In-Depth: Recent Accounting Standard Update Clarifies and Adds Guidance to Troubled Debt Restructurings

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.[1]

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 debtor has defaulted on debt obligations.
• The debtor has declared or has started the process of declaring bankruptcy.
• There is substantial doubt as to the debtor's going concern.
• The debtor's securities have been or are under threat of being delisted.
• Absent the restructuring, the debtor cannot obtain funds from another source at market rates available to nontroubled debtors.
• The debtor's cash flow is insufficient to service existing debt based upon actual or projected performance.

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.

New Guidance Given on Concessions

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:

• A creditor may have granted a concession if the debtor is otherwise unable to access funds at a market rate for debt with similar risk characteristics as the restructured debt.
• A temporary or permanent increase in the interest rate does not preclude the restructuring from being deemed a concession.
• A creditor may restructure a debt in exchange for additional collateral or guarantees from the debtor. However, the transaction may still be considered a concession when the nature and amount of consideration received does not serve as adequate compensation for the restructuring's other terms.

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.

"Significance" Factor Added

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:

• The amount of the restructured delayed payments is insignificant relative to the unpaid principal or collateral value of the debt, and it will result in an insignificant shortfall in the contractual amounts due.
• The delay in timing of the restructured payment period is insignificant relative to any one of the following:
  • the frequency of payments due under the debt,
  • the original contractual maturity of the debt or
  • the original expected duration of the debt.[2]

As previously noted, the update also prohibits a creditor's use of debtor TDR determinants in the identification of a TDR.[3] 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.

To Summarize

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?"

Endnotes

1. The specific update is ASC Subtopic 310-40, Receivables – Troubled Debt Restructurings by Creditors, formerly FASB Statement No. 15. [back to text]
2. Various examples associated with insignificant delays in payment are illustrated within the update. [back to text]
3. Debtor TDR requirements are found in ASC 470-60-55-10. [back to text]