that lack of guidance, here are some items borrowers should consider when analyzing such a modification:
- Departing lenders. If the modification involves the removal of a lender from the credit facility, extinguishment accounting should be applied to that component of the credit facility.
- New lenders. If the modification involves the addition of a new lender (that is, the lender was not initially involved with the facility), then the portion held by the new lender should be treated as a new debt instrument.
- Continuing lenders. Accounting for lenders that were involved both before and after the modification will depend on the individual facts and circumstances. For example, if the restructuring with a continuing lender was done under troubled circumstances and involved a concession granted by the lender, the totality of the revised debt might need to follow the rules for TDRs (see “Determination of the accounting scope” later). On the other hand, for a nontroubled modification of debt with a continuing lender, the 10% cash flow test is used to determine the accounting when term debt exists both before and after the modification or when term debt is replaced with revolving debt. For a nontroubled modification with a continuing lender involving revolving loans before and after the modification or revolving loans that are replaced with term debt, the debtor uses a borrowing capacity test to determine the accounting.
3. Debt modifications involving related-party creditors
These modifications require careful analysis to determine whether a restructuring or extinguishment gain that otherwise would affect the income statement is, in substance, a capital transaction.
4. Identification of lender fees and third-party costs
Fees paid to a syndication or administrative agent in a debt modification or debt issuance can be significant. When the syndication agent also is a lender in the debt arrangement, careful analysis is required to assess if some or all of the fees paid to the syndication agent might represent a third-party cost.
5. Determination of the accounting scope
U.S. GAAP guidance covering debt modifications is located in two places. Subtopic 470-60 covers TDRs, and Subtopic 470-50 covers modifications that aren’t of a troubled nature. Getting the accounting scope right can help entities avoid errors in reporting gains or losses that otherwise might not be permitted. However, determining the scope can be complex.
- TDRs – “financial difficulty” criterion. To determine if a debt modification is a TDR, it is important to understand the underlying reasons for the modification, including whether the borrower is experiencing financial difficulty. Accounting teams should avoid overreliance on a single factor to assert that the debtor is or is not experiencing financial difficulty. That is, significant judgment might be needed to make this determination based on the facts and circumstances that existed at the restructuring date.
- TDRs – “concession” criterion. Determining if a concession was granted in a possible TDR is not as simple as comparing the coupon rate of the debt before and after the restructuring. The concession criterion requires accounting teams to compare the effective borrowing rate based on the terms of the restructured debt to the effective borrowing rate of the old debt immediately before the restructuring. The effective borrowing rate could be influenced by premiums or discounts, such as those caused by proceeds allocated to bifurcated derivatives or other freestanding financial instruments (for example, warrants), or by fees paid to the creditor.
Under U.S. GAAP, a TDR represents a scenario in which, for legal or economic reasons, a lender agrees to grant to a borrower that is experiencing financial difficulties a concession that it otherwise would not consider – for example, full or partial forgiveness of certain principal or interest payments or a reduction of the stated interest rate. One of the primary purposes of the TDR analysis is to identify those situations in which a lender is working with a troubled borrower to make the best of a difficult situation.
6. Multiple modifications within a 12-month period
Accounting teams should review the totality of changes to the debt arrangement over the preceding 12 months rather than individually analyzing each incremental modification in order to properly assess the substance of those changes.
7. 10% cash flow test for non-TDR modifications of term loans
The accounting for non-TDR modifications of term loans requires an entity to determine whether the revised terms are substantially different (that is, greater than a 10% difference in cash flows) from the original debt terms and, therefore, represent an extinguishment of the original debt. In an extinguishment, the debtor recognizes a gain or loss upon derecognition of the old debt and initial recognition of the revised debt. In contrast, an exchange or modification that is not accounted for as an extinguishment is accounted for prospectively, with no gain or loss recognized, by adjusting the effective interest rate through the remaining term of the debt. Performing the 10% cash flow test can be difficult. Some complexities might include:
- Fees exchanged between the borrower and lender. In addition to capturing changes to future principal and interest payments, an entity should verify that its analysis captures any fees exchanged between the borrower and lender attributable to changes in debt covenants, collateralization requirements, and recourse features, among other things. These fees generally would be considered up-front cash flows in the 10% test.
- Changes in principal amount. Additional borrowings resulting from the modification should be treated as a cash inflow in the 10% test, while repayments made in connection with the modification are treated as a cash outflow.
- Rights to prepay the debt. If the original or modified debt instrument is callable or prepayable, then the borrower should prepare separate cash flow analyses assuming both exercise and nonexercise of the options, regardless of the entity’s ability to prepay the debt. The borrower would then use the analysis that generates the smallest change for purposes of the 10% test.
- Variable interest rates. If the original or modified debt instrument has a variable interest rate, then the variable interest rate in effect at the date of the modification should be used to forecast future interest payments.
- Exchanges of noncash consideration. In some modifications, the borrower might issue noncash consideration to the lender as part of the modification (for example, either shares or warrants on the borrower’s shares). When a borrower exchanges noncash consideration to the lender as part of a modification, the fair value of the noncash consideration should be treated as an up-front cash flow in the 10% test.
All applicable changes in cash flows exchanged between the lender and debtor should be included in the analysis, including fees paid to the lender (as well as those related to covenant waivers), changes in principal on the modification date, revised interest payments, revised principal payments, and the fair value of any warrants or sweeteners granted to the lender.
Beyond accounting for the revised nature, timing, and amount of cash flows of the debt arrangement, sometimes the debtor must analyze whether new or revised embedded features associated with the debt arrangement – such as a conversion feature, redemption feature, or contingent interest provision – require separate accounting as, for example, a derivative instrument. Additionally, new, removed, or revised conversion features might affect a debtor’s conclusion about whether the modification transaction represents an extinguishment.
8. Line-of-credit or revolving debt arrangements
Modifications of these debt instruments follow an accounting analysis different from that for term debt. A modification of a line-of-credit or revolving debt arrangement requires a comparison of the borrowing capacity under the old and new terms. This assessment is prone to error if the borrowing capacity (the product of the remaining term and maximum available credit) is miscalculated.
Accounting for debt modifications is heavily dependent on the facts and circumstances of the transaction, and knowing where to start can be difficult. Real estate organizations might find it helpful to turn to a team of specialists to help them understand how guidance in Subtopics 470-50 and 470-60 applies to strategic changes in their debt arrangements.