Accounting for Debt Modifications
There are many reasons why companies refinance or restructure their debt. The market conditions and interest rate environment may prompt many companies to review their current capital structure. Others may want to conserve their cash by extending the maturity date or increasing their revolving credit limit. No matter the reason, companies must analyze the reason for the modification, the parties involved, and the changes in cash flows to correctly account for the debt modification.
Types of Debt Modifications
To properly account for debt modifications, the type of debt modification must first be identified. Modifications or exchanges of debt with the same lender fall under ASC 470-50, Debt- Modifications and Extinguishments.
Type of Modification | Description |
Troubled debt restructuring (TDR) | To be classified as a TDR, the borrower must be experiencing financial difficulties, AND the lender must grant a concession. The lender would grant a concession to protect its investment and recoup whatever it can. These concessions include settling the debt for less than the outstanding principal amount or partial settlement through other noncash considerations. These concessions would cause the effective borrowing rate of the restructured debt to be less than the effective borrowing rate of the original debt. |
Modification of a term loan | A term loan is essentially non-convertible debt with a principal amount, interest component, and maturity date (straight debt). Changes to a term loan arrangement include extending the maturity date, changing the interest rate, increasing the borrowing amount, or changing the principal amortization. |
Modification of a revolving line of credit | A revolving line of credit allows the company to borrow up to a certain amount, repay portions of previously borrowed amounts, and reborrow the portion it paid off. Changes to a revolving line of credit include increasing or decreasing the borrowing capacity or changing the revolver’s commitment fee. |
Modification of a loan syndication or loan participation | A loan syndication involves multiple lenders, typically arranged by an investment bank to raise a large amount of capital. Changes to a loan syndication involve an existing lender changing its principal amount, a new lender entering the syndicate and taking over for an exiting lender, etc.
A loan participation involves the debtor borrowing from a lead lender. The lead lender then sells and transfers interests in the loan to other participating banks. Changes to the terms of the loan are between the debtor and the lead lender. |
Modification of a credit facility | A credit facility typically includes term loans and revolving credit arrangements. A change to a credit facility can include new lenders joining, old lenders leaving, or a change to an existing lender’s loan amount or type. |
This article does not cover the accounting for convertible debt (e.g., conversions or modifications).
Accounting Considerations
- Is the modification or exchange of debt with the same lender?
ASC 470-50 only applies to modifications or exchanges of debt with the same lender. Whenever there is a transaction with a different lender, it is not a modification. If existing debt is paid off and there is a contemporaneous issuance of new debt with a new or different lender, the existing debt would be accounted for as an extinguishment. If there are transactions between or among lenders, these do not affect the accounting by the debtor for the original debt instrument.
When a company has public debt and refinances its existing debt by repurchasing the debt in the market (i.e., through a tender offer) and simultaneously issues new public debt, some of the lenders in the new debt may be the same as the existing debt. However, these transactions are not typically negotiated between the company and its existing lenders. Instead, at a high level, the original public debt is seen as issued by a different lender from the new public debt and treated as an extinguishment. This approach is reasonable when no single investor holds a significant concentration of both the old and new debt, the holders of the original debt were not involved in the negotiations with the underwriter on the terms of the new debt, the new debt was offered to all potential qualified investors, and there was no preferential treatment given to the holders of the original debt.
- Is the debt modification considered a TDR?
The first step in accounting for modifications of debt instruments is to determine if the modification is considered a TDR. Once it is established whether the modification is a TDR, the appropriate accounting model should be applied. See criteria below.
Step 1: Is the debtor experiencing financial difficulty? | · Debtor is currently in default on its debt · Debtor has declared bankruptcy · Significant doubt debtor will continue to be a going concern · Debtor’s securities are delisted · Debtor’s forecasts show it won’t be able to pay its debt obligations · Debtor can’t find financing from other sources |
Step 2: Did the lender grant a concession? | To be considered a concession, the effective borrowing rate on the restructured debt should be calculated. The effective borrowing rate of the restructured debt is calculated by solving for the discount rate that equates the current carrying amount of the original debt to the present value of the cash flows under the terms of the restructured debt. If the new effective borrowing rate is less than the original effective borrowing rate, then it is considered a concession. |
- Is the third-party intermediary considered a principal or agent?
Oftentimes, a third-party intermediary (e.g., an investment banker) is involved in the modification of debt by coordinating the buyback or issuance of new debt. Whenever a third-party intermediary is involved, the company should consider whether they are acting as a principal or agent. If they are acting as the principal, then they are considered the lender. If they are acting as an agent, then their involvement doesn’t affect the company’s accounting for the modification and all their actions are considered to be on behalf of the company. Key considerations in determining principal vs. agent are as follows:
- Did the third-party intermediary commit its own funds?
- Is the agreement with the third-party intermediary based on best efforts or a firm commitment?
- Can the third-party intermediary act independently?
- Is the third-party’s compensation based on the value of the debt offered or a pre-established fee?
Accounting Models
Troubled debt restructurings
The recognition and measurement of a troubled debt restructuring depend on the future undiscounted cash flows under the new terms, which include all payments and contingent payments.
| Accounting impact |
Future undiscounted cash flows < net carrying value of debt | · A gain is recorded based on the excess amount but is reduced by the amount of new fees paid to the lender and third parties. · The carrying value of the debt is written down for the excess amount. · No interest is recorded going forward. · Interest payments are recognized as a decrease in the carrying value. |
Future undiscounted cash flows > net carrying value of debt | · No gain or loss is recorded. · No adjustment to the carrying value. · Changes, including any lender fees, are accounted for prospectively through a new effective interest rate. |
If the debt has a variable rate of interest, then the change in interest rate in future periods should be accounted for as a change in estimate, unless it results in a gain through a subsequent decrease in interest rates. However, the gain should be deferred and only recognized when the debt is settled. With a subsequent increase in interest rates, the company should recognize the incremental interest expense in the period incurred.
Additional consideration should also be given to lenders holding the company’s equity prior to the restructuring. These lenders would be considered related parties, and any transactions with these lenders might be considered capital transactions.
Term Loan Modifications
In accordance with ASC 470-50, modifications or exchanges are considered extinguishments with gains or losses recognized in current earnings if the terms of the new debt and original instrument are substantially different. The instruments are considered “substantially different” when the present value of the cash flows under the new debt instrument is at least 10% different from the present value of the remaining cash flows under the original instrument. If the instruments are not considered substantially different, they are treated as modifications.
| Accounting Impact |
Extinguishment (present value of cash flows under new instrument is substantially different) | · A gain or loss is recognized based on the difference between the new debt’s fair value and the old debt’s carrying value. · The new debt is recorded at fair value while the old debt is derecognized. · Interest expense is recognized based on the effective interest method over the term of the new debt. · New lender fees are expensed (included in the gain or loss). · New third-party issuance costs are capitalized and amortized based on the effective interest method. · The existing unamortized debt discount is written off (included in the gain or loss). |
Modification (present value of cash flows under new instrument is not substantially different) | · No gain or loss is recognized. · A new effective interest rate is established. · New lender fees are capitalized and amortized based on the effective interest method. · New third-party issuance costs are expensed. · The existing unamortized debt discount is amortized over the new loan term. |
If the cash flows are not substantially different, additional consideration should be given to whether the modification added, removed, or changed a substantive embedded conversion option from the original debt instrument. The addition or removal of a substantive embedded conversion option, or a change in the fair value of the embedded conversion option > 10% of the original carrying value of the debt instrument, would typically result in the exchange being accounted for as an extinguishment.
Line-of-Credit and Revolving Agreement Modifications
Within ASC 470-50, there is separate guidance for modifications of line-of-credit or revolving arrangements. The accounting for the costs and fees related to modifications of line-of-credit arrangements depends on the change in the borrowing capacity. Borrowing capacity is defined as the remaining term multiplied by the maximum available credit under the original agreement. The accounting for the fees and costs in a revolving arrangement are as follows:
| Accounting for fees and costs |
Borrowing capacity under new agreement > borrowing capacity of old agreement | · The unamortized costs under the old agreement are deferred and amortized over the term of the new agreement. · Similarly, any costs and fees incurred in connection with the new arrangement are deferred and amortized over the term of the new agreement. |
Borrowing capacity under new agreement < borrowing capacity of old agreement | · The unamortized costs under the old arrangement are written off based on the pro-rata decrease in borrowing capacity. Any remaining unamortized costs are amortized over the term of the new arrangement. · Any costs and fees incurred in connection with the new arrangement should be deferred and amortized over the term of the new arrangement. |
Loan Syndication and Loan Participation Modifications
The main difference between a loan syndication and a typical term loan or revolver arrangement is that multiple lenders loan specific amounts to the borrower, and each lender has the right to repayment from the borrower. Therefore, there are separate debt instruments between the borrower and each of the individual lenders in the syndicate. As such, the modification guidance above should be applied on a lender-by-lender basis. For example, if there is a modification to the existing term loan amounts that affect some lenders, the 10% cash flow test should be applied to those affected lenders.
For loan participation arrangements, since the debt instrument is only between the debtor and lead lender, any changes in the debt instrument with the lead lender should be accounted for under ASC 470-50. Any transactions between or among the participating lenders do not affect the debtor’s accounting.
Credit Facility Modifications
A credit facility usually has multiple lenders. A change to a credit facility should be evaluated on a lender-by-lender basis. If there are new lenders that join the facility, those are considered new issuances. If certain lenders leave the facility, those are considered extinguishments. If an existing lender continues to be involved after the modification and continues to hold the same type of debt (i.e., either term loan or revolving line-of-credit), the respective accounting model should be applied. If the modification changes the type of debt held, the modification should be accounted for as follows:
- If the lender’s line-of-credit is replaced with a term loan, the line-of-credit model modification guidance should be applied.
- If the lender’s term loan is replaced with a line-of-credit, the term loan modification guidance (10% cash flow test) should be applied.