COVID-19 ACCOUNTING CONSIDERATIONS: DEBT MODIFICATIONS

In the coming weeks, business will face unprecedented challenges as a result of the COVID-19 pandemic.   Among other priorities, companies will be:

• Actively managing customer relationships and monitoring the risks associated with business disruption;
• Evaluating risks associated with supply chain disruptions and coordinating closely with third-party supplies and vendors;
• Working closely with lenders, investors and attorneys to raise new capital, to restructure current financing arrangements or to renegotiate contracts; and
• Keeping pace with rapid regulatory updates and the impact to business.

This alert is intended to aid businesses and practitioners as they navigate the financial accounting implications resulting from the COVID-19 crisis.   Understanding these impacts will be essential to businesses as they communicate their financial position, performance, and risks with regulators, financers and advisors in the coming weeks. In addition to their financial statements, companies will also need to evaluate potential changes to their internal controls over financial reporting (ICFR) stemming from the disruption caused by the pandemic.  Public companies will need to consider the implications to their SEC filings[1], including updates to their risk factors, MD&A, and disclosures that could materially affect an entities ICFR.

This alert highlights certain accounting areas that will likely need to be considered by companies as they prepare their financial statements during the COVID-19 crisis.  For example, organizations and practitioners will need to evaluate the accounting for loans received under programs established by the government and SBA under the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”). Entities will need to consider the accounting related to, but not limited to, the following:

• Troubled debt restructuring and debt modifications
• Debt classification (current vs non-concurrent, liability vs equity)
• Recapitalization transactions
• Asset impairment, including goodwill, intangible assets and long-lived assets
• Impairment of loans, receivables and debt securities
• Fair value of financial instruments
• Loss contingencies and loss contracts
• Contract modifications
• Lease concessions and modifications
• Stock compensation performance conditions and modifications
• Employment termination benefits
• Insurance recoveries related to business interruptions
• Government grants
• Going concern
• Subsequent events

Regulatory Update

The CARES Act provides temporary relief to financial institutions from Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) No. 2016–13 (“Measurement of Credit Losses on Financial Instruments”).  Section 4014 of the CARES Act allows financial institutions to defer their adoption of the new “CECL”[2] standard until the earlier of the end of the emergency declaration or December 31, 2020.

Section 4013 also provides temporary relief to financial institutions from the requirements under the troubled debt restructuring standards.  Financial institutions are not required to categorize COVID-19 pandemic-related loan modifications as troubled debt restructurings for the period between March 1, 2020 and the earlier of December 31, 2020 or the date that is 60 days after the end of the emergency declaration.  The CARES Act does not impact that accounting for borrowers, which is discussed in the next section.

Accounting Considerations

In this first alert, we focus on the accounting for debt modifications from the borrower’s perspective, which are addressed in FASB ASC 470-50, Debt - Modifications and Extinguishments, and FASB ASC 470-60, Debt - Troubled Debt Restructurings with Creditors.  These transactions will likely be priority to many businesses as they consider their options in the weeks to come, including whether they take advantage of the various government-sponsored loan programs.  We will address other topics in subsequent alerts.

Troubled debt restructurings and debt modifications

Many businesses are likely exploring their options to modifying their debt.  These options may include amending key terms of existing debt, such as changing the amounts and/or timing of cash flows, replacing existing arrangements with new ones from the same lender, or extinguishing existing debt using the proceeds from a loan with a different lender.  The accounting guidance applied to a debt modification varies depending on the nature of the transaction and the counterparties involved.

The simplest transaction to understand is the reporting entity’s accounting when it repays an existing obligation using the proceeds from a new debt instrument with a different lender.  In this situation, the entity should account for the transaction as a debt extinguishment, which results in a gain or loss on extinguishment.  ASC 470-50-40-2 provides guidance on how to calculate the gain or loss:

A difference between the reacquisition price of the debt and the net carrying amount of the extinguished debt shall be recognized currently in income of the period of extinguishment as losses or gains and identified as a separate item. Gains and losses shall not be amortized to future periods. If upon extinguishment of debt the parties also exchange unstated (or stated) rights or privileges, the portion of the consideration exchanged allocable to such unstated (or stated) rights or privileges shall be given appropriate accounting recognition. Moreover, extinguishment transactions between related entities may be in essence capital transactions.

Next, we discuss debt modifications involving the same lender.  These transactions fall into three[3] distinct accounting models depending on the nature of the arrangement: 1) Troubled debt restructuring, 2) Modification of a term loan or debt security, 3) Modification of a line of credit or revolving-debt arrangement.

1) Troubled debt restructuring (TDR)

A transaction is a TDR if 1) the borrower is experiencing financial difficulty, and 2) the lender grants the borrower a concession.  The following decision tree from ASC 470-60-55-5 is helpful to navigate the literature:

In a TDR transaction in which the terms of the debt are modified, the reporting entity’s accounting is dictated by whether the future undiscounted cash flows exceed the net carrying value of the original debt.  If the undiscounted cash flows are greater than the carrying amount, no gain is recorded and a new effective interest rate is established on debt.  On the other hand, if the undiscounted cash flows are less than the carrying amount, a gain is recorded for the difference[4], the carrying amount of the debt is adjusted to reflect the future undiscounted cash flows, and no interest expense is recorded going forward.

2) Modification of a term loan or debt security with the same lender

An organization’s accounting for a debt modification not considered a TDR depends on whether the change in the debt terms are considered “substantial” as indicated by the “10% Test” in ASC 470-50-40-10.  The legal form of the transaction (whether a legal exchange or a legal amendment) is irrelevant in this determination.

ASC 470-50-40-10 states, in part:

From the debtor’s perspective, an exchange of debt instruments between or a modification of a debt instrument by a debtor and a creditor in a nontroubled debt situation is deemed to have been accomplished with debt instruments that are substantially different if the present value of the cash flows under the terms of the new debt instrument is at least 10 percent different from the present value of the remaining cash flows under the terms of the original instrument. If the terms of a debt instrument are changed or modified and the cash flow effect on a present value basis is less than 10 percent, the debt instruments are not considered to be substantially different….[5] 

Based on this guidance, if the terms are not substantially different, the reporting entity accounts for the transaction as a modification of the existing debt.  Accordingly, the entity does not recognize a gain or loss and a new effective rate is established on the debt based on the revised cash flows.  Conversely, if the terms are substantially different, the reporting entity accounts for the transaction as an extinguishment of the old debt and the issuance of new debt, in which the old debt is derecognized and the new debt is recorded at fair value.  The reporting entity would record a gain or loss for the difference between the carrying value of the old debt and the fair value of the new debt (similar to the accounting described above per ASC 470-50-40-2).  Interest expense is then recorded based on the effective interest rate of the new debt.

3) Modification of a line of credit or revolving-debt arrangement

An organization’s accounting for a modification to a line of credit or revolving-debt arrangement not considered a TDR is governed by ASC 470-50-40-21:

Modifications to or exchanges of line-of-credit or revolving-debt arrangements resulting in either a new line-of-credit or revolving-debt arrangement or resulting in a traditional term-debt arrangement shall be evaluated in the following manner:

1. The debtor shall compare the product of the remaining term and the maximum available credit of the old arrangement (this product is referred to as the borrowing capacity) with the borrowing capacity of the new arrangement.
2. If the borrowing capacity of the new arrangement is greater than or equal to the borrowing capacity of the old arrangement, then any unamortized deferred costs, any fees paid to the creditor, and any third-party costs incurred shall be associated with the new arrangement (that is, deferred and amortized over the term of the new arrangement).
3. If the borrowing capacity of the new arrangement is less than the borrowing capacity of the old arrangement, then:
   1. Any fees paid to the creditor and any third-party costs incurred shall be associated with the new arrangement (that is, deferred and amortized over the term of the new arrangement).
   2. Any unamortized deferred costs relating to the old arrangement at the time of the change shall be written off in proportion to the decrease in borrowing capacity of the old arrangement. The remaining unamortized deferred costs relating to the old arrangement shall be deferred and amortized over the term of the new arrangement.

The assessment under ASC 470-50-40-21 should be made on a lender by lender basis.

Next Steps

The accounting for troubled debt restructurings and debt modifications can be extremely complex, involves significant judgments, and depends on the facts and circumstance of each transaction.  Organizations should consider consulting with their accounting advisors early in the process.

During these uncertain times, it will be important to establish structure and process around the changing business and regulatory environment.  Proactively understanding how the financial accounting standards should be applied to various organizations and to transactions will be critical as business leaders communicate with their boards, regulators, lenders, investees, and other stakeholders during the pandemic.  Please also know that you are not alone; utilize your team’s experience and consult with your accounting advisors as necessary to help interpret these complex standards for your situation.

Please contact Michael Poveda if further guidance concerning these standards is necessary.

[1] On March 25, 2020, the SEC extended the conditional relief from reporting and proxy delivery requirements for public companies, funds, and investment advisers affected by COVID-19.   Subject to certain conditions, the issued Order provides public companies with a 45-day extension to file certain disclosure reports that would otherwise have been due between March 1 and July 1, 2020. 

[2] ASU 2016-13 is commonly referred to as CECL (Current Expected Credit Loss).

[3] Note that for simplicity this alert does not consider the guidance for modifications involving loan syndications or loan participations. Readers should refer to ASC 470-50 for additional guidance and are encouraged to consult with their accounting advisors.

[4] Note that if the lender also holds the reporting entity’s equity securities, the reporting entity must evaluate whether the gain represents a capital contribution.

[5] For simplicity, the consideration of conversion options embedded in a debt instrument have been omitted from this discussion.  Readers should refer to ASC 470-50 for additional guidance on modifications involving convertible debt.