Treat or Trick? Changes to TDR Accounting
It’s October and that means Halloween will be here before we know it! Unfortunately for bankers, there’s a ghoul that haunts them year-round: accounting for troubled debt restructurings (TDRs)! But a recent accounting standards update (ASU) may reduce their fright! ASU 2022-02 Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures was issued in response to feedback received by the FASB during the post-implementation review process associated with ASC 326 Financial Instruments – Credit Losses.
The ASU tackled two issues:
- TDRs by creditors and
- Vintage disclosures of gross write offs
While the ASU eliminated the accounting guidance for TDRs, it enhanced disclosure requirements. This post will discuss the changes as a result of the revised guidance and you can decide for yourself if this is a treat or if it makes things trickier for you!
TDRs: A source of toil and trouble
Currently, a modification is a TDR if both of two conditions are met:
- The borrower is experiencing financial difficulty, and
- A concession is granted by the creditor that would not be granted to a borrower of similar credit risk and situation (e.g., not a market interest rate).
The accounting treatment for TDRs is to carry forward any unamortized net deferred fees/costs into the amortized cost basis of the modified receivable. Entities are required to estimate and record lifetime expected credit losses for TDRs in scope of ASC 326. The guidance specifically notes that when the discounted cash flow (DCF) model is used for estimating expected credit losses on TDRs, that the original contractual interest rate (e.g., the “old” rate) is to be used in the DCF calculation to measure expected credit losses.
This guidance was noted as unnecessarily complex by both preparers and users of the financial statements. As a result, the FASB performed research and cast a spell (ASU 2022-02) to transform the guidance!
Main provisions of the new TRD accounting rules under ASU 2022-02
ASU 2022-02 has two main components:
- Eliminated TDR recognition and measurement guidance
- Required disclosure of gross write-offs by vintage for public business entities (PBEs) only
Let’s talk about the first provision, which I think most of you will consider to be a treat!
Elimination of TDR recognition and measurement guidance
ASU 2022-02 explains that when a loan is modified, a creditor is now required to utilize the guidance found in ASC 310-20-35-9 through 35-11 to determine if the modification results in a new loan or if it is a continuation of an existing loan. Sound familiar? It should! This is the guidance commonly referred to as the 10% test or “more than minor” modification.
A creditor (i.e., a bank) must answer the following questions to determine the accounting treatment:
- Is the modified loan’s terms at least as favorable to the bank as those that would be given to the bank’s other customers with similar credit risk? (e.g., a market interest rate would qualify as a “yes”). If yes, move to #2. If no, account for the modification as a continuation of an existing loan.
- Is the present value of the cash flows under the new terms at least 10% different from the present value of the remaining cash flows under the original terms (“old” terms)? If yes, account for as a new loan. If no, move to #3.
- Is the modification “more than minor” based on the specific facts and circumstances surrounding the modification? If yes, account for the modification as a new loan. If no, account for the modification as a continuation of an existing loan.
So why does it matter if a loan is determined to be a modification of an existing loan or a new receivable? This determination drives the accounting treatment and fee recognition!
If a modification is determined to be a new receivable, then any unamortized net fees/costs and prepayment penalties are immediately recognized in interest income when the new receivable is granted. However, if the modification is deemed to be a modification of an existing receivable (“continuation”) then these fees/costs are carried forward as part of the modified receivable and any new fees/costs associated with the modification are added to the amortized cost basis of the receivable.
Additionally, if the DCF model is chosen to be utilized by the creditor when estimating cash flows, the effective interest rate used in the calculation is required to be the modified effective interest rate (e.g., use the “new” rate).
This all feels like quite the treat, but unfortunately TDRs haven’t been sent to the graveyard completely…
The ASU requires enhanced disclosures to be made for modified receivables for debtors experiencing financial difficulty. These include the requirement to disclose each reporting period, by class of financing receivable:
- Types of modifications
- Financial effect of modification by type of modification
- Receivable performance in the 12 months following a modification
Additionally, qualitative information about how credit losses are estimated for the modifications is required to be disclosed each reporting period, by portfolio segment.
Disclosure of gross write-offs by vintage
The second component of ASU 2022-02 impacts PBEs only.
The FASB received feedback that gross write-offs by year of origination (or vintage) was useful information for financial statement users. ASU 2022-02 was revised to note the requirement (for PBEs only) to disclose gross write-offs by vintage. Based on what we’ve seen, many banks were already disclosing this information, so hopefully this doesn’t cause you too much horror!
Lastly, there were inconsistencies noted in the illustrative disclosures previously included in ASC 326. The illustrated example found within the standard contained a line item disclosing current period recoveries by vintage; however, this was not specifically required by the guidance to be disclosed. Example 15 (ASC 326-20-55-79) was updated to reflect this change as part of ASU 2022-02.
Effective date and transition
For entities that have adopted ASC 326, the amendments in ASU 2022-02 are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.
For entities that have not yet adopted ASC 326, the effective dates for the amendments in ASU 2022-02 are the same as the effective dates in ASC 326.
The amendments in ASU 2022-02 should be applied prospectively for modifications and write-offs after the first day of the fiscal year of adoption. Entities have the option to apply a modified retrospective approach by making a cumulative-effect adjustment to retained earnings to recognize any changes in credit losses due to the change in TDR recognition and measurement guidance.
Closing thoughts
Accounting for TDRs is only one of many topics that bankers must evaluate. Does the accounting guidance for banks send a chill up your spine? Consider our Banking Industry Fundamentals course collection, where we provide an in-depth understanding of the various industry-specific requirements applicable to banks.
We hope you have a Happy Halloween!
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
