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How New Accounting Rules Alter Corporate Debt Restructurings

How New Accounting Rules Alter Corporate Debt Restructurings

New accounting rules issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are changing the way companies account for debt restructurings. These new standards aim to provide more transparency into a company’s financial health by requiring earlier recognition of losses on debt.

Overview of the New Accounting Rules

The new accounting rules, known as ASC 470-60 and IFRS 9, require companies to record losses on debt restructurings sooner than under previous rules. Specifically, the new standards require that:

  • Losses on debt restructurings be recorded when the debt becomes probable of restructuring, rather than when the restructuring actually occurs. This means losses may need to be recorded before a formal agreement is reached.
  • Losses be measured based on the cash flows expected from the restructured debt, discounted at the original effective interest rate. This often results in larger losses than under previous rules.

The key impact is that companies will have to record losses earlier in the process, reducing net income and regulatory capital.

Why the New Accounting Rules Were Issued

The new rules aim to address some shortcomings of past standards that allowed companies to delay recognizing losses on debt. For example:

  • Companies did not have to record a loss until the restructuring actually occurred, even if it was likely for months. This delayed loss recognition.
  • The amount of losses recorded was often too small compared to the economic impact of the restructuring.

By requiring earlier loss recognition, regulators believe the new standards will provide investors and others with better insight into a company’s financial health. Companies will have to be more transparent about their likelihood of restructuring debt and the impact on cash flows.

Challenges for Companies Under the New Accounting Rules

Complying with the new debt restructuring rules poses some key challenges for companies:

  • Determining probability of restructuring – Companies will now have to closely monitor their debt and ability to make payments to determine if a restructuring becomes probable. This requires judgement and estimates.
  • Calculating expected cash flows – When a restructuring becomes likely, companies have to estimate future cash flows expected under the new terms. This can be complex.
  • Technology and data – Tracking debt restructurings and performing complex cash flow projections requires robust models and data. Many companies will need to enhance systems.
  • Volatility – Recording losses earlier under the new rules will increase net income volatility as large losses hit the financial statements sooner. This could alarm investors.

Impact on Various Industries

The new standards will impact many industries, but particularly:

Oil & Gas – Many oil and gas companies have large debt loads and have already restructured or are likely to in the future. Early loss recognition will accelerate write-downs.

Retail – Struggling retailers have restructured debt or leased stores amidst industry disruption. The new rules will likely trigger large writedowns sooner.

Telecom – Competitive and capital intensive telecom companies often restructure debt. The new standards will prompt faster recognition of losses.

Healthcare – Hospital groups facing regulatory changes may have to restructure debt, booking losses faster under the new guidance.

Examples of Restructurings Impacted

Some actual corporate debt restructurings that may have played out differently under the new rules include:

JC PenneyRestructured $4 billion of debt in 2018 to alleviate liquidity concerns. Losses may have hit sooner.

California Resources Corp – The oil & gas producer restructured $5 billion of debt in 2020 after a Chapter 11 filing. Earlier loss recognition seems likely.

Neiman Marcus – The high-end retailer filed for bankruptcy in 2020 and restructured nearly $5 billion in debt. The new standards could have accelerated losses.

Conclusion

In summary, new accounting rules are now requiring companies to record losses on debt restructurings much sooner than in the past. This aims to provide more transparency but also introduces new complexity and volatility. Heavily leveraged companies in sectors like retail, energy, and healthcare seem most likely to be impacted. But the impact of early loss recognition under the new guidance could ripple more broadly, as investors become aware of deteriorating financial positions sooner. Companies will have to closely monitor their debt and probability of restructuring to comply with the standards.

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