COVID-19 increases focus on troubled debt restructurings

In the wake of the COVID-19 outbreak, many financial institutions are finding it necessary to modify loan terms for the benefit of borrowers.

Institutions must then determine whether these loan modifications meet the definition of a troubled debt restructuring (TDR) as defined in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 310-40. 

Here is how you can determine whether a loan is a TDR and, if so, what that means.

Loan modifications

A TDR occurs when a financial institution restructures a debt and, for economic or legal reasons related to a borrower's financial difficulties, grants a concession to the borrower that it would not otherwise consider.

TDRs include certain modifications to terms of loans and receipt of assets from borrowers in partial or full satisfaction of loans. 

Modifications to terms of loans may include, but are not limited to, one or a combination of the following:

• Reduction of the stated interest rate for some or all of the remaining term of the loan
• Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new loans with similar risk
• Reduction of the face amount or maturity amount of the loan as stated in the instrument or other agreement
• Reduction of accrued interest

Regulators have encouraged financial institutions to consider modifications and loan accommodation programs to assist borrowers facing setbacks from the COVID-19 outbreak (e.g., FIL-36-2020). 

Loan accommodation programs may include payment accommodations such as payment or maturity due date extensions and deferring or skipping some payments. 

Financial institutions will not be criticized for prudent efforts to accommodate customers in response to COVID-19.  As noted in the Interagency Statement on Loan Modifications for Financial Institutions Working with Customers Affected by the Coronavirus (Revised) dated April 7, 2020 (the “Interagency Statement”), regulators and FASB staff members agreed that short-term modifications due to COVID-19 for borrowers who were current prior to any loan modification will not be considered TDRs.  This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms or other delays in payment that are insignificant.

In addition, on March 27, 2020, the “CARES Act,” was signed into law, and permits financial institutions to NOT classify a loan modification related to the COVID-19 pandemic as a TDR if the loan modification is made between March 1, 2020, and earlier of the date 60 days after the end of the public health emergency or December 31, 2020, and if the underlying loan was not more than 30 days past due as of December 31, 2019.

Determining whether a financial institution has granted a concession

A loan modification or restructuring is only considered a TDR if the financial institution grants a concession it would not otherwise consider. Accounting standards clarify when a concession is granted by noting the following:

• A financial institution has granted a concession when, as a result of the restructuring, it does not expect to collect all amounts due, including interest accrued at the original contract rate.
• A concession has been granted by a financial institution if the institution restructures the debt in exchange for additional collateral or guarantees from the borrower and the nature and amount of the additional collateral or guarantees received do not serve as adequate compensation for other terms of the restructuring.
• If a borrower does not otherwise have access to funds at a market rate for debt with similar risk characteristics as the restructured debt, the restructuring would be considered to be at a below-market rate, which may indicate that the financial institution has granted a concession.However, as noted in FIL36-2020, a loan deferred, extended or renewed at a stated interest rate equal to the current interest rate for new debt with similar risk is not reported as a TDR.
• 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 concession because the new contractual interest rate on the restructured debt could still be below the market interest rate for new debt with similar risk characteristics.

A restructuring that results in a delay in payment that is insignificant is not a concession. The following factors, when considered together, may indicate that a restructuring results in an insignificant delay in payment:

• 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.
• The delay in timing of the restructured payment period is insignificant relative to the frequency of payments due under the debt, the debt’s original contractual maturity and/or the debt’s original expected duration.

If the debt has been previously restructured, a financial institution shall consider the cumulative effect of the past restructurings when determining whether a delay in payment resulting from the most recent restructuring is insignificant.

Determining whether a borrower is experiencing financial difficulties

A loan modification or restructuring is only deemed a TDR if the borrower is experiencing financial difficulties.  When determining whether a borrower is experiencing financial difficulties, the accounting standards clarify that the financial institution should consider whether:

• The borrower is currently in payment default on any of its debt or it is probable that the borrower would be in payment default on any of its debt without the modification.(In other words, the borrower may be experiencing financial difficulties even though the borrower is not currently in payment default.)
• The borrower has declared or is in the process of declaring bankruptcy.
• There is substantial doubt as to whether the borrower will continue to be a going concern.
• On the basis of estimates and projections that only encompass the borrower’s current capabilities, the financial institution forecasts that the borrower’s entity-specific cash flows will be insufficient to service any of its debt in accordance with the contractual terms of the existing debt.
• Without the current modification, the borrower cannot obtain funds from sources other than the existing financial institution(s) at an effective interest rate equal to the current market interest rate for similar debt for a nontroubled borrower.

Many institutions are contemplating programs that would be made available to all borrowers or all borrowers within a class to provide short-term relief as the United States addresses COVID-19. As noted in the Interagency Statement, for loan modification programs designed to provide temporary relief for Creditworthy borrowers affected by COVID-19 and less than 30 days past due on payments at December 31, 2019, financial institutions may elect not to account for such loan modifications as TDRs without any further analysis.

Accounting for troubled debt restructuring

TDRs are required to be accounted for as impaired loans under ASC Topic 310-10, even if the loan was exempt from the impaired loan accounting standards prior to the restructuring (for example, a residential loan that was evaluated collectively as part of a homogenous loan pool). In most cases, impairment of TDRs is measured using the discounted cash flow method. Under the discounted cash flow method, the institution calculates impairment as the decline in the present value of future cash flows resulting from the modification, discounted at the original loan’s contractual interest rate. If the contractual rate is a variable rate based on changes in an independent index, such as prime or LIBOR, the discount rate may be calculated based on the factor as it changes over the life of the loan or fixed at the rate in effect at the date of modification. The institution should not project changes in the index for purposes of estimating future cash flows. Once a method is chosen, it must be applied consistently for all impaired loans.

Nonaccrual loans

Generally accepted accounting principles do not provide specific guidance as to whether a loan that has been modified in a TDR should be classified as nonaccrual. However, regulatory agencies often recommend loans that were on nonaccrual before restructuring remain on nonaccrual until the borrower has demonstrated a willingness and ability to make the restructured loan payments. Regardless of whether the loan is on nonaccrual, all TDRs are considered impaired loans and must be disclosed as such in the financial statements, including real estate and consumer loans that are not typically evaluated for impairment on an individual loan basis. 

Short-term loan modifications that are part of a program designed to provide temporary relief for borrowers affected by COVID-19 generally should not be reported as nonaccrual unless more information becomes available indicating a specific loan will not be repaid.

Delinquent loans

Typically, a loan that is past due 30 days or more is considered delinquent. The Interagency Statement provides some additional guidance for reporting delinquent loans granted due to COVID-19. Borrowers who were current prior to any payment deferrals or other accommodation generally would not be reported as past due as long as they meet the performance requirements (if any) of the accommodation. For borrowers who were past due on payments prior to receiving payment accommodations related to COVID-19, the delinquency status of the loan may be adjusted back to the status that existed at the date of the loan modification. Specific facts and circumstances of each borrower’s situation should be considered in determining the appropriate treatment of delinquent loans.

Concluding thoughts

Accounting standards related to TDRs have not changed in recent years, but these standards will be more relevant given recent events and the current world environment.

We recommend management review TDR related guidance and communicate with all employees that work with loan modifications and restructurings to verify all TDRs are identified and properly accounted for and disclosed in financial reports. 

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