Accounting & Auditing

On April 5, 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-02, Receivables (Topic 310):  A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The ASU helps creditors evaluate the criteria required to determine whether a restructuring is a troubled debt restructuring (TDR). The ASU does not change the definition of a TDR.

A restructuring is a TDR if both of these criteria are met:

• The creditor has granted a concession.
• A borrower is experiencing financial difficulties.

The ASU also requires creditors to begin making TDR disclosures previously deferred for public entities only by ASU 2011-01, Receivables (Topic 310):  Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20.

Scope

The ASU applies to all entities, both public and nonpublic, that are creditors and restructure receivables. Receivables that could be involved in TDRs commonly result from lending cash, or selling goods or services on credit. The impact of the ASU is not limited to entities in the financial services industry. Other entities that could be significantly affected by the ASU include companies involved in product financing and not-for-profit entities with loan funds, including higher education. However, this article focuses principally on financial services entities.

The ASU applies to all creditor receivables except the following:

• Restructurings of loans within a pool accounted for in accordance with Accounting Standards Codification (ASC) 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality
• Loans measured at fair value, with changes in fair value recognized through earnings
• Loans measured at lower of cost or fair value
• Leases, as defined by ASC 840
• Debt securities

Implementation of this ASU introduces new complexities and regulatory risks. This guidance requires a more rigorous analysis of restructurings than some creditors may have previously undertaken. Financial services industry regulators expect institutions will classify more restructurings as TDRs under this guidance than under previous guidance. Without a thorough analysis of its implementation-year restructurings, a creditor cannot assume the impact on its financial statement disclosures will be immaterial.

Is the Borrower Experiencing Financial Difficulties?

In applying the ASU, this question may be the more apparent of the two criteria to evaluate. If this criterion is not met, the restructuring is not a TDR and further analysis is not necessary.

The ASU requires creditors to consider the following indicators to help clarify whether a borrower is experiencing financial difficulty. However, the ASU states this list is not intended to include all indicators of financial difficulty:

• The borrower is currently in payment default on any of its debt.
• Without the restructuring, it is probable the borrower will default in the foreseeable future.
• The borrower has declared bankruptcy or is in the process of declaring bankruptcy.
• There is substantial doubt about the borrower's ability to continue as a going concern.
• The borrower's securities have been delisted, are in the process of being delisted or under threat of being delisted.
• Based on estimates of the borrower's current capabilities, cash flow is insufficient to service any portion of its debt, according to existing contractual terms, for the foreseeable future.
• Without the restructuring, the borrower cannot obtain funds from sources other than existing creditors at an effective rate equal to current market rate for similar debt for a nontroubled borrower.

In reaching its conclusions for the ASU, FASB noted there may be cases where receivables are restructured because the creditor’s historical experience with similar borrowers indicates payment default by the borrower is probable in the foreseeable future, even if there is no current default. Such cases may be especially prevalent in regards to residential mortgages with monthly payments that increase significantly at some point during their term because of an interest-only payment period in the earlier years of the term. In cases where payment default is probable, the creditor should conclude a borrower is experiencing financial difficulties.

Has the Creditor Granted a Concession?

YES—The ASU describes the following situations in which the creditor will conclude it has granted a concession:

• When, as a result of the restructuring, the creditor does not expect to collect all amounts due, including interest accrued at the original contract rate; to make this determination, the creditor should consider the current value of the collateral when the payment of principal at original maturity is primarily dependent on the value of collateral.
• When the nature and amount of additional collateral or guarantees received by the creditor as part of the restructuring are not adequate compensation for other terms of the restructuring; to make this determination, the creditor must evaluate both a guarantor’s ability and its willingness to pay the balance owed when additional guarantees are received.

MAYBE—The ASU describes the following situations in which the creditor may conclude it has granted a concession:

• When 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.
• When a temporary or permanent increase in the contractual interest rate as a result of a restructuring could still be below market interest rates for new debt with similar risk characteristics.

In these situations, the creditor must continue its evaluation by considering all aspects of the restructuring to determine whether it has granted a concession. FASB acknowledges the mere absence of a market rate for debt with similar risk should not automatically result in a TDR, because credit markets occasionally contract severely and can affect a borrower’s access to market-rate funds. Therefore, the presence of this one indicator should not lead creditors to automatically presume a concession has been granted.

NO—A restructuring resulting only in an insignificant delay in payment is not a concession. The following factors, when considered together, are indicators of a restructuring that results in an insignificant delay in payment:

1. The amount of the restructured payments subject to the delay is insignificant relative to the unpaid principal or collateral value of the receivable and will result in an insignificant shortfall in the contractual amount due.
2. The delay in timing of the restructured payment period is insignificant relative to any one of the following:

• The frequency of payments due under the contract
• The receivable’s original contractual maturity
• The receivable’s original expected duration

If the receivable previously has been restructured, the creditor must consider the cumulative effect of past restructurings when determining whether the most recent restructuring resulted in an insignificant delay in payment.

Impact on Past Common Practices

As a result of the ASU, the following common practices will change:

• The ASU specifically precludes use of the effective rate test in the debtor’s guidance (ASC 470-60-55-10) when evaluating whether a restructuring is a TDR because such a test fails to consider all terms of the restructuring.
• A temporary or permanent increase in the borrower’s interest rate as part of a restructuring does not automatically mean a concession has not been granted, because the new rate may still be below market.
• The ASU’s complexities make it very unlikely creditors can effectively evaluate all restructurings as part of the financial statement preparation process or on a nonroutine basis. To effectively implement the ASU, creditors need to create a systematic process to evaluate all restructurings and determine, based on the criteria in Topic 310, whether the restructuring is a TDR. The evaluation will be most effective if it’s incorporated into the creditor’s existing restructuring preparation, review and approval process.

TDR Disclosures

Certain TDR disclosures were introduced by ASU 2010-20 and then deferred for public entities by ASU 2011-01:

1. For TDRs that occurred during each period for which an income statement is presented:

• By class of financing receivable, qualitative and quantitative information, including both of the following:
• How receivables were modified (by rate reduction, nonmarket rate, interest only, extension, etc.)
• Financial effects of the restructurings
• By portfolio segment, qualitative information about how such restructurings are factored into the determination of the allowance for credit losses

2. For TDRs that have occurred within the previous 12 months and for which there was a payment default during the period, for each period for which an income statement is presented:

• By class of financing receivable, qualitative and quantitative information about those defaulted financing receivables, including both of the following:
• Types of financing receivables that defaulted
• Amount of financing receivables that defaulted
• By portfolio segment, qualitative information about how such defaults are factored into the determination of the allowance for credit losses

The disclosure requirements for condensed interim financial statements in ASC 270-10 are amended to generally require all of these TDR disclosures each quarter. Refer to ASC 310-10-20 for definitions of key terms, such as "portfolio segment" and "class of financing receivable."

Effective Date & Transition
All creditors, both public and nonpublic, will have to evaluate all restructurings occurring after the beginning of the annual period in which they adopt the ASU. Creditors will not have to re-evaluate restructurings from fiscal years prior to the year they adopt the ASU.

Public Entities—The ASU is effective for interim and annual periods beginning on or after June 15, 2011, and is to be applied to all restructurings occurring on or after the beginning of the year of adoption. Early adoption is permitted.

As a result of adopting the ASU, a creditor may identify loans considered impaired under ASC 310-10-35 (FAS 114) that were previously evaluated under 450-20 (FAS 5). Those creditors shall disclose the total recorded investment in such loans and the associated allowance for credit losses as of the end of the adoption period.

For example, assume a creditor with a December 31 year-end restructures a loan in January 2011 and determines it is not a TDR under pre-ASU 2011-02 guidance. Upon adopting the ASU on July 1, 2011, the creditor determines the restructuring is a TDR. Under these assumptions, the creditor must disclose the amounts of the reclassified loan and its related allowance as of September 30, 2011, in its third-quarter financial statements, as well as the TDR disclosures deferred by ASU 2011-01.

The following is an illustrative disclosure required for situations involving restructurings described in the preceding example:

As a result of adopting the amendments in Accounting Standards Update No. 2011-02 (the ASU), the Company reassessed all restructurings occurring on or after the beginning of its current fiscal year (January 1, 2011) for identification as TDRs. The Company identified as TDRs certain receivables for which the allowance for credit losses had previously been measured under a general allowance for credit losses methodology. Upon identifying those receivables as TDRs, the Company identified them as impaired under the guidance in Accounting Standards Codification (ASC) 310-10-35. The ASU requires prospective application of the impairment measurement guidance in ASC 310-10-35 for those receivables newly identified as impaired. At the end of the first interim period of adoption (September 30, 2011), the recorded investment in receivables for which the allowance for credit losses was previously measured under a general allowance for credit losses methodology and are now impaired under ASC 310-10-35 was $__________, and the allowance for credit losses associated with those receivables, on the basis of a current evaluation of loss, was $__________.

Nonpublic Entities—Except for new TDR disclosures, the ASU is effective for annual periods ending on or after December 15, 2012, including interim periods within those annual periods. Early adoption is permitted; if early adoption is elected, the ASU should be applied to all restructurings occurring on or after the beginning of the year of adoption. (See example in public entities section above.)

The TDR disclosures required by ASU 2010-20, as described above, are effective for annual reporting periods ending after December 15, 2011. Therefore, nonpublic entities must use the pre-ASU 2011-02 accounting standards to classify and report TDRs until they adopt the ASU.

If you have questions related to these or other standards that may affect your company, contact your BKD advisor.

Read the appendix to this article for examples of situations that may result in a TDR.