Accounting News: Troubled Debt Restructurings, Lecture notes of Accounting

Download Accounting News: Troubled Debt Restructurings and more Lecture notes Accounting in PDF only on Docsity! 26 Supervisory Insights Summer 2012 This regular feature focuses on topics of critical importance to bank accounting. Comments on this column and suggestions for future columns can be e-mailed to SupervisoryJournal@fdic.gov. Over the last several years, many parts of the United States experienced declining real estate values and high rates of unemployment. This economic environment has rendered some borrowers unable to repay their debt according to the original terms of their loans. Interagency guidance encour- ages bankers to work with borrowers who may be facing financial difficul- ties.1 Prudent loan modifications are often in the best interest of financial institutions and borrowers, and in fact many financial institutions are restructuring or modifying loan terms to provide payment relief for borrow- ers whose financial condition has deteriorated. These loan modifications may meet the definition of a troubled debt restructuring (TDR) found in the accounting standards. FDIC examiners and supervisors frequently receive questions from bankers about TDRs. Often the answers to these questions can be found in the framework for TDRs established by the accounting stan- dards, a framework which governs the identification of TDRs, the impairment analysis that banks must perform, and the required disclosures. Other important guidance is found in the banking agencies’ published instruc- tions for the Consolidated Reports of Condition and Income (Call Report) and selected policy statements of the federal banking agencies. This article summarizes and distills the aspects of these standards and guidance that are most relevant to identifying and accounting for TDRs and complying with the associated regulatory report- ing requirements.2 Accounting Guidance A modification of the terms of a loan is a TDR when a borrower is troubled (i.e., experiencing financial difficul- ties) and a financial institution grants a concession to the borrower that it would not otherwise consider. The following discussion will focus on the generally accepted accounting prin- ciples (GAAP) that provide relevant guidance for the financial reporting of TDRs. The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 310 provides the basis for identifying TDRs and treating TDRs as impaired loans when estimating allocations to the allowance for loan and lease losses (ALLL).3 In this regard, ASC Accounting News: Troubled Debt Restructurings 1 FIL-35-2007, Statement on Working with Mortgage Borrowers, April 17, 2007, www.fdic.gov/news/news/finan- cial/2007/fil07035.html; FIL-128-2008, Interagency Statement on Meeting the Needs of Creditworthy Borrowers, November 12, 2008, www.fdic.gov/news/news/financial/2008/fil08128.html; FIL-61-2009, Policy Statement on Prudent Commercial Real Estate Loan Workouts, October 30, 2009, www.fdic.gov/news/news/financial/2009/ fil09061.html; and FIL-5-2010, Interagency Statement on Meeting the Credit Needs of Creditworthy Small Business Borrowers, February 12, 2010, www.fdic.gov/news/news/financial/2010/fil10005.html. 2 Additional guidance on accounting for TDRs is included in the transcript from the FDIC’s Seminar on Commer- cial Real Estate Loan Workouts and Related Accounting Issues, December 15, 2011, www.fdic.gov/news/ conferences/2011-12-15-transcript.html. 3 ASC Subtopic 310-40, Receivables – Troubled Debt Restructurings by Creditors (formerly Statement of Financial Accounting Standards No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings), and ASC Subtopic 310-10, Receivables – Overall (formerly Statement of Financial Accounting Standards No. 114, Account- ing by Creditors for Impairment of a Loan), respectively. 27 Supervisory Insights Summer 2012 Subtopic 310-40 addresses receiv- ables that are TDRs from the lending institution’s standpoint. Other GAAP guidance addresses the accounting for TDRs from the borrower’s stand- point, a discussion of which is beyond the scope of this article.4 Finally, this article incorporates the new guidance in the FASB’s Accounting Standards Update No. 2011-02 (ASU 2011-02) that, among other clarifications of TDR issues, discusses whether a delay in payment as part of a loan modifica- tion is insignificant.5 These resources along with complementary regulatory guidance provide the foundation for discussing TDRs. Identification of a TDR A TDR involves a troubled borrower and a concession by the creditor. ASU 2011-02 identifies several indicators a creditor must consider in determining whether a borrower is experiencing financial difficulties. These indica- tors include, for example, whether the borrower is currently in payment default on any of its debt and whether it is probable the borrower would be in payment default on any debts in the foreseeable future without the modifi- cation. Thus, a borrower does not have to be in payment default at the time of the modification to be experienc- ing financial difficulties. Types of loan modifications that may be concessions that result in a TDR include, but are not limited to: „ A reduction of the stated interest rate for the remaining original life of the debt, „ An extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk, „ A reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement, or „ A reduction of accrued interest. The lending institution’s concession to a troubled borrower may include a restructuring of the loan terms to alleviate the burden of the borrower’s near-term cash requirements, such as a modification of terms to reduce or defer cash payments to help the borrower attempt to improve its financial condition. An institution may restructure a loan to a borrower experiencing financial difficulties at a contractual interest rate below a current market interest rate, which normally is considered to be a conces- sion resulting in a TDR. However, a change in the interest rate on a loan does not necessarily mean that the modification is a TDR. For example, an institution may lower the interest rate to maintain a relationship with a borrower that can readily obtain funds from other sources. In this scenario, extending or renewing the borrower’s loan at the current market interest rate for new debt with similar risk is not a TDR. To be designated a TDR, both borrower financial difficulties and a lender concession must be present at the time of restructuring. Determining whether a modification is at a current market rate of interest at the time of the restructuring can be challenging. The following scenarios 4 ASC Subtopic 470-60, Debt – Troubled Debt Restructurings by Debtors (formerly Statement of Financial Account- ing Standards No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings). 5 Accounting Standards Update No. 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. 30 Supervisory Insights Summer 2012 7 FIL-105-2006, Allowance for Loan and Lease Losses Revised Policy Statement and Frequently Asked Questions, December 13, 2006, www.fdic.gov/news/news/financial/2006/fil06105.html. 8 Ibid. 9 Instructions for the Preparation of Consolidated Reports of Condition and Income, Glossary, “Allowance for Loan and Lease Losses,” page A-3 (9-10), http://www.fdic.gov/regulations/resources/call/crinst/2012- 03/312Gloss_033112.pdf. 10 Furthermore, the Uniform Retail Credit Classification and Account Management Policy calls for charge-offs of retail loans, including TDRs, in certain circumstances. See FIL-40-2000, June 29, 2000, www.fdic.gov/news/news/ financial/2000/fil0040.html. Troubled Debt Restructurings continued from pg. 29 Fair Value of Collateral Method Questions and Answers Q) Is the definition of collateral dependent for regulatory reporting purposes the same as under GAAP, which includes loans for which the cash flow from the operation of the collateral is the only source of repayment? Or is a loan collateral dependent only when repayment is dependent on the sale of the collateral? A) Collateral dependent is defined in ASC Subtopic 310-10, which is the same definition used in the December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses: A loan is collateral dependent if repayment of the loan is expected to be provided solely by the underlying collateral.7 The instructions for the Call Report elaborate on this definition, noting that it applies to situations where there are no other available and reliable sources of repayment other than the underlying collateral. Thus, the definition of collateral dependent includes cases where repayment of the loan is dependent on the sale of the collateral as well as cases where repayment is dependent only on the operation of the collateral. Q) Impairment measurement on an impaired collateral dependent loan for which repay- ment is dependent only on the operation of the collateral should not reflect costs to sell. What is the reference for this guidance? A) FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan, was the original source. This guidance is now in ASC paragraph 310-10-35-23, which states “if repayment or satisfaction of the loan is dependent only on the operation, rather than the sale, of the collateral, the measure of impairment shall not incorporate estimated costs to sell the collateral.” Q) When is an allocation to the ALLL appropriate for a collateral dependent TDR and when is a charge-off needed? A) The December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses and the Glossary section of the Call Report instructions provide guidance on measuring impairment relevant to TDRs. Each institution must maintain an ALLL at a level appropriate to cover estimated credit losses associated with the loan and lease portfolio in accordance with GAAP.8 Additions to, or reductions of, the ALLL are to be made through charges or credits to the “provision for loan and lease losses” in the Call Report income statement.9 When available information confirms that specific loans or portions thereof are uncollectible, including loans that are TDRs, these amounts should be promptly charged off against the ALLL.10 31 Supervisory Insights Summer 2012 the ALLL.12 Institutions must apply the fair value of collateral method appro- priately to TDRs. With regard to the present value of cash flows method, an institution’s esti- mate of the expected future cash flows on a TDR should be its best estimate based on reasonable and supportable assumptions (including default and prepayment assumptions) and projec- tions. GAAP also specifies the effective interest rate to be used for discount- ing. Under ASC Subtopic 310-10, when measuring impairment on a TDR using the present value of expected future cash flows method, the cash flows should be discounted at the effective interest rate of the original loan, not the rate after the restructuring. For a restructured residential mortgage loan that originally had a “teaser” or starter rate less than the loan’s fully indexed rate, the starter rate is not the original effective interest rate. In this case, the effective interest rate should be a blend of the “teaser” rate and the fully indexed rate. If the results are not materially different from using the blended rate, the fully indexed rate may be used as the effective interest rate. Using the proper effective inter- est rate is critical to allocating the appropriate amount to the ALLL when measuring impairment on a TDR under the present value method. 11 FIL-61-2009, Policy Statement on Prudent Commercial Real Estate Loan Workouts, October 30, 2009, www.fdic. gov/news/news/financial/2009/fil09061.html. 12 FIL-105-2006, Allowance for Loan and Lease Losses Revised Policy Statement and Frequently Asked Questions, December 13, 2006, www.fdic.gov/news/news/financial/2006/fil06105.html. For an individually evaluated impaired collateral dependent loan, including a TDR, the banking agencies require that impairment be measured using the fair value of collateral method in ASC Subtopic 310-10. In this situation, as discussed in the October 2009 Policy Statement on Prudent Commercial Real Estate Loan Workouts, if the recorded amount of the loan exceeds the fair value of the collateral (less costs to sell if repayment of the loan is dependent on the sale of the collateral), this excess represents the measurement of impairment on the loan and is the amount to be included for this loan in the overall ALLL. However, determining the portion of this difference that represents a confirmed loss, if any, which should be charged against the ALLL in a timely manner, is based on whether repayment is dependent on the sale or only on the operation of the collateral.11 Q) Are institutions required to evaluate impairment using the present value of expected future cash flows method when an impaired loan, including a TDR, is not collateral depen- dent? Can an institution use the fair value of collateral method to measure impairment on an impaired non-collateral dependent loan? A) A TDR is not collateral dependent when there are available and reliable sources of repayment other than the sale or operation of the collateral. ASC Subtopic 310-10 acknowl- edges that a loan’s observable market price may be used as a practical expedient to measure impairment. However, such a price is not usually available for individual impaired loans, including TDRs. Therefore, the present value of expected future cash flows method normally would be used when a TDR is not collateral dependent. The fair value of collateral method may only be used when an impaired loan, including a TDR, is collateral dependent. It would be inappropriate under GAAP to measure impair- ment using the fair value of collateral method when an impaired loan or TDR is not collateral dependent. 32 Supervisory Insights Summer 2012 Applying the Appropriate Impairment Measurement Method Example 1: Discounted Cash Flow Method FACTS: A banker makes a commercial loan to a small wholesale business, which has a market interest rate at origination. The loan matures in five years and is secured by a first lien on the business’s warehouse. „ After 24 months, the local economy has weakened, adversely affecting the borrower’s wholesale business. The borrower has fallen delinquent on several loans including this commercial loan, which is 90 days past due. After carefully analyzing the borrower’s personal and business financial statements and credit reports, the banker determines that it is likely the borrower’s business will be able to generate only enough cash flow to partially service this commercial loan. The borrower plans to operate the business for five more years and expects economic conditions to improve by the end of this period, enabling the borrower to sell the business at that time, including remaining inventory and the warehouse. „ The banker decides to restructure the remaining principal balance of this commercial loan to mature in five years. Based on the borrower’s expected cash flows from the business, the banker lowers the contractual interest rate to a below market rate (i.e., to an interest rate that is less than the rate the banker would charge at the time of the restructuring for a new loan with comparable risk). The required monthly payments are reduced, with these payments expected to come from business operations. A balloon payment is scheduled at the end of five years. „ Based on reasonable and supportable assumptions and projections, which take default probability into account, the banker develops an estimate of the expected monthly cash flows over the five year loan term. The banker also concludes that the current “as is” appraised value of the warehouse is not likely to increase over this period. Considering the borrower’s current inventory levels and other information, the banker estimates that the sale of the borrower’s warehouse and other available business assets at the end of five years would generate additional funds to satisfy the debt. „ Considering all available evidence, including the borrower’s current financial difficul- ties, the banker’s best estimate is that 90 percent of the contractual loan payments under the modified terms will be collected. IMPAIRMENT MEASUREMENT METHOD: This restructured commercial loan is a TDR subject to impairment measurement in accordance with ASC Subtopic 310-10. Because the available and reliable sources of repayment include cash flow from the borrower’s business operations, this commercial loan is not collateral dependent. The banker will use the discounted cash flow method to determine the impairment amount.13 13 The commercial loan does not have an observable market price. Troubled Debt Restructurings continued from pg. 31 35 Supervisory Insights Summer 2012 Accrual Status The Glossary section of the Call Report instructions provides guid- ance for nonaccrual status, which is consistent with GAAP and applies to loans that have undergone TDRs. The general rule is that institutions shall not accrue interest on any loan: „ which is maintained on a cash basis because of deterioration in the financial condition of the borrower, „ for which payment in full of princi- pal or interest is not expected, or „ upon which principal or interest has been in default for a period of 90 days or more unless the loan is both “well secured” and “in the process of collection.”14 Assuming the accrual of interest has not already been discontinued on a loan undergoing a TDR, this Call Report general rule should be consid- ered when evaluating whether the loan should be placed in nonaccrual status. However, the general rule need not be applied to consumer loans and loans secured by one-to-four family residential properties on which prin- cipal or interest is due and unpaid for at least 90 days. If not placed in nonaccrual status, these loans should be subject to alternative methods of evaluation to assure the institu- tion’s net income is not materially overstated. When such consumer and residential loans are treated as nonaccrual by the institution, these loans must be reported as nonaccrual in the Call Report. The exception from the general rule for nonaccrual status and related guidance also apply to consumer and residential loans that are TDRs. 14 Instructions for the Preparation of Consolidated Reports of Condition and Income, Glossary, “Nonaccrual Status,” page A-59 (9-10), http://www.fdic.gov/regulations/resources/call/crinst/2012-03/312Gloss_033112.pdf. 15 Ibid. „ A loan is “well secured” if it is secured by collateral in the form of liens on or pledges of real or personal property, including securities, with a realizable value sufficient to discharge the debt (including accrued interest) in full, or by the guarantee of a finan- cially responsible party. „ A loan is “in the process of collection” if collection of the loan is proceeding in due course through either legal action or other collection efforts which are reasonably expected to result in repayment of the loan or in its restoration to a current status in the near future.15 36 Supervisory Insights Summer 2012 A nonaccrual loan may be restored to accrual status: „ when none of its principal and interest is due and unpaid, and the institution expects repayment of the remaining contractual principal and interest, or „ when it becomes “well secured” and “in the process of collection” as previously defined. With regard to satisfying the first parameter, the institution must have received repayment of the past-due principal and interest unless the loan has been formally restructured in a TDR and qualifies for accrual status. Thus, a nonaccrual loan that has been formally restructured and is reason- ably assured of repayment (of prin- cipal and interest) and performance according to the modified terms may be returned to accrual status even though amounts past due under the original contractual terms have not been repaid. In this scenario, the restructuring and any charge-off taken on the loan must be supported by a current, well documented credit evaluation of the borrower’s financial condition and prospects for repay- ment under the modified terms. Otherwise, the restructured loan must remain in nonaccrual status. The credit evaluation must include consid- eration of the borrower’s sustained historical repayment performance for a reasonable period before the date the loan is returned to accrual status. A sustained period of repay- ment performance is generally a minimum of six months and involves payments of cash or cash equivalents. In returning a nonaccrual TDR to accrual status, sustained historical repayment performance for a reason- able time before the restructuring may be considered. Such a restructuring must improve the collectability of the loan in accordance with a reason- able repayment schedule and does not relieve the institution from the responsibility to promptly charge off identified losses. Returning a nonac- crual TDR to accrual status must be carefully documented and supported. The structure of a modified loan that is a TDR may influence whether the loan is reported in nonaccrual or accrual status. A formal restruc- turing may involve a multiple note structure in which a troubled loan is divided into two notes. In accordance with the October 2009 Policy State- ment on Prudent Commercial Real Estate Loan Workouts16 and the Call Report instructions, institutions may separate the portion of an outstand- ing troubled loan into a new legally enforceable note (i.e., the first note) that is reasonably assured of repay- ment (of principal and interest) and performance according to prudently modified terms. The second note represents the portion of the original loan that is unlikely to be collected and has been charged off at or before the restructuring. The first note may be placed in accrual status provided the conditions in the preceding para- graph are met and the restructuring has economic substance and qualifies as a TDR under GAAP. In contrast, a loan that undergoes a TDR should remain or be placed in nonaccrual status if the modifica- tion does not include the splitting of the troubled loan into multiple notes, but the institution instead internally 16 FIL-61-2009, Policy Statement on Prudent Commercial Real Estate Loan Workouts, October 30, 2009, www.fdic. gov/news/news/financial/2009/fil09061.html. Troubled Debt Restructurings continued from pg. 35 37 Supervisory Insights Summer 2012 recognizes a partial charge-off for the identified loss on the loan before or at the time of its restructuring as a single note. A partial charge-off would indicate the institution does not expect full repayment of the amounts contractually due under the loan’s original terms. After the restructuring, the remaining balance of the TDR may be returned to accrual status without having to first recover the charged-off amount if the conditions for returning a nonaccrual TDR to accrual status discussed above are met. The charged- off amount may not be reversed or re-booked when the loan is returned to accrual status. If a loan appropriately in accrual status has its terms modified in a TDR, the loan may not meet the crite- ria for placement in nonaccrual status at the time of the restructuring. The TDR can remain in accrual status provided the borrower’s sustained historical repayment performance for a reasonable time prior to the TDR (generally a minimum of six months) is consistent with the loan’s modi- fied terms and the loan is reasonably assured of repayment (of principal and interest) and of performance in accordance with its modified terms. This determination must be supported by a current, well documented credit evaluation of the borrower’s financial condition and prospects for repay- ment under the revised terms. Income on nonaccrual TDRs should be reported in accordance with the Call Report instructions and GAAP. For a nonaccrual TDR, some or all of the cash interest payments received may be recognized as interest income on a cash basis provided the remain- ing recorded investment in the loan (i.e., after charge-off of identi- fied losses, if any) is deemed fully collectible. If a nonaccrual TDR that has been returned to accrual status subsequently meets the criteria for placement in nonaccrual status as a result of past-due payments based on its modified terms or for any other reason, the TDR must again be placed in nonaccrual status. Regulatory Reporting Properly applying the accounting and Call Report requirements for TDRs provides useful financial infor- mation about the quality of the loan portfolio and an institution’s efforts to work with troubled borrowers. Two Call Report schedules specifically disclose information on TDRs by loan category: „ Schedule RC-C, Part I, “Loans and Leases,” Memorandum item 1, if the TDR is in compliance with its modi- fied terms, and „ Schedule RC-N, “Past Due and Nonaccrual Loans, Leases, and Other Assets,” Memorandum item 1, if the TDR is not in compliance with its modified terms. To be considered in compliance with its modified terms, a loan that is a TDR must be in accrual status and must be current or less than 30 days past due on its contractual princi- pal and interest payments under the modified terms. A TDR that meets these conditions must be reported as a restructured loan in Schedule RC-C, Part I, Memorandum item 1. In the calendar year after the year in which