How should debtors account for changes in the terms of debt?
Under U.S. GAAP, a change in debt terms is accounted for under one of the three accounting models:
- Troubled Debt Restructuring (TDR);
- Extinguishment of the existing debt and the issuance of new debt;
- Modification of the existing debt;
Management should first determine if the change in the terms of debt should be accounted for as TDR.
TDR accounting model applies when a) the debtor is experiencing a financial difficulty and b) the creditor has granted the debtor the concession specifically due to the financial difficulty. The concession is granted if the effective interest rate of the modified debt is lower than the effective rate of the pre-modified debt. The effective rate is a level rate applied to the sum of the carrying amount of the debt including face amount and the unamortized premium or discount, used to arrive at a periodic interest expense.
Conceptually, the effective rate equates, through application of present value techniques, future cash payments related to debt including interest and principal with the carrying amount of debt. Effective rate of modified debt is calculated to equate the future cash payments associated with the modified debt with the carrying amount of pre-modified debt immediately before the change in debt terms (ASC 470-60-55-10).
Other things being equal, the effective rate will decrease if the creditor forgives part of the debt in exchange for debtor’s repayment of the remaining debt in accordance with the original terms. However, the reduction of the effective rate may also be due application of the compound interest rate techniques used in discounted cash flow calculations. For example, if the debt holder agrees to defer repaying interest-bearing principal while other terms, including face interest, remain the same, the deferral may result in the lower effective interest rate. This is because debt issued for a longer term with the same face interest is “cheaper” from debtor’s perspective or provides a lower compound return to the creditor than a similar debt issued for a shorter term. Judgement may be required to determine if the concession took place, from the accounting perspective, as a result of the change in debt terms.
TDR accounting varies depending on whether the undiscounted cash flows of the modified debt are higher or lower than the carrying amount of debt immediately before the modification.
TDR Option 1: If the undiscounted cash flow are lower, a gain is recorded for the difference. The carrying value of the debt is adjusted to equal the future undiscounted cash flow amount. No interest expense is recorded going forward.
TDR Option 2: If the undiscounted cash flow are higher than the carrying amount of debt, a revised effective interest rate is established based on the carrying value of the original debt and the revised cash flows. There is no day one income statement impact.
The situation when undiscounted cash flow are higher than the carrying amount of debt is common when debt related payments were deferred but no part of debt principal or interest was “forgiven” by a debt holder. In this case, the sum of future cash payments including the interest will generally exceed the carrying amount of debt before the change in debt terms took place. This is because the carrying amount excludes future interest cash payments, included in future undiscounted cash flows used to determine which TDR accounting option applies.
Many borrowers sought to modify their debt agreements in the effort to mitigate existing adverse effects arising from COVID-19 pandemic. The question arose whether changes in debt terms should be accounted for as TDR.
On March 22, 2020 federal and state banking regulators issued a guidance, in consultation with FASB, indicating that “short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief, are not TDRs.” Further, according to the joint statement, the modifications in question include “short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant.” Borrowers considered current if they are less than 30 days past due on their contractual payments at the time a modification program became effective.
If the TDR model does not apply, management needs to determine whether the change in debt terms should be accounted for using modification or extinguishment model. Overall, which model to apply depends on the extent of changes in debt terms, i.e. how different new and original terms are.
To determine the extent of changes in debt terms, an entity needs to perform a so called 10% test. As part of the test, the entity calculates present values of the remaining cash flows of the “new” debt and the “old” debt. If the difference between the two is at least 10% higher than the present value of remaining cash flows of the original debt, the modification is considered an extinguishment. Otherwise, the change in debt terms is considered a modification.
In general, if modified terms include a non-cash component, e.g. warrants, the value of the non-cash consideration is treated as a day one cash flow as part of the 10% test.
Extinguishment of debt is accounted for by derecognizing “old” debt including debt discount and recognizing a “new” one, measured at fair value. The difference between the “old” carrying amount of debt and the fair value of the “new” debt is recognized in the income statement as extinguishment gain/loss.
Modification is accounted for by establishing a new effective interest rate that will amortize “old” debt to revised future cash flows. In this case, no gain or loss is recognized immediately. Generally, application of the modification accounting model will have the same impact on entity’s financial statements as application of TDR Option 2 discussed above.
In certain cases entities may issue a convertible debt to repay a non-convertible debt that has matured. In these situations, the debtor accounts for the repayment of the old debt at maturity in return for the non-cash consideration (i.e. the new debt) consistent with the extinguishment model. The new debt is measured at fair value. The difference between the fair value and the carrying amount of old debt is reported as an extinguishment or exchange gain or loss (ASC 470-20-30-19). The issuer is required to recognize intrinsic value of any BCF associated with the new debt. The above accounting model does not apply if the exchange transaction is a TDR, in which case the transaction must be accounted for in accordance with accounting requirements applicable to TDR per ASC 470-60.
Modification of Convertible Debt
Change in the terms of convertible debt is subject to additional accounting requirements. Similar to non-convertible debt, first, determination is made if the change in terms should be accounted for as TDR.
In general, if modification terms include a non-cash component, e.g. modification of the conversion option, the value of the non-cash consideration is included as a day one cash flow. The above inclusion applies to calculations of the revised effective interest rate and determination of undiscounted cash flows of the modified debt.
If TDR accounting does not apply, an entity should determine if the change in terms should be accounted for as modification or extinguishment. The evaluation is performed as a two-step process.
First, management performs a 10% net present value test described above. If the tests indicates that the change in terms is a modification, management proceeds to step two. Otherwise, the change is considered an extinguishment. The above 10% test performed ignoring the impact on the cash flows arising from the change in the conversion option.
As part of step two, management needs to determine the change in the fair value of the conversion option arising from the modification. If the change in the fair value of the conversion option is greater than 10% of the carrying amount of the original debt instrument immediately before the modification, the modification should be accounted for as an extinguishment. Otherwise, the change in debt terms is considered a “modification”.
According to ASC 470-50-40-10, if the modification adds or removes a “substantive” conversion option from the original debt instrument, the modification should be accounted for as an extinguishment. No 10% tests above are required to be performed in this case.
If the extinguishment model applied to convertible debt, the conversion option embedded in the modified debt will be reported as part of the modified debt (unless bifurcation requirements under ASC 815-40, Contracts in Entity’s Own Equity were met) and initially measured at fair value.
10% Cash Flow Test for Debt with Call/Put Option
If the pre or post-modified debt is callable or puttable, then separate cash flow analyses should be performed assuming exercise and non-exercise of the put and call. The scenario that generates the smallest change should be used in the 10% cash flow test (ASC 470-50-40-12c).
If the debt has a call or put option exercisable at any time, a debtor should assume that it is exercised immediately. This will usually result in the smallest change in cash flows. Therefore, the difference between the present value of the puttable or callable debt after the modification will always be lower than 10%. However, the above conclusion does not apply if the debt can only be repaid earlier at a premium or discount. In such situations, the early payment premium/discount should be factored into day one cash flow to see if the 10% cash flow test is met.
An example of a callable debt, from borrower’s perspective, can be a debt instrument that a debtor can prepay at any time. Existence of a non-contingent prepayment option embedded in pre and post-modified debt will frequently result in the difference in respective present cash flow values to be under 10%. In such cases, the entity should move to step two test focused on the changes in the value of the conversion option.
Modification of Convertible Debt with BCF
Special considerations apply to modification of convertible debt that contains a beneficial conversion feature or BCF.
Generally, a BCF is defined as a nondetachable conversion feature, other than separated conversion option that is in the money at the debt issuance date. BCF is measured at intrinsic value derived from converting debt into entity’s stock (equity) instead of receiving contractual cash. As an example, if the carrying amount of debt is $ 100, the conversion price is $ 9/share while share’s market value is $ 10/share, the BCF is calculated as 100 / 9 * 10 – 100, which equals $ 11. A BCF should be separated from a convertible instrument and recorded in additional paid-in capital as follows: Db Debt Discount; Cr APIC. Debt discount created by BCF is amortized over the contractual debt terms. If, according to the terms of contract, the conversion price is adjusted, BCF is remeasured as well.
For the purpose of the step two 10% test, the change in the fair value of the option should be compared to the current carrying amount of debt as if the BCF had not been separated at inception. In other words, while performing the respective 10% test, the entity ignores the impact of the unamortized debt discount arising from BCF. Alternatively, the use of the carrying amount of debt reduced by the discount will likely result in more changes in debt terms to be accounted for using the “extinguishment” model. Application of the “extinguishment” model under the above circumstances would not be representative of the facts and circumstances of specific debt modification transaction.
When the extinguishment accounting applies, the carrying amount of the “old” debt removed from the books may include the unamortized discount associated with BCF. Also, BCF recorded in APIC at inception will need to be “redeemed” or “derecognized” at part of the extinguishment accounting. The redeemed amount is intrinsic value of BCF as determined on the extinguishment date using the then-current market price of entity’s stock. The following entry is recorded to derecognize BCF: Db APIC; Cr Extinguishment Gain/Loss. The above entry is recorded regardless of how much of the initially recognized BCF was amortized through the date of the change in debt terms.
If the change in debt terms is accounted for as a “modification”, the issuer of debt is precluded from revaluating an existing BCF or recognizing a new BCF. The above approach is consistent with the application of the “modification” accounting model on prospective basis. However, an increase in the fair value of BCF should reduce the carrying amount of debt, i.e. increase a debt discount with a corresponding increase in APIC. Reduction in the fair value of the BCF should be disregarded (ASC 470-50-40-15).
If a convertible debt instrument is converted pursuant to a contractual conversion option, the convertible debt is settled in exchange for equity and no gain or loss is recognized upon such conversion. In other words, the contractual conversion of debt is not an “extinguishment”. However, if the convertible debt has a beneficial conversion feature or BCF as defined above, the entity should recognize any unamortized discount resulting from the initial separation of BCF upon debt conversion as interest expense (ASC 470-20-40-1).
Induced conversion applies if the Company offers additional shares or other consideration (“sweeteners”) for a limited amount of time to incentivize investors to convert their convertible instrument on more favorable terms. As part of the induced conversion, an entity should recognize an inducement expense equal to the fair value of additional shares or other consideration issued to induce the conversion. The amount is determined as the fair value of all consideration transferred in excess of the fair value of shares transferred according to the original terms (ASC 470-20-40-16).
Under U.S. GAAP, a modification in debt terms is accounted for under one of the three accounting models: 1. Troubled Debt Restructuring (TDR), 2. extinguishment of the existing debt and the issuance of new debt; 3. modification of the existing debt. Management should first determine if the change in debt terms is considered a TDR. TDR accounting model applies when a) an entity is experiencing a financial difficulty and b) the creditor has granted the debtor the concession due to debtor’s financial difficulty. If the TDR model does not apply, management needs to determine the change in debt terms should be accounted for as a modification or extinguishment. In such case an entity performs so called 10% cash flow test. Special accounting considerations apply to the change in terms of convertible debt and convertible debt that includes BCF. A different 10% test focused on the analysis of the change in the fair value of the conversion option may apply. The test is used to determine the extent of changes in debt term.
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