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FASB Issues Final ASU on Creditor Accounting for Troubled Debt Restructuring

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August 2011

Executive Summary

How do creditors account for a troubled debt restructuring (TDR) when a loan has been modified? In the current economic environment, the answer to this question has become increasingly important as there have been significant increases in the number of residential mortgages and commercial real estate loans restructured. The FASB recently clarified how creditors identify TDRs in ASU 2011-02.[1] The TDR standards for debtor accounting were not changed and are provided in ASC 470-60.[2]

The ASU primarily affects financial institutions such as banks that hold loans or other financing receivables. Under ASU 2011-02, if a creditor determines that a loan modification is a TDR, then the creditor may need to perform a different impairment measurement and provide additional disclosures. This alert summarizes the new guidance for identifying a creditor’s concessions and a debtor’s financial difficulties, concepts key to the determination of whether a modification is a TDR. It also summarizes the new TDR disclosures required by ASU 2010-20.[3]

Indicators of Creditor Concessions and Debtor Financial Difficulties

If a creditor concludes that both of the following exist, a restructured loan constitutes a TDR:

  • The restructuring constitutes a concession; and
  • The debtor is experiencing financial difficulties.

When a loan is restructured in a TDR, the creditor should presume the loan is impaired and subject it to a specific impairment measurement under Topic 310.[4] Impairment for this type of loan should be measured by comparing the carrying amount of the loan to the present value of the cash flows expected to be collected. As a practical expedient, impairment can be measured loan-by-loan based on a loan’s observable market price or the fair value of the collateral, if the loan is collateral-dependent.[5] However, if it is probable that a loan will be foreclosed, then impairment must be measured based upon the fair value of the loan’s collateral. Impairment measured using an estimated loss factor method is only appropriate for non-impaired loans and cannot be used to measure impairment for loans restructured in a TDR.

Concession

ASU 2011-02 clarifies that a creditor has granted a concession as a result of the loan restructuring when it does not expect to collect all amounts due, including principal and interest, or because the fair value of the collateral is insufficient. The ASU further notes that a creditor:

  • Is not allowed to use the borrower’s effective interest rate to determine whether a concession was granted. Before ASU 2011-02, some creditors used the debtor’s effective interest rate test[6] to support that a concession had been granted if the modified loan had a lower effective interest rate than the original loan.
  • Has granted a concession when a loan has been restructured in exchange for additional collateral or guarantees from the debtor when those enhancements do not adequately compensate the creditor for all the terms that have been modified.
  • May conclude it has made a concession by restructuring a loan if the debtor was unable to secure a loan with risk characteristics similar to the modified debt at a market rate. In this situation, the creditor effectively has provided the debtor with a loan at a below market interest rate.

Further, a creditor has not granted a concession if it restructures a loan that results in an insignificant delay in payment. ASU 2011-02 provides the following factors as possible indicators that a delay in payment is insignificant:

  • Return of principal and interest – The amount of the restructured payments subject to the delay is insignificant relative to the unpaid principal or collateral value of the debt and will result in an insignificant shortfall in the contractual amount due.
  • Amount of delay – The delay in timing of the restructured payment period is insignificant relative to any one of the following factors:
    1. The frequency of payments due under the debt;
    2. The debt’s original contractual maturity; or
    3. The debt’s original expected duration.

The ASU provides the following examples[7] that provide guidance on whether a delay is significant (Note: If the debt has been previously restructured, the cumulative effect of past restructurings must be considered in the assessment.):

  • Not Insignificant – The creditor grants a three-month extension to a borrower whose debt is collateralized by commercial real estate. The fair value of the collateral has decreased below the principal amount due, and the debtor had planned to either refinance the property or sell it to pay off the debt. Although the extension is for an insignificant period of time, the creditor expects a significant shortfall in cash flows relative to the contractual amount. Consequently, the delay is not insignificant.
  • Insignificant – The creditor accepts nonpayment of a residential mortgage for two monthly payment cycles by forbearing and not beginning foreclosure action. The debtor agrees to make up the back payments over the next four months and to resume making regular monthly payments. Because the creditor expects to collect all amounts due, the delay in payment is considered insignificant. Furthermore, the length of delay resulting from the forbearance arrangement is insignificant in relation to the three factors noted above.
  • Insignificant – A commercial debtor has a line of credit with an original term of five years, and the debtor is required to pay interest every quarter on the average daily balance of the line. The creditor and debtor begin renegotiating the line as it nears maturity. Because of a temporary cash shortfall due to a delay in collections from two key customers, the debtor is unable to make the final interest payment before they finish renegotiating the terms of the new line of credit.

The terms of the renegotiated line are expected to be similar to the current line, and these terms are comparable to terms available to debtors with similar risk characteristics. The creditor extends a three-month payment deferral by adding the missed interest payment to the balance of the line and requiring the debtor to make its first interest payment 90 days after the new line of credit is finalized. Although the debtor is unable to make the contractual interest payment when it is due, the creditor still expects to collect all amounts due. Also, the delay in timing of the payment represents only one payment cycle under the terms of the line, which is insignificant relative to the three factors noted above.

Financial Difficulties

The ASU notes that a creditor should consider the following indicators in determining whether a debtor is experiencing financial difficulties (Note: The list is not intended to be all-inclusive, nor are any of the indicators individually determinative.):

  • The debtor is currently in payment default on any of its debt, or is probable of payment default in the foreseeable future without the loan modification. Consequently, a creditor may conclude that a debtor is experiencing financial difficulties, even though the debtor is not currently in payment default.
  • The debtor has declared or is in the process of declaring bankruptcy.
  • There is substantial doubt as to whether the debtor will continue to be a going concern.
  • The debtor has securities that have been delisted, are in the process of being delisted or are under threat of being delisted from an exchange.
  • On the basis of estimates and projections that only encompass the debtor’s current capabilities, the creditor forecasts that the debtor’s entity-specific cash flows will be insufficient to service any of its debt for the foreseeable future according to the contractual terms of the existing agreement.
  • Without the current 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 non-troubled debtor.

Disclosures

As required by ASU 2010-20, for each period for which a statement of income is presented, companies are required to disclose the following about TDRs of loans that occurred during the period:

  • By class of loan, qualitative and quantitative information, including both of the following:
    1. How the loans were modified; and
    2. The financial effects of the modifications.
  • By portfolio segment, qualitative information about how such modifications are factored into the determination of the allowance for credit losses.

For each period for which a statement of income is presented, a company shall disclose the following for loans modified as TDRs within the previous 12 months and for which there was a payment default during the period:

  • By class of loan, qualitative and quantitative information about those defaulted loans, including both of the following:
    1. The types of loans that defaulted; and
    2. The amount of loans that defaulted.
  • By portfolio segment, qualitative information about how such defaults are factored into the determination of the allowance for credit losses.

For public companies, the ASU 2010-20 TDR disclosure requirements are effective for interim and annual periods beginning on or after June 15, 2011, concurrent with the effective date for ASU 2011-02. See below for the effective date related to the identification of TDRs under ASU 2011-02.

For nonpublic companies, the ASU 2010-20 disclosures are effective for annual periods ending on or after December 15, 2011. Nonpublic companies that do not early adopt ASU 2011-02 are required to provide ASU 2010-20 disclosures based on existing TDR identification guidance.

Effective Date and Transition

ASU 2011-02 requires public companies to identify and account for TDRs for interim and annual periods beginning on or after June 15, 2011. Early adoption is permitted. The guidance applies retrospectively to restructurings occurring on or after the beginning of the year of adoption. Therefore upon adoption, TDR accounting should be applied to two groups of restructured loans:

  • Loans that have been restructured since the beginning of the fiscal year of adoption but prior to the period of adoption (e.g., loans restructured in the first and second quarter for calendar year companies); and
  • Loans that are restructured in the quarter of adoption (e.g., loans restructured in the third quarter for calendar year companies).

For calendar year public companies, the new accounting and disclosures must be provided beginning with their third quarter Form 10-Qs.

ASU 2011-02 requires nonpublic companies to identify and account for TDRs for annual periods ending on or after December 15, 2012, including interim periods within that year. Early adoption is permitted. Upon adoption, TDR accounting should be applied as follows:

  • If the company only reports annually – Loans that have been restructured from the beginning through the end of the year (e.g., January 1 to December 31, 2012 for calendar year companies).
  • If the company reports quarterly – Loans that have been restructured in the quarters of the fiscal year that have already been reported plus loans that have been restructured in the quarter of adoption. For a calendar year company, ASU 2011-02 would be adopted January 1, 2012 and there would be no cumulative effective with respect to prior periods.

For calendar year nonpublic companies that report annually and adopt ASU 2011-02 in fiscal 2012, the ASU 2010-20 disclosures would be adopted in fiscal 2011 resulting in new TDR disclosures provided under the current TDR identification guidance. Then in 2012, the company would adopt ASU 2011-02, and provide the new disclosures under the new TDR identification guidance. If a nonpublic company early adopts ASU 2011-02, it should apply the guidance to loan modifications that occur on or after the beginning of the year of adoption, and provide the disclosures required by ASU 2010-20 under the TDR identification guidance of ASU 2011-02.

Companies should assess their current systems, processes and internal controls to ensure they are prepared to implement the new TDR requirements.

In the period of adoption, a company must provide the following disclosures for the newly identified TDRs that have occurred since the beginning of the annual period of adoption:

  • The effect, if any, of changing the method of calculating impairment from the method applicable to non-impaired loans (e.g., using an estimated loss factor; see the loss contingency guidance of ASC 450-20[8]) to the method applicable to TDRs (e.g., comparing carrying amount to the present value of cash flows expected to be collected, see the guidance of ASC 310-10[9]). We understand that most commercial real estate loans subject to modification under both the new and previous TDR guidance would likely have been considered impaired with the impairment amount already calculated on the basis of ASC 310-10. As such, it is expected that the new guidance will primarily affect the calculation of impairment on consumer loans.
  • The total amount of loans newly identified as TDRs and the allowance for credit losses on those loans at the end of the period of adoption (September 30 for calendar year end public companies).

The following illustrates the disclosure required upon transition:

As a result of adopting the amendments in ASU 2011-02, R Bank reassessed all restructurings that occurred on or after the beginning of the current fiscal year (January 1, 2011) to determine whether they are now considered troubled debt restructurings (TDRs). R Bank identified as TDRs certain loans for which the allowance for loan losses had previously been measured under a general allowance methodology. Upon identifying those loans as TDRs, R Bank identified them as impaired under the guidance in ASC 310-10-35. The amendments in ASU 2011-02 require prospective application of the impairment measurement guidance in ASC 310-10-35 for those loans newly identified as impaired. At the end of the first interim period of adoption (September 30, 2011), the recorded investment in loans for which the allowance was previously measured under a general allowance methodology and are now impaired under ASC 310-10-35 was $33.8 million, and the allowance for loan losses associated with those loans, on the basis of a current evaluation of loss was $5.3 million.



[1] ASU 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring

[2] ASC 470-60, Troubled Debt Restructurings by Debtors (SFAS 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, and EITF 02-4, Determining Whether a Debtor’s Modification or Exchange of Debt Instruments Is within the Scope of FASB Statement No. 15)

[3] ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses

[4] Topic 310, Receivables

[5] See ASC 310-10-35-22.

[6] See 470-60-55-10.

[7] All examples assume that the debtor is having financial difficulties.

[8] ASC 450-20, Contingencies

[9] ASC 310-10, Receivables

Material Discussed in this Alert is meant to provide general information and should not be acted on without obtaining professional advice tailored to your firm's individual needs. The information is for general guidance only and is not a substitute for professional advice.

IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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