Many banking industry participants and analysts anticipate that the publication of Accounting Standards Update (ASU) 2011-02 earlier this year will result in additional loans being reported as troubled debt restructurings (TDR). While this outcome may be true, the update's stated purpose was to address perceived diversity in practice and concerns associated with comparability of financial information. As such, the update does not change the principal definition of a TDR, but rather attempts to provide additional clarity.
ASU 2011-02 reiterates that a restructuring of a debt constitutes a TDR if the creditor—for economic or legal reasons related to the debtor's financial difficulties—grants a concession that it would not otherwise consider. The update expands on how the standard defines identifying when a borrower is experiencing financial difficulties as well as when a concession has been granted. Moreover, the revision introduces significance in the determination of a concession, prohibits a creditor's use of debtor TDR determinants and also alters disclosure requirements.
Determining if a creditor is experiencing financial difficulties continues to require a significant amount of professional judgment. However, previously issued accounting literature provided some key indicators, including the following:
The update further expands the first indicator noted above by stating that a creditor should evaluate whether it is probable that, in the foreseeable future, a debtor will default on any of its debt without the modification being made. This evaluation should assess whether probable changes in interest rates, interest-only periods, income or other factors will likely cause a default. As a result, a creditor may conclude that a debtor is experiencing financial difficulties despite the absence of a current payment default. Keep in mind that the aforementioned indicators are not the sole determinants of a debtor's financial difficulties, but merely a sample of potential items.
ASU 2011-02 explains what a concession means for a TDR. Concessions can take many forms, including granting an interest rate below market for the risk characteristics of the loan, forgiving interest and/or principal, modifying or extending repayment requirements, and waiving financial covenants to enhance cash flow. The update states that a creditor should consider all aspects of a restructuring to determine whether a concession has been granted to a debtor, and includes the following additional guidance:
Lastly, a restructuring includes a concession if the creditor does not expect to collect all amounts due, including both the contractual original principal and accrued interest.
While the primary purpose of the update is to provide further clarity around the terms "troubled financial condition" and "concession," it also introduces a significance concept that the previous guidance did not possess. The amendments in ASU 2011-02 state that a restructuring resulting in an insignificant delay in payment does not involve a concession and therefore is not a TDR. When considered together, the following factors may indicate that a restructuring will result in an insignificant payment delay:
As previously noted, the update also prohibits a creditor's use of debtor TDR determinants in the identification of a TDR. This prohibition resulted from the belief that some creditors used analogies to debtor guidance—such as the effective interest rate test—when determining whether an interest rate concession had been granted. Because the effective interest rate test was only intended for debtors and may result in inconsistent accounting by creditors, the update explicitly prohibits creditors from using this test.
While it is possible that the recent update could lead to more troubled debt restructurings, that was not the purpose of ASU 2011-02. It does not change the essential TDR definition, but instead clarifies what is meant by "troubled financial condition" and "concession," and adds a "significance" factor to the guidance.
The revision applies to all public and private creditors, but does not add any new disclosure requirements. For public companies, the amendments were effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retroactively to the beginning of the annual period of adoption for financial statement disclosures of problem loans. For private companies, the amendments are effective for annual periods ending after Dec. 15, 2012, including interim periods within those annual periods.
For more information on TDR, see this in-depth exploration in the winter 2009 Central Banker, "Debt Restructuring--Is It a Simple Refinancing or a Troubled Debt Restructuring?"