Last month the Financial Accounting Standards Board issued a proposed guidance related to troubled debt restructuring that included several important clarifications for both debtors and creditors. The proposed accounting standards update (ASU), Clarifications to Accounting for Troubled Debt Restructurings by Creditors, was issued on October 12 and set forth criteria for determining when an arrangement between a debtor and creditor rises to the level of a so-called troubled debt restructuring or TDR. These clarifications, in general, will be effective for periods ending after June 15, 2011.
TDRs are restructurings in which the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider.1 They are also a classification that engenders a special set of accounting rules.
A TDR might involve, for example, the transfer from the debtor to the creditor of real estate to satisfy a debt, including a transfer resulting from foreclosure or repossession. The restructuring could also be a modification of terms of a debt, such as reduction of the stated interest rate for the remaining original life of the debt, extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk, reduction of the face amount of the debt, or reduction of accrued interest.
Under the guidance, a debtor that transfers real estate or other assets to a creditor to fully satisfy a payable recognizes a gain on “restructuring of payables.” The gain is measured by calculating the excess of the carrying amount of the payable as compared with the value of the assets transferred. Moreover, a difference between the value and carrying amount of assets transferred to a creditor to satisfy a payable is booked as “a gain or loss on transfer of assets.”
A creditor that receives from a debtor a fully satisfied receivable in the form of real estate or other assets accounts for the assets at fair value (less costs to sell if a “long-lived” asset is involved). The excess of the recorded investment (the receivable satisfied) over the fair value of the assets received is recognized as a loss. Legal fees and other direct costs incurred by a creditor to effect a TDR are included in expense when incurred.
A creditor in a TDR involving a modification of terms accounts for the restructured loan in a special manner. In these cases, the accounting literature requires that impairment losses be measured at their present value of expected future cash flows discounted at the loan’s effective interest rate.2 A loan is considered impaired if it is probable the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.3
If a debtor does not have access to funds at a market rate that has similar risk characteristics as the restructured debt, the restructuring is considered to be below a market rate and therefore should be considered a TDR.4 Moreover, a temporary or permanent increase in the contractual interest rate as a result of a restructuring does not preclude the restructuring from being considered a TDR. That’s because the new contractual interest rate could still be below market interest rates for new debt with similar terms.