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.
For a TDR to occur, the debtor must be experiencing “financial difficulties.” The proposed ASU provides that in determining whether a debtor is experiencing such difficulties, a creditor should consider the following “indicators”:
• The debtor is currently in default on any of its indebtedness;
• The debtor has declared, or is in the process of declaring, bankruptcy;
• There is “significant doubt” as to whether the debtor will continue to be a going concern;
• The debtor issued securities that have been delisted from an exchange, or are in the process of being delisted, or are “under threat” of being delisted;
• The creditor forecasts that the debtor’s entity-specific cash flows will be insufficient to service the debt in accordance with the contractual terms of the existing agreement through maturity; and
• Absent the modification, the debtor cannot obtain funds from sources other than the existing creditors at an effective interest rate equal to the current market interest rate for similar debt for a nontroubled debtor.
In addition, a creditor may conclude that a debtor is experiencing financial difficulties even though the debtor is not currently in default if the creditor determines that payment default is probable “in the foreseeable future.”
By contrast, the proposed ASU sets forth factors (both of which need to be present) that provide determinative evidence that the debtor is not experiencing financial difficulties and, thus, the modification or exchange is not a TDR. These exculpatory factors are as follows:
• The debtor is currently servicing the original debt and can obtain funds to repay the old prepayable debt from sources other than the existing creditors at an effective interest rate equal to the current market interest rate for a nontroubled debtor; and
• The creditors agree to restructure the old debt solely to reflect a decrease in current market interest rates for the debtor or “positive changes” in the creditworthiness of the debtor.
Finally, the proposed ASU provides that a restructuring that results in an “insignificant delay” in current cash flows may still be considered a TDR if other incriminating factors are present.
To be sure, if and when this proposed ASU is finalized, it will expand, perhaps materially, the number of arrangements between debtors and creditors that are accounted for under the special regime appurtenant to TDRs. Most notably, FAS 15′s most vexing imponderable — the question of when the debtor is in the throes of financial difficulties — is clarified to a significant extent by the proposed ASU.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings (Subtopic 310-40).
2 Alternatively, in measuring the impairment loss, the loan’s observable market price may be used. In cases where the loan is said to be “collateral-dependent,” the value of such collateral would be employed for purposes of gauging the extent of the impairment loss.
3 See SFAS No. 114, Accounting by Creditors for Impairment of a Loan.
4 In general, a debtor that can obtain funds from sources other than the existing creditor at market interest rates at or near those for nontroubled debtors will not be viewed as involved in a TDR.