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Loan Modifications:
When Are They Troubled Debt Restructurings?

by Louise Hanson, Partner, and Anthony Porter, Manager, Financial Services Group

Current economic conditions have created many unique scenarios within problem loan accounting, particularly in regard to troubled debt restructuring arrangements, known as TDRs. TDRs are becoming more common as credit unions attempt to retain and restore existing member relationships; however, evolving accounting guidance coupled with unusual circumstances has made their accounting a complex process.

Reviewing a few common situations and questions can help you better decide if you’re dealing with a TDR and should be using special accounting rules.

What determines whether a delay in loan payments is significant enough to create a TDR?

Unfortunately there is no definitive measure to determine whether a delay is significant. Like most credit-related decisions, this depends on the circumstances.

For example, if a business suffering from declining cash flow has an amortizing commercial loan with a sizable balloon payment due in 18 months, is a modification of the loan into interest-only payments for six months considered significant? It’s likely, because the decline in business cash flows might indicate further credit deterioration on top of a looming balloon payment.

In contrast, a member with a 30-year mortgage on a single-family residence requests to skip two months of payments. This situation is likely not considered significant relative to the overall mortgage or timing to maturity.

In either instance robust documentation detailing the facts, circumstances, and conclusions should be included with the credit analysis.

How should identified impairment on TDR loans be recorded?

Depending on the likely and supportable repayment of the loan, different measures should be evaluated to record the impairment of a TDR.

If repayment of the debt is expected to be from the sale of collateral, the loan is considered collateral dependent and impairment should be recorded at the fair value of collateral less costs to sell. The impairment is considered a known loss and should be charged off immediately.

If the repayment of the TDR is determined to come from the member’s cash flow under the modified terms, then impairment upon restructuring should be calculated from the present value of future expected cash flows discounted using the original rate of the loan and recognized through a valuation allowance for loan losses on the loan. Consideration should be given to whether additional risk factors based on the assumptions of credit quality should be priced in. Regardless of the measures used, quarterly evaluation of the facts and assumptions should be performed, which can change the recorded impairment.

A member pays a fixed 5 percent interest rate on a loan with a balloon payment upon maturity. If on that date the lender extends the maturity date at the same interest rate, is the loan considered a TDR?

Possibly. There are several factors to consider when extending existing loan maturities.

A member experiencing financial difficulty and requiring multiple extensions is an indication of a TDR. Likewise, if the member’s 5 percent rate is lower than the current market rate for a new loan of the same credit quality, the extension may also be a TDR. An extension may also be a TDR if the institution would not grant the terms of the extension to a new member.

Whether a loan extension qualifies as a TDR usually comes down to one question: Can the member receive the same terms from another lender and qualify for the same terms? If the answer is no, then the loan modification is likely a TDR.

A member with a mortgage loan lost her job and asked for a loan modification. The institution modifies the loan by reducing the rate and requiring interest-only payments for 12 months. The institution understands that this loan is now a TDR, but it's also part of a homogenous loan pool for loan and lease loss reserving purposes. Can the institution keep the loan within this pool for both reserving and disclosure purposes?

No, the institution should implement guidance found in Accounting Standards Codification Section 310-10-35. The loan should be removed from the pool of homogenous loans and should also be classified as impaired for disclosure purposes. It’s important to note that if an institution is modifying larger volumes of homogenous loans (credit cards, auto loans, residential mortgages, etc.), it’s not practical to calculate impairment specific to the loan level. In this situation the entire restructured pool—or a sample of restructured loans within the pool—can be collectively evaluated to determine impairment.

Depending on the size of the institution and the volume of restructures, various methods can be utilized to calculate impairment. This may include using a sample of cash flows to apply to the entire population or actual historical loss rates for the modified category.

The Bottom Line

Consider the following when evaluating whether loan modifications are TDRs:

• A modified loan for a troubled borrower is not always a TDR; the determination depends on existing facts and circumstances.
• The ultimate source of repayment drives the method for calculating impairment.
• Known losses should be charged off immediately.
• Assumptions should be vetted by both accounting and credit administrations.
• Robust documentation should accompany assumptions when establishing a valuation allowance based on estimated cash flows.
• Because facts and circumstances can change, TDR-impairment calculations should be revisited quarterly.

Louise Hanson has been in public accounting since 1999 and specializes in audits of financial institutions, initial public offerings, registration statements, and recapitalizations.

Anthony Porter has been in public accounting since 2006 and specializes in audits of financial institutions.

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