Given current economic conditions, borrowers of all types are experiencing declines in income and cash flow. As a result, many borrowers are seeking to reduce contractual cash outlays, the most prominent being debt payments. Moreover, in an effort to preserve net interest margins and earning assets, institutions are open to working with existing customers in order to maintain relationships. Both of these matters lead to the question: Is a debt restructuring a simple refinancing or a “troubled” debt restructuring (TDR)?
To answer this question, we need to know the three factors that must always be present in a troubled debt restructuring.
First, an existing credit agreement must be formally renewed, extended and/or modified. Informal agreements do not constitute a restructuring because the terms of a note have not contractually changed.
Second, the borrower must be experiencing financial difficulty. Determining this factor requires a significant amount of professional judgment. However, accounting literature does provide some indicators on financial difficulties, including:
Third, the lender grants a concession that it would not otherwise consider. Concessions can take many forms, including the lowering of the effective interest rate, interest and/or principal forgiveness, modification or extension of repayment requirements, and waiving financial covenants to enhance cash flow.
If all three factors are present, a troubled debt restructuring has occurred, and various issues must be considered and appropriately accounted for. Some of these issues include the Statement of Financial Accounting Standards (SFAS) 114 portion of the allowance for loan and lease losses, revenue recognition and internal credit risk grade. Under SFAS 114, a troubled debt restructuring is considered to be impaired, and an impairment analysis must be performed.
While three impairment measurement techniques are available, the valuation technique generally prescribed is the discounted cash flow method. This method results from the fact that the lender and borrower have established an expected stream of cash flows. If these underlying cash flows are separate from collateral liquidation or loan sales, then the fair market value techniques are not available.
Another measurement to consider is interest income recognition. Generally, if a credit was on non-accrual prior to the restructuring, regulatory guidance indicates that the credit should remain on nonaccrual until the borrower displays a willingness and ability to repay. If the credit was on accrual, income may continue to be recognized, provided that a documented analysis of the borrower indicates that performance is assured. Lastly, troubled debt restructurings should generally remain within an institution’s criticized or classified internal credit risk ratings until repayment is reasonably assured, well-defined weaknesses have subsided and loss is not anticipated.
Sound risk management practices are an important aspect when considering the issues and risks associated with troubled debt restructurings. The foundations of these practices include the development and implementation of appropriate policies, procedures and limits; sound management information systems; and adequate internal controls. An institution’s credit policies and procedures must provide a clear understanding of what a troubled debt restructuring is, how it is to be handled, who has the ability to authorize such transactions and what associated limits are in place (authority as well as risk tolerance limits). From a management information systems perspective, procedures must be established to ensure that restructurings are correctly reported in regulatory as well as financial filings. In addition, reporting should keep senior management and the directorate apprised of the extent of this activity and its relative success.
Moreover, effective internal control systems are needed to effectively identify and manage associated risks. Two very important control functions are internal loan review and internal audit. An effective loan review function will report on compliance with established policies and procedures, assist in the identification of troubled debt restructurings, attest to the appropriateness of restructurings, and ensure that appropriate internal credit risk ratings are maintained. Sound internal audit functions verify that appropriate reporting procedures are in place and reporting is accurate. They ensure that troubled debt restructurings are included within
the SFAS 114 portion of the allowance for loan loss analysis and that the impairment measurement technique used is correct. Finally, they attest that sound revenue recognition practices have been established and are being followed.
For more information, see the update that appeared in the fall 2011 Central Banker, "Recent Accounting Standard Update Clarifies and Adds Guidance to Troubled Debt Restructurings."