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SRC Insights: Second Quarter 2008

Revisiting SFAS 15: Potential Restructuring Activities and the Re-Emergence of the TDR

Recent evidence obtained during on-site examinations and interim reviews of Call Report data suggests that TDRs are beginning to re-emerge and that there may be some confusion regarding their treatment under accounting and regulatory reporting requirements. Part I of this two-part SRC Insights series discussed the conditions under which a restructured loan is considered a troubled debt restructuring (TDR). This article, part II, provides an overview of the accounting and regulatory reporting requirements specific to TDRs that involve a modification of terms.

Accounting Pronouncements
The accounting for the recognition of TDRs is outlined in Statement of Financial Accounting Standards No. 15 (FAS 15), Accounting by Debtors and Creditors for Troubled Debt Restructurings, which was amended by Statement of Financial Accounting Standards No. 114 (FAS 114), Accounting by Creditors for Impairment of a Loan.1 FAS 114 requires a creditor to account for TDRs that involve a modification of terms as impaired assets. Other accounting literature that addresses TDR-related activities (e.g., transferring of assets or the granting of equity interests) includes the following:

  • Statement of Financial Accounting Standards No. 144 (FAS 144), Accounting for the Impairment or Disposal of Long-Lived Assets, addresses TDRs involving transfers of other real estate (ORE).
  • Statement of Financial Accounting Standards No. 66 (FAS 66), Accounting for Sales of Real Estate, provides guidance on the subsequent disposition of ORE.
  • Statement of Financial Accounting Standards No. 115 (FAS 115), Accounting for Certain Investments in Debt and Equity Securities, addresses TDRs involving transfers of investment securities.
  • Statement of Financial Accounting Standards No. 157 (FAS 157), Fair Value Measurements, amended certain sections of FAS 15 and addressed TDR activities resulting from the granting of equity interests.
  • Statement of Financial Accounting Standards No. 118 (FAS 118), Accounting by Creditors for Impairment of Loan-Income Recognition and Disclosures, is an amendment of FASB Statement No. 114, providing guidance on the recognition and reporting of interest income on an impaired loan.

Measuring a TDR Loan for Impairment
When TDRs involve a modification of terms, the loans should be evaluated for impairment in accordance with FAS 114; this includes TDRs for residential mortgages. Impairment measurement for TDRs depends on whether the loan is collateral-dependent. A collateral-dependent loan is defined as a loan where repayment is expected to be provided solely by the underlying collateral.2 For regulatory reporting purposes, if the loan is collateral-dependent, the measurement for impairment must be based on the fair value of the collateral, less any costs the institution expects to incur to liquidate the collateral. These costs are commonly referred to as "selling costs," such as broker's commissions, legal and title transfer fees, and closing costs.

If the loan is deemed to be impaired and is not collateral-dependent, impairment is based on the difference between the loan balance and its discounted cash flow or, although less frequently used, observable market price. The effective interest rate utilized in the discounted cash flow method is the original effective interest rate rather than the modified rate granted at restructuring. It should be noted that for a loan with a starter or "teaser" rate that is less than the loan's fully indexed rate, the fully indexed rate should be used.

If the fair value of the collateral, less the selling cost for a collateral-dependent loan, or the calculated present value of a non-collateral-dependent loan is less than the book value of the loan, the difference becomes the amount of impairment, which would be factored into the assessment of the allowance for loan and lease losses. If the amount of impairment is determined to be uncollectible, it should be charged off accordingly. If the fair value, net of selling costs, or the present value, as determined through a discounted cash flow technique, is greater than the book value of the loan, no impairment is recognized.

Accrual or Nonaccrual Status of TDRs
One frequently asked reporting question concerning TDRs is whether a restructured loan classified as a TDR should remain on nonaccrual status. According to the Call Report instructions, a credit that has been formally restructured so as to reasonably ensure repayment and performance, according to its modified terms, need not be maintained on nonaccrual status, provided the restructuring is supported by a current, well-documented credit evaluation of the borrower's financial condition and prospects for repayment under the revised terms. Otherwise, the restructured credit must remain on nonaccrual status.

If a TDR retains its nonaccrual status, an institution should not restore it to accruing status until the borrower can show the ability to comply with the modified terms and has demonstrated a sustained period of repayment performance, which typically is a minimum of six months. In some instances, such as when a borrower's financial condition is greatly improved by the signing of a new lease or because of increased sales contracts, a shorter performance period may be acceptable. Institutions are encouraged to evaluate and document the strength and sustainability of these sources of improved cash flow to support the decision to return the loan to accruing status.

TDRs and Residential Mortgages
A few important issues have arisen regarding the treatment of TDRs involving residential mortgages. The first issue pertains to the impact of waivers of scheduled, contractual rate resets. The question is whether or not allowing a borrower to continue to pay an initial below-market interest rate after a scheduled reset to a higher market rate qualifies as a TDR. The answer is yes. A loan that is modified under this circumstance qualifies as a TDR because a concession is being granted (i.e., lower interest payments than contractually agreed upon, presumably to alleviate debt service requirements and reduce the probability of default), which the bank would not otherwise consider.

Call Reports
Another area of potential confusion regarding TDRs is associated with the disclosure requirements within regulatory reports. Once a loan has been restructured as a TDR, for call reporting purposes it remains a TDR until paid in full. Specific regulatory reporting instructions require that loans and leases that are restructured and in compliance with their modified terms be disclosed in Memoranda Item No. 1 under Schedule RC-C (Loans and Leases). Disclosure may be discontinued in the calendar year following the year in which the restructuring took place if the restructured loan is in compliance with its modified terms and yields a market rate at the time of restructuring (i.e., the effective rate is equal to or greater than what the bank is willing to accept for a new loan with comparable risk). Restructured loans and leases that are 30 or more days past due or are on nonaccrual are reflected in the appropriate columns in Memoranda Item No. 1 under Schedule RC-N (Past Due).

It should be noted that starting in the first quarter of 2008, Memoranda Item No. 1 under Schedules RC-C and RC-N has been expanded to include restructured loans secured by 1–4 family residential properties.

Tax Implications for Borrowers
In some instances, debt forgiveness may accompany a restructure program. Generally, borrowers must include debt forgiven by lenders as income on their tax returns. Depending on the amount of debt forgiveness, lenders normally would have to issue Form 1099-A or 1099-C to borrowers. Lenders should consult with their tax advisors regarding the responsibilities associated with debt forgiveness and properly inform borrowers of the tax implications as part of a prudent renegotiation disclosure process.

Stressed housing and credit market conditions are increasing the need for lenders to understand the accounting treatment and regulatory reporting requirements for TDRs. The main accounting standards for TDRs are prescribed in FAS 15, as amended by FAS 114. Regulatory reporting schedules have been expanded to provide additional disclosures on TDRs for residential mortgages. Lenders should also be mindful of the tax implications associated with TDRs, particularly as they relate to prudent disclosure practices. For further information regarding the accounting treatment and regulatory reporting requirements for TDRs, contact Eddy Hsiao at (215) 574-3772 or Sharon Wells at (215) 574-2548.

  • 1   Statement of Financial Accounting Standards No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, June 1977, and No. 114, Accounting by Creditors for Impairment of a Loan, External Link May 1993.
  • 2   FAS 114, paragraph 13.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.