What Is Troubled Debt Restructuring?

In a troubled debt restructuring (TDR), a creditor (financial institution or other lender) grants a concession to a debtor that they might not otherwise have considered due to economic or legal reasons causing a debtor’s financial difficulties.

Troubled debt restructurings have become increasingly relevant in today’s economic landscape. This article aims to demystify TDRs by explaining their nature, the reasons behind their resurgence, and the accounting implications under U.S. Generally Accepted Accounting Principles (GAAP).

Understanding TDR

A TDR occurs when a creditor grants concessions to a debtor experiencing financial difficulties.

These concessions might include a reduction in the stated interest rate, an extension of the debt’s maturity date, a reduction in the face amount of the debt, or a combination of these. The transaction can also involve an array of debt settlements, such as transferring tangible or intangible assets to the creditor or granting an equity interest in the debtor as full or partial satisfaction of the debt.

Why More Companies Are Experiencing a TDR?

An increase in TDR activities can be attributed to various factors:

• Economic uncertainty. Fluctuating market conditions, rising inflation, and economic downturns can strain a company’s cash flow, making it challenging to meet original debt obligations or covenants.
• Avoiding bankruptcy. TDRs can offer a mutually beneficial solution for both the debtor and the creditor. They help companies avoid bankruptcy, while creditors can recover a greater portion of the loan compared to a potential write-off.
• Regulatory environment. Regulation changes can sometimes make creditor concessions a more viable option for debt resolution.
• Declining real estate values. Many firms and employees continue to embrace hybrid and remote work. For commercial real estate owners, increased vacancies, rent holidays, and reductions can negatively impact cash flows and property owners’ ability to make loan payments.

Creditors may be willing to restructure the debt because they realize it’s in their best interest to reconsider the loan terms rather than losing the borrower to a competitor, forcing the borrower to file bankruptcy, or foreclosing on collateralized assets.

What Qualifies as a TDR?

Naturally, accounting for TDRs differs depending on whether you’re looking at the debtor’s or creditor’s side of the transaction. This article focuses solely on the debtor’s accounting for TDRs, which is addressed by Accounting Standards Codification (ASC) 470-60, Debt – Troubled Debt Restructurings by Debtors. A Financial Accounting Standards Board (FASB) staff educational paper on the topic includes a helpful flowchart illustrating the accounting treatment for debt modifications and exchanges and is a good starting point for identifying the appropriate accounting treatment.

It’s important to note that not all debt modifications constitute a TDR. Under GAAP, a restructuring of debt qualifies as a TDR if it meets two conditions:

Condition 1: Borrowers Experiencing Financial Difficulty

Evidence that the company is experiencing financial difficulty can include:

• Declaring or being in the process of declaring bankruptcy
• Being delinquent in making required principal and interest payments on any debts
• Significant doubt about the entity’s ability to continue to be a going concern
• Having the company’s stock delisted from an exchange
• Expected future cash flows will be insufficient to service the existing debt
• Not having access to any other funds to service the company’s debt
• Violating financial or non-financial covenants

Condition 2: The Creditor Grants a Concession

If the company has concluded it is facing financial difficulties, the next step is to determine whether the creditor has granted the creditor a concession. This involves assessing whether the effective borrowing rate of the modified debt instrument is less than that of the original debt instrument.

Under ASC 470-60-55-10, the creditor has granted a concession if the borrower’s effective interest rate on the new debt is less than the effective rate on the old debt immediately prior to the restructuring.

The effective interest rate is the discount rate that equates the present value of all future cash payments with the net carrying amount of the old debt and provides a constant return over the life of the debt. The old debt’s carrying amount includes any unamortized/unaccreted premium, discount, issuance costs, accrued interest payable, etc.

If the modified debt instrument meets the criteria of a TDR and the future undiscounted cash flows are:

• Less than the net carrying value of the original debt, the company must recognize a gain for the difference. The carrying value of the debt is adjusted to the future undiscounted cash flow amount. The company would have no future interest payments, and all future payments reduce the debt’s carrying value.
• More than the net carrying value of the original debt, the company does not recognize a gain. Instead, it establishes a new effective interest rate based on the carrying value of the original debt and the revised cash flows.

If the transaction does not meet the two conditions noted above, it is not a TDR, and the modifications and exchanges guidance in ASC 470-50 applies.

Accounting for TDRs

Because a TDR can involve various possible settlements, accounting for the modification depends on the nature of the transaction.

While a detailed analysis of accounting for every type of loan modification is beyond the scope of this article, here is a high-level overview of the accounting treatments.

Settlement With Assets or Equity

When the debtor transfers assets or equity to the creditor to fully settle a debt, the company recognizes a gain on the transaction for the amount by which the carrying amount of the debt exceeds the fair value of the transferred assets.

If the transfer of assets only partially settles the debt, the company reduces the carrying amount of the debt by the fair value of the assets transferred and recognizes a gain/loss on the assets transferred (difference between the fair value and carrying value of the assets transferred).

Change in Terms

If there is only a change in terms, then the company accounts for the change on a go-forward basis from the date of the restructuring. This means it does not change the carrying amount of the debt unless that amount exceeds the total amount of all remaining cash payments required under the new agreement. A gain exists if the carrying amount of the old debt exceeds the undiscounted cash flows associated with the new debt, including direct fees paid to the lender to affect the TDR.

Partial Settlement and Change in Terms

If the lender settles a portion of the debt and changes the terms of the debt instrument, the company first reduces the carrying amount of the debt by the fair value of the assets transferred. Then, it records a gain or loss on any difference between the fair value and the carrying amount of the transferred assets.

Keep in mind that GAAP does not allow recognition of a gain on the restructuring unless the total future cash payments remaining are less than the remaining carrying amount of the financial instruments.

Interest on Contingent Payments

When determining the total future cash payments of the modified debt, the debtor assumes it will make the future contingent payments. In terms of recognition, if the restructuring agreement includes any contingent payments, the company recognizes interest expense for these payments only when the amount of the liability can be reasonably estimated and it is probable that the debtor has incurred the liability.

If the new arrangement has a variable interest rate, estimate the amount of future payments based on the current interest rate on the date of the restructuring and adjust for any subsequent changes in the rate later on. A debtor does not recognize a gain on a restructured debt instrument that involves indeterminate future cash payments if the maximum total future cash payments may exceed the carrying amount of the original debt.

Fees

If fees are associated with granting an equity interest in the debtor, offset them against the recorded amount of the equity interest. Any other fees not related to granting an equity interest are used to reduce any gain recognized on the restructuring transaction. If there is no gain to offset, the company expenses those fees as incurred. Any remaining unamortized debt issuance costs at the time of the restructuring are part of the debt’s net carrying amount immediately before the restructuring. Accordingly, if the total amount of future undiscounted cash flows of the restructured debt exceeds the net carrying amount, such costs continue to be amortized after the TDR. Alternatively, if the TDR involves the recognition of a gain, any remaining unamortized debt issuance costs reduce the amount of the gain that would otherwise have been recognized.

Get Help with TDRs from CBIZ ARC

Troubled debt restructurings can provide a lifeline to struggling businesses while offering a pragmatic solution for lenders. However, accounting for these transactions requires thoroughly analyzing the facts and circumstances and the relevant authoritative accounting literature. It can also require a significant amount of professional judgment.

If you’re grappling with debt challenges or need expert advice on troubled debt restructurings, don’t hesitate to contact CBIZ ARC. Our team is equipped to guide you through the complexities of determining whether loan modifications qualify as a TDR, recording the transaction and drafting the related financial statement disclosures. Connect with us today for a consultation and take the first step towards resolving your financial difficulties with confidence.