Accounting for Debt Modifications

As the economy continues to recover for its third year since the beginning of the COVID-19 pandemic, 2022 has presented companies with other issues, such as inflation and increasing fuel prices, which may have a negative impact on both operations and cash flows. Companies with debt currently recorded on the balance sheet may be considering an amendment to a current debt agreement if experiencing financial difficulties and are unable to make the required principal and/or interest payments, or anticipate they will violate debt covenants.

Amendments to debt agreements can provide companies with financial support and relief through:

• Changes or reductions in interest rates;
• Deferred repayment terms on principal balances; or
• Temporary relief from restrictive debt covenants.

How does a modified debt agreement impact financial statements and disclosures?

When a company modifies its debt, there are accounting impacts to consider. The Financial Accounting Standards Board (“FASB”) provides guidance on which companies are required to consider each time debt terms are amended as follows:

• A troubled debt restructuring (“TDR”) under Accounting Standards Codification (“ASC”) 470-60; or
• A nontroubled modification or exchange under ASC 470-50.

Troubled Debt Restructuring

Upon a modification, a company must initially evaluate whether the modification qualifies as a TDR under ASC 470-60. The accounting standards define a TDR as a restructuring of a debt that constitutes a troubled debt restructuring if the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debt that it would not otherwise consider. An amendment or modification to a debt instrument would meet the definition of a TDR if:

• The company is facing financial difficulties; AND
• The lender has granted a concession to the company as a result of the borrowers’ economic situation.

Evaluating whether a company is facing financial difficulties can be a subjective aspect of this guidance. Below are key considerations a company should consider to determine whether the company is experiencing financial difficulties:

• Has the company filed for bankruptcy?
• Is the company delinquent in making required principal and/or interest repayments?
• Is there substantial doubt about the company will continue to be a going concern?
• If publicly traded, has the company’s stock been delisted from an exchange?
• Is the company in violation of any financial or non-financial covenants?

If a company has concluded it is facing financial difficulties, the next step would be to determine whether a concession has been granted. To make this determination, companies must assess whether the effective borrowing rate of the modified debt instrument is less than the effective borrowing rate of the original debt instrument.

If the amended debt meets the criteria of a TDR and the future undiscounted cash flows are:

• Less than the net carrying value of the original debt, a company would record a gain for the difference. A company would have no further interest and all future payments would reduce the carrying value of debt.
• Greater than the net carrying value of the original debt, no gain is recorded, and a new effective interest rate (“EIR”) is established.

Modifications or exchanges of debt that do not meet the criteria of a TDR according to ASC 470-60 should be evaluated under ASC 470-50.

Modification or Extinguishment

A comparison between the existing debt terms and the new debt terms would be required to determine if they are “substantially different”.  If the terms are substantially different, the amendment will be required to be treated as an extinguishment with a gain or loss reflected in current earnings. The guidance defines substantially different as when the present value of the cash flows under the terms of the new debt instrument is at least 10% different from the present value of the remaining cash flows under the terms of the original instrument.

A substantially different debt instrument could be evaluated qualitatively or quantitatively. A borrower could conclude that the terms of the amended debt are substantially different than the original if:

• The new debt is with a new lender; or
• The new debt provides for additional equity or incorporates equity-like features (such as a substantive conversion feature).

However, the guidance stipulates how to calculate and determine if there is more than a 10% change in the present value of future cash flows. Additional considerations must be made if the original or revised debt instrument includes any of the following:

• Variable interest rates;
• Conversion features;
• A “sweetener” has been provided to the lender, such as the issuance or modification of a warrant to purchase capital stock.

If the debt is considered extinguished, the “new” debt would be recognized at its estimated fair value and the company would record a gain or loss on the difference between the carrying value of the existing debt and the estimated fair value of the modified debt. If the debt is considered modified, the amendment is accounted for prospectively with no gain or loss recognized in the company’s statement of operations.

Debt Issuance Costs

In connection with the analysis of amended debt terms, companies are required to evaluate the impact of existing and new debt issuance costs. The following chart summarizes the related impacts:

Reference Rate Reform

The London Interbank Offered Rates (“LIBOR”) will be replaced with LIBOR beginning to sunset as of December 31, 2021, continuing through June 30, 2023. If current debt agreements reference LIBOR, it may require an amendment to reference another interest rate benchmark, such as the Secured Overnight Financing Rate (“SOFR”)-based interest rate.

In response to this upcoming change, the FASB has provided temporary relief guidance companies can follow. In accordance with Accounting Standards Update No. 2020-04, Reference Rate Reform (“Topic 848”); Facilitation of the Effects of Reference Rate Reform on Financial Reporting, issued in March 2020, companies that modify their debt to transition from LIBOR to SOFR or another interest rate benchmark would not be required to consider the debt modification accounting guidance and could account for the modification prospectively by adjusting the effective interest rate. This relief is available for companies that have LIBOR (or other rates that are expected to be discontinued) through December 31, 2022. However, if other terms and conditions in the debt amendment are modified, other than the interest rate benchmark, this relief would not be available and companies will need to evaluate the full accounting guidance as summarized above.

How Centri Can Help

When a company executes an amendment to a debt instrument, Centri can assist in evaluating the accounting considerations by:

• Serving as the central point of contact for the working group, ensuring that responsibilities are clearly defined, and critical deadlines are met;
• Prepare memorandum(s) outlining key terms and accounting analysis and conclusions, including illustrative disclosures;
• Estimate the fair value of the debt based on the revised or modified terms;
• Perform the significance test, as described above, to determine if the debt was extinguished or modified; and/or
• Provide prospective accounting treatment for the new debt, including calculation of the new effective interest rate for recognition of interest expense, and modification considerations related to reference rate reform.

Contact us to learn how our experts can help you.

About Centri Business Consulting, LLC

Centri Business Consulting provides the highest quality advisory consulting services to its clients by being reliable and responsive to their needs. Centri provides companies with the expertise they need to meet their reporting demands. Centri specializes in financial reporting, internal controls, technical accounting research, valuation, and CFO and HR advisory services for companies of various sizes and industries. From complex technical accounting transactions to monthly financial reporting, our professionals can offer any organization the specialized expertise and multilayered skillsets to ensure the project is completed timely and accurately.

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