Saying Goodbye to Troubled Debt Restructurings
by Robert Canova, Lead Financial Specialist, Supervision and Regulation, Federal Reserve Bank of Atlanta, and Beth Ewing, Lead Risk Management Specialist, Supervision and Regulation, Federal Reserve Bank of Chicago
The troubled debt restructuring (TDR) designation, along with the specific accounting requirements that accompany it, has been the subject of lengthy discussions between examiners and institutions’ management during examinations since the designation’s inception in May 1993. However, on March 31, 2022, the Financial Accounting Standards Board (FASB) issued a new Accounting Standard Update (ASU), 2022-02,1 that eliminates the accounting and reporting requirements for TDRs once an institution adopts the current expected credit losses (CECL) allowance methodology. In analyzing the new credit loss methodology, key aspects of the forward-looking measurements of losses found in the TDR guidance were determined to already be incorporated into CECL. As a result, the FASB issued the ASU to address industry concerns that the TDR designation, along with the related accounting, is unnecessarily complex and no longer provides useful information under CECL.
Historical TDR Designation
Prior to ASU 2022-02, generally accepted accounting principles (GAAP) for TDRs were outlined in Accounting Standards Codification (ASC) Subtopic 310-40, “Receivables — Troubled Debt Restructurings by Creditors.” Under the standards, banks were required to perform an analysis for each loan modification to determine whether a borrower suffered financial difficulties at the time of renewal or restructuring and, if so, whether the bank granted a concession that it would not otherwise have granted as a result of the borrower’s financial difficulties. Concessions included principal forgiveness, a lower interest rate than the current market rate, or an extension in maturity. While the two accounting requirements for determining a TDR under ASC Subtopic 310-40 were relatively straightforward, institutions indicated that the analysis was operationally difficult to complete, including identifying and then documenting evidence of financial difficulty, performing additional recordkeeping, and conducting market rate analyses.
Over the years, banking regulatory agencies issued guidance on the relationship between TDRs and regulatory credit risk classification, such as Supervision and Regulation (SR) letter 13-17, “Interagency Supervisory Guidance Addressing Certain Issues Related to Troubled Debt Restructurings.”2 Once a TDR was established, loans were evaluated for impairment under ASC Subtopic 310-10, “Receivables — Overall.” Prior to the implementation of ASU 2022-02, the TDR designation often resulted in the modified loan being classified as “individually impaired” and correspondingly a higher allowance for loan losses being recorded.
With the advent of CECL and the recording of lifetime expected losses, the FASB concluded that credit losses for loans modified would already be considered as part of the calculation of the allowances for credit losses (ACL). In gathering feedback from the financial industry and other stakeholders, the FASB determined that the additional TDR designation on the modified loans, and the related accounting analysis, added complexity without providing useful information to external users of financial statements.
Modifications Under CECL
Under CECL, the potential losses associated with making loan modifications for borrowers experiencing financial difficulties will be evaluated for expected lifetime losses consistent with the entire portfolio. Using the accounting standards in ASC Subtopic 310-20-35, “Receivables — Nonrefundable Fees and Other Costs — Subsequent Measurement,” institutions will still need to determine whether a modification represents a new loan or a continuation of an existing loan, as was required prior to CECL. A loan modification will be treated as a new loan if two conditions are met. First, the terms of the new loan must be at least as favorable to the lender as the terms of similar loans to other borrowers with similar risk characteristics. Second, the modifications to the original loan must be more than minor. The more than minor designation means that the modifications have an impact on an institution’s earnings. Determining a modification to be a new loan will allow an institution to recognize any associated net deferred fees in earnings during the current period. Yet, if a modification is deemed to be a continuation of the original loan, any net deferred fees and costs will continue to be accreted or amortized over the remaining life of the modified loan.
While ASU 2022-02 eliminates TDR accounting guidance, it also introduces new qualitative and quantitative disclosure requirements for loan modifications made for borrowers experiencing financial difficulties. These new disclosures differ from the historical TDR disclosures, as they are not dependent upon whether the institution has provided a concession. Types of modifications for which disclosures will be required are outlined in ASU 2022-02. They include modifications for interest rate concessions, principal forgiveness, other-than-insignificant payment delays, and term extensions.3 Consistent with the pre-existing TDR identification criteria, institutions may continue to exclude from disclosures any modifications that result in an insignificant delay in payment. Both institutions that are public business entities (as defined by the FASB) and private institutions will be required to provide new disclosures. These disclosures are also required regardless of whether the modification is accounted for as a new loan.
The FASB’s goal in adding more disclosures is to provide financial statement users with enough information to gauge the potential usefulness of a modification in mitigating future losses. Qualitative disclosures include information about how modifications, and borrowers’ subsequent performance, were considered in the institution’s ACL calculation. Quantitative disclosures include information on how the loans performed in the 12 months following modification. Additionally, institutions that are considered public business entities are also required to provide current period gross write-offs by the year of origination, or vintage.
Changes to Policies and Procedures
For institutions that have already adopted CECL, the update is effective beginning in 2023 (although early adoption was permitted). For all other firms, the change is effective upon their adoption of CECL. The Federal Financial Institutions Examination Council member agencies have updated the Supplemental Call Report Instructions to provide information on reporting modified loans under ASU 2022-02.4 In April 2023, the agencies issued a revision to the 2020 Interagency Policy Statement on Allowances for Credit Losses to remove references to TDRs to conform with U.S. GAAP.5
These disclosure changes may require institutions to revise long-standing processes and procedures related to the accounting and reporting of modified loans. From a supervisory perspective — given that the TDR designation will no longer be relevant for institutions adopting CECL in 2023 — institutions should review and update policies and procedures of their loss estimation method and ensure appropriate estimates of ACL are made in accordance with GAAP.
- 1 See ASU 2022-02, “Financial Instruments—Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures,” available at https://fasb.org/Page/ShowPdf?path=ASU+2022-02.pdf&title=Accounting+Standards+Update+2022-02%E2%80%94Financial+Instruments%E2%80%94Credit+Losses+%28Topic+326%29%3A+Troubled+Debt+Restructurings+and+Vintage+Disclosures&acceptedDisclaimer=true&Submit=.
- 2 SR letter 13-17 is available at www.federalreserve.gov/supervisionreg/srletters/sr1317a1.pdf.
- 3 A note of clarification: Covenant waivers would not be considered term extensions.
- 4 The update is available at www.ffiec.gov/pdf/FFIEC_forms/FFIEC031_FFIEC041_FFIEC051_suppinst_202212.pdf.
- 5 For purposes of this guidance, the “agencies” are the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the National Credit Union Administration. The revised SR letter 20-12 is available at www.federalreserve.gov/supervisionreg/srletters/SR2012.htm.