How should a company account for a debt modification or restructuring under GAAP?

As companies rethink their financing with banks and investors, they are experimenting with the best way to renegotiate existing debt, thereby improving their credit profile and liquidity. When a company is unable to meet its capital or interest payments, or believes it will break a covenant, it can (try to) amend the agreement with its lender, rather than defaulting.

To the borrower, agreements help the company’s cashflow situation improve without going to an extreme (shutting down or filing for bankruptcy). Common amendments include:

• Changing the rate or reducing the amount of interest (coupon rate).
• Asking for capital repayment deadlines to be delayed, or temporarily reducing financial metrics needed to break covenants.

All debt amendments have implications for financial statements, because they are not all treated the same way under GAAP. Given that there are many possible amendments, proper assessment of the accounting and potential impact is vital: under US GAAP, and the Financial Accounting Standards Board (FASB) guidelines in particular, consideration needs to be given to the accounting impact of a change, every time the terms are amended.

All amendment-related items fall into one of two buckets: troubled debt restructurings handled under ASC 470-60, or modifications and exchanges under ASC 470-50.

Troubled Debt Restructuring

The first question for any amendment is to determine whether it is, or is not, a troubled debt restructuring. Troubled debt restructuring, or TDR, occurs when a creditor, for economic or legal reasons related to the debtor’s deteriorating operating results or financial position, grants a concession to the debtor that it would otherwise not consider.

To classify an agreement as such, two conditions need to be met: the borrower should be experiencing financial difficulty and the creditor should have granted a concession because of it. Both must be true.

Judgment is needed to conclude overall financial difficulty, not just a box ticking exercise. A few questions help:

• Has the borrower filed for bankruptcy?
• Are principal or interest payments on debt past due?
• Is there substantial doubt about the company’s ability to continue as a going concern?
• For a public company, has its stock been delisted from its exchange?
• Is there a breach of covenant, financial or otherwise?

If the answer to any of these is yes, one must examine whether a concession has been granted by the lender. A concession is where a creditor does something that would otherwise not have been done (before financial difficulty). In practice, a concession is granted if the effective interest rate on the new debt instrument is below the existing debt instrument’s pre-modified effective interest rate.

The subsequent TDR accounting turns on one further comparison, between the total undiscounted future cash flows of the restructured instrument’s new terms with the old debt’s net carrying value.

If the total undiscounted cash flows of the new terms are less than the net carrying value of the debt, the difference is recognized as a gain. No future interest expense is recognized, and every cash payment reduces the carrying value.

If the total undiscounted cash flows of the new terms are greater than the net carrying value of the debt, no gain is recognized, and the new effective interest rate on the debt is recalculated.

Modification or Extinguishment of the Debt Instrument

If the change does not qualify as a TDR, it must be treated under ASC 470-50.

The next step is to determine whether a debt amendment is treated as a modification, or an extinguishment. You line up the old debt against the new one. If the terms are “substantially different” the old debt is treated as extinguished, the new one takes its place, and any gain or loss is booked currently. Substantially different means the present value of cash flows under the new terms differing by at least 10% from the present value of remaining cash flows under the original terms.

A few factors tend to point toward substantial difference.

The debt may now be held by a new lender. The new or restructured debt (or other restructuring terms) include features with substantive conversion options or equity.

The ASC 470-50 guidance spells out how to calculate whether the present value of the remaining cash flows is substantially different. Some features, however, require more careful consideration.

• Floating interest rates.
• Conversion options.
• Sweeteners given to the lender, like issuing or amending a warrant to buy stock.

If the change is treated as an extinguishment, the existing debt is removed from the books and a gain or loss is calculated. The new debt replaces it at its estimated fair value. Any gain or loss on the difference between the carrying amount of the old debt and the fair value of the new is put through the income statement. If the change is a modification, no gain or loss is booked in the income statement; the term change only is applied going forward.

The guidance on accounting for any change to a debt instrument also includes help on handling changes to costs incurred when issuing debt. A debt modification sees two sets of costs that must be separately analyzed and tracked. The first is the value of whatever costs are still left over from the original debt agreement. The second is any costs the borrower pays for the debt modification.

When examining amended debt, any leftover costs on the books associated with the old agreement must be amortized over the new debt instrument’s remaining term.

Reference Rate Reform

The days of using LIBOR are winding down. The transition began December 31, 2021 and is set to end June 30, 2023. Loan agreements that use LIBOR may need to be amended to use another benchmark such as the Secured Overnight Financing Rate (SOFR).

The FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848), in March 2020, and ASU No. 2022-06, “Reference Rate Reform (Topic 848): Deferral of the Sunset Date of Topic 848,” in December 2022. For companies moving debt from LIBOR to SOFR or another benchmark, the guidance lets them skip the debt modification analysis and adjust the effective interest rate going forward. The relief can be taken through the end of 2024. The FASB gives this relief only if a change to the reference rate is all that happens. If any term other than the benchmark rate is changed at the same time, you lose the relief and the normal guidance applies.