Classifying restructured loans as “troubled debt restructurings” (TDRs) could have a significant impact on a bank’s financial statements. Unfortunately, determining whether a restructuring is a TDR can be a challenge, but recent guidance from the Financial Accounting Standards Board (FASB) and the Office of the Comptroller of the Currency (OCC) is helpful.
What is a TDR?
A restructuring is a TDR if a bank or other creditor, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower it wouldn’t otherwise consider. Several factors may signal financial difficulties, including default on debts, bankruptcy, inadequate cash flows and other problems.
Concessions may take many forms, including reducing the interest rate for the remaining life of the loan, extending the maturity date at a below-market rate, or forgiving interest or principal.
Once a restructuring is classified as a TDR, the bank must measure it for impairment and, if appropriate, recognize a valuation allowance or loss. Also, a loan that’s the subject of a TDR will likely need to be placed on nonaccrual status.
Is it a concession per the new standards?
A bank has granted a concession if, as a result of a restructuring, it doesn’t expect to collect all amounts originally due, including interest accrued at the original loan rate. Last year, FASB amended its accounting standards to help creditors make this determination. Among other things, the amendments clarify that:
• If a borrower doesn’t have access to funds at market rate for a loan with similar risk characteristics as the restructured loan, the restructuring is considered to be at below-market rate. This may indicate that the bank has granted a concession, depending on other aspects of the restructuring.
• Even if a loan modification temporarily or permanently increases the contractual interest rate, it may still be considered a concession. This is the case, for example, if the new rate is below market rate, at the time of the restructuring, for new loans with similar risk characteristics. Again, the determination requires consideration of all aspects of the restructuring.
• A restructuring that involves only a delay in payment that’s “insignificant” isn’t a concession.
• A bank may conclude that a borrower is experiencing financial difficulties even if the business isn’t currently in default.
• The fact that the effective interest rate after restructuring is at least equal to the prerestructuring rate doesn’t mean a concession hasn’t been granted. It depends on the terms of the restructuring.
Keep in mind that, even if there has been a concession, there’s no TDR unless the borrower is experiencing financial difficulties. A bank may reduce the interest rate on a loan to a healthy borrower for competitive reasons. Also, a borrower’s inability to obtain credit elsewhere doesn’t necessarily signal financial trouble.
What about loan renewals?
FASB’s amendments didn’t expressly address renewals, but in April 2012 the OCC published guidance on this issue. Renewing a loan classified as “substandard” under regulatory guidelines isn’t automatically considered a TDR. But if a bank renews the loan — unmodified, and without additional underwriting — it’s presumed to be a TDR.
If, after additional underwriting, the bank takes steps to address its risk — such as adding collateral or new guarantors or adjusting the pricing — the renewal might not be a TDR, depending on all the facts and circumstances. If collateral or guarantees are added, the bank should evaluate whether they serve as adequate compensation for other terms of the restructuring (including an evaluation of any guarantor’s ability and willingness to pay). If new collateral or guarantees don’t adequately compensate the bank, the bank has granted a concession.
Document the process
Identifying TDRs involves significant judgment. To satisfy regulators, conduct a thorough analysis and document the reasoning behind your conclusions. Work with your accounting department and contact your CPA if you have any TDR questions.