Ultimately, to properly account for modifications to debt agreements, it’s important to know which questions to ask and what complexities might arise along the way. To help borrowers better understand some of the accounting issues that might accompany their modification of debt arrangements, we address several common questions about debt modifications.
As a borrower, why do I have to consider whether my modification is a troubled debt restructuring (TDR)? What’s so important about the TDR designation?
Under U.S. GAAP, a TDR represents a scenario in which, for legal or economic reasons, a lender agrees to grant to a borrower who is experiencing financial difficulties a concession that it would not otherwise 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. In these situations, the Financial Accounting Standards Board (FASB) requires that a separate accounting model be used under which the modified debt arrangement generally would be treated as the continuation of the old debt arrangement – subject, of course, to the type of restructuring (for example, full termination of the debt versus solely a modification of the debt terms).
Given the differences in the accounting requirements applicable to TDRs versus other types of modifications, failure to properly classify a debt modification as a TDR could result in:
- Inappropriate recognition or measurement of a gain or loss upon modification of the debt arrangement
- Inappropriate recognition of future interest expense on the modified debt arrangement
- Inappropriate accounting of legal fees and other direct costs incurred in connection with the modification
What are some complexities that could arise if I determine my debt modification is, in fact, a TDR?
The proper accounting treatment for a TDR is driven by the form of the modification. Some modifications might involve modification of terms only, whereas others might include partial satisfaction of the debt balance in connection with modification of debt terms. ASC 470-50 provides guidance for each type.
However, in some circumstances, the nature of the modification can give rise to several complexities when applying the TDR guidance. Here are just a few examples borrowers should be aware of:
- Variable interest rates. If future payments on the modified debt can fluctuate based on changes in a variable interest rate, an entity should estimate the maximum total future cash payments based on the variable interest rate (for example, LIBOR) in effect at the time of the restructuring when determining whether future cash flows exceed the current carrying amount of the debt.
- Put and call features. If the number of future interest payments is not determinable because the modified debt is payable on demand, then an entity should estimate the total future cash payments based on the maximum number of periods that payments might possibly be made by the debtor when determining whether future cash flows exceed the current carrying amount of the debt. Similarly, prepayment provisions would be ignored when estimating total future cash payments.
- Contingent payments. Some modifications include provisions that require future payments from the borrower when certain conditions are met in the future. As a general rule, no gain would be recognized on a modified debt arrangement that involves contingent payments as long as it is possible, without considering the probability of the contingency, that the maximum total future cash flows exceed the carrying amount of the debt arrangement at the date of the modification.
I’ve concluded that my debt modification is not a TDR, and I am now trying to determine if the modification should be treated as an extinguishment or as a continuation of the old loan. What are some complexities that can arise in making this assessment?
To determine how to account for a debt modification that is not a TDR, an entity must assess whether the terms of modified debt instrument and the original debt instrument are substantially different. Under U.S. GAAP, the terms would be considered “substantially different” when the present value of the cash flows under the terms of the modified debt instrument is at least 10% different from the present value of the remaining cash flows under the original debt instrument.
Several complexities that might arise when performing this “10% test” 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 would generally be considered upfront cash flows in 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. Borrowers don’t have to project what the interest rate could be over the life the modified debt.
- Exchanges of noncash consideration. In some modifications, the borrower might issue noncash consideration to the lender as part of the modification (for example, warrants on the borrower’s common shares). When a borrower exchanges noncash consideration to the lender as part of a modification, we believe that the fair value of the noncash consideration should be treated as an upfront cash flow in the 10% test.
- Considering prepayment features. 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. The borrower would then use the analysis that generates the smallest change for purposes of the 10% test.
- Multiple modifications in a 12-month period. If the debt agreement has been modified multiple times during a 12-month period, then the current 10% test should be based on a comparison of the modified terms and the terms that existed just prior to the earliest modification occurring 12 months ago.
- Embedded conversion features. If the original debt instrument has an embedded conversion feature, then additional analysis by the borrower is required. For example, in addition to performing the 10% test, the borrower would be required to compare the change in the fair value of the conversion option to the carrying amount of the premodified debt. Borrowers also need to consider if a substantive conversion feature is added or eliminated in the modification.
How should I analyze a debt modification when my current debt arrangement involves multiple lenders?
Two common scenarios in which a debt modification might involve multiple lenders are loan syndications and loan participations. In a loan participation, the debtor borrows from a lead lender who then typically would issue participating interests in the loan to other third parties. These interests could take the legal form of either assignments or participations. In a loan syndication, each lender loans the borrower a specific amount and has the right to repayment from the borrower. In syndications, separate debt instruments exist between each lender and the borrower, even when one lender has been identified as the lead lender.
For a loan participation, the borrower analyzes the debt modification between itself and the lead lender because the lead lender is the only party with legal rights against the borrower.
By contrast, for a loan syndication, the debt modification guidance should be applied on a lender-by-lender basis, even if a lead lender has been identified.
In some cases, a borrower might need to apply judgment to determine if its debt arrangement is more akin to a loan participation or a loan syndication.
I understand that the modification analysis for revolving lines of credit differs from the analysis used for term debt. What do I need to consider if I am modifying a credit facility that includes both a revolving line of credit and term debt?
Credit arrangements can include both term loans and revolving credit arrangements. While the accounting guidance outlines separate models for modifications to term loans and revolving credit loans, it does not explain how a borrower would apply the two accounting models when a modification is made to a credit facility that contains both.
Given that lack of guidance, here are some items borrowers should consider when analyzing the modification of a credit facility that involves both term debt and a revolving line of credit:
- 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 continuing lender held only term loans both before and after the modification, then the 10% test would apply.
Where can I learn more about the accounting guidance for debt modifications?
In October 2020, the FASB issued a Staff Educational Paper that provides a summary of a borrower’s accounting for debt modifications. While not all-encompassing, the document provides “an overview of the accounting guidance for common modifications to and exchanges of debt arrangements and illustrative examples of common debt modifications and exchanges.”
Navigating the accounting for debt modifications
Crowe accounting professionals have deep expertise in the accounting for debt modifications, including those that represent troubled debt restructurings. We can help you think through the accounting complexities that might apply to your situation, develop and implement policies and procedures that can stand up to an audit, and prepare required disclosures for your financial statements.
