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How Will A Debt Modification Affect Your Financial Statement?

As a result of the Coronavirus pandemic, lenders may have had to restructure and modify debt agreements with borrowers.

The accounting guidance provides two possible methods to treat these debt modifications. The Financial Accounting Standards Board (FASB) provides guidance on determining whether the modification or exchange is treated as a troubled debt restructure (TDR), FASB Subtopic 470-60, or a non-troubled modification or exchange, FASB Subtopic 470-50.  Some factors to consider to determine if accounting application for a debt modification exists includes but are not limited to:

  • Extending maturity date at a stated interest rate lower than current rate
  • Reduction of stated interest rate for the remaining term
  • Reduction of the face amount or maturity amount of debt
  • Amending debt covenants

A TDR exists when the borrower is experiencing financial difficulties and the lender has granted a concession to the borrower. Such factors that may be evidence of financial difficulty include but are not limited to:

  • Borrower has filed bankruptcy,
    • Borrower has not remitted timely payments to the creditor or is in default of a loan.
    • Future cash flows are insufficient to cover debt
    • Securities are delisted on an exchange

A concession has been granted when the borrower’s effective borrowing rate on the restricted debt is less than the effective borrowing rate on the  original debt.

Why Does This Matter? 

The effect on the entity’s statement of operations and statement of financial condition depends on the nature and extent of a debt modification. The accounting treatment will depend on if the TDR involves modification of terms of the debt arrangement and if the undiscounted future cash payments under the terms of the new arrangement are greater or less than the total carrying amount of the old debt. The borrower recognizes a gain from the restructured debt equal to the difference between the carrying amount of the old debt and the total future undiscounted cash payments specified in the terms of the new debt. No interest expense should be recognized on the debt for any period between the restructuring and maturity of the debt. Cash payments are accounted for as reductions of the carrying amount of the debt. If the undiscounted cash flows of the new debt are greater than or equal to the net carrying value of the original debt, no gain or loss is recognized. The carrying amount of the debt at the time of the modification does not change.  The new effective interest rate equates to the present value of the future cash payments specified in the new debt agreement. Interest expense is prospectively recognized at a constant effective rate.  The interest rate is applied to the carrying amount of the debt at the beginning of each period, consistent with the interest method.

When the TDR involves transferring assets or issuing equity interest to a creditor to satisfy the borrower’s obligation, an entity should consider relevant guidance in FASB Subtopic 470-60.

What if the Debt Modification is Not a TDR?

When the debt modification does not qualify as a TDR, the borrower accounts for the exchange as either a modification or an extinguishment, in accordance with FASB Subtopic 470-50.  When the borrower has arranged for a debt agreement with a different lender and the original debt arrangement is concurrently satisfied, the transaction is accounted for as an extinguishment of debt and an issuance of new debt. If the modification is not considered substantial, there is no recognized gain or loss on the extinguishment. When the modification is considered substantial, a gain or loss on extinguishment is recognized by comparing the fair value of the new debt plus fees paid to the lender to the carrying value of the old debt.

If the modification is not significant, a new effective interest rate is calculated, and interest expenses are accounted for under the interest method using the new effective interest rate.

What Is A Significant Modification?

A modification is significant when the difference between the present value of the cash flows of the new debt is 10% greater than the present value of remaining cash flows on the old debt instrument. Modification accounting under FASB Subtopic 470-50 is applied when the modification is deemed significant, and if not significant, the borrower shall apply extinguishment accounting.  A modification to or an exchange of debt instrument with the same lender with substantially different terms is accounted for as a debt extinguishment.

When the existing debt and new debt have substantially different terms, the new debt is recorded at fair value and that amount will be used to determine the gain or loss.  Interest expense would be accounted for under the interest method using the new effective rate.

Conclusion

Borrowers with debt modifications follow relevant guidance to determine the proper accounting treatment.  Determining if the transactions qualified for a total debt restructure is the first step in the process.

Author: Kristin Fee, Associate Quality Control Principal | kfee@withum.com

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