Navigating debt modifications in 2021

Bumps ahead

However, not all debt modifications are created equally. In other words, certain scenarios are inherently more complex to handle under the accounting rules than others. Awareness of these complexities is key to financial reporting success. Accounting teams should anticipate the following scenarios that can complicate the accounting:

• Modifications involving multiple lenders. When a borrowing arrangement involves multiple lenders, accounting for the modification might need to be done on a lender-by-lender basis (for example, in a syndicated loan scenario) versus at a more aggregated level.

• Modifications involving multiple instrument types. Modifications of borrowing arrangements that involve multiple instruments – such as term loans, revolving lines of credit, and warrants – can require a complex assessment of the correct unit of analysis and the appropriate accounting framework to use.

• Modifications involving related-party creditors. These modifications require careful analysis to determine whether a restructuring or extinguishment gain that would otherwise impact the income statement is, in substance, a capital transaction.

• Multiple modifications within a 12-month period. Accounting teams should review the totality of changes to the debt arrangement over that period rather than individually analyzing each incremental modification in order to properly assess the substance of those changes.

• Embedded features in modified credit facilities. Beyond accounting for the debt modification, sometimes the debtor must analyze whether new or revised terms of the debt arrangement – such as a conversion feature, redemption feature, or contingent interest provision – require separate accounting as, for example, a derivative instrument.

Watch out for the “gotchas”

In addition to the more complex modification scenarios, certain provisions of the accounting rules often lend themselves to mistakes in application. Some of the more common mistakes we’ve observed accounting teams make when analyzing debt modifications include:

• Troubled debt restructurings (TDRs) and “financial difficulty” criterion. To determine if a debt modification is a TDR, it is important to understand the underlying reasons for the modification, including whether the borrower is experiencing financial difficulty. Accounting teams should avoid overreliance on a single factor to assert that the debtor is or is not experiencing financial difficulty.

• TDRs and “concession” criterion. Determining if a concession was granted in a possible TDR is not as simple as comparing the coupon rate of the debt before and after the restructuring. The concession criterion requires accounting teams to compare the effective borrowing rate based on the terms of the restructured debt to the effective borrowing rate of the old debt immediately before the restructuring.

• 10% cash flow test for non-TDR modifications of term loans. Non-TDR modifications of term loans require application of a 10% test to determine how the modification should be treated. Determining the correct inputs into the 10% cash flow test can be difficult. All applicable changes in cash flows exchanged between the lender and debtor should be included in the analysis, including fees paid to the lender (as well as those related to covenant waivers), changes in principal on the modification date, revised interest payments, revised principal payments, and the fair value of any warrants or sweeteners granted to the lender.

• Lender fees and third-party costs. Fees paid to a syndication or administrative agent in a debt modification or debt issuance can be significant. When the syndication agent also is a lender in the debt arrangement, careful analysis is required to assess if some or all of the fees paid to the syndication agent might represent a third-party cost or a lender fee allocable to all of the lenders in the syndication.

• Line-of-credit or revolving debt arrangements. Modifications of these debt instruments follow a different accounting analysis than term debt. A modification of a line-of-credit or revolving debt arrangement requires a comparison of the borrowing capacity under the old and new terms. This assessment is prone to error if the borrowing capacity (the product of the remaining term and maximum available credit) is miscalculated.

New for 2021

While many of the complex scenarios and common mistakes highlighted here have been around for some time, accounting teams should be mindful of two relatively new developments as they address debt modifications in 2021:

• Modifications involving reference rate reform. The London Interbank Offered Rate (LIBOR) – an oft-used reference rate in variable-rate debt – is phasing out soon. Companies effecting modifications of existing borrowing arrangements must decide whether to update LIBOR references in their agreements at the same time as other debt modifications. But teams should remember that ASC 848, which simplifies the accounting for LIBOR-reform modifications, can be applied only if the modifications relate solely to reference rate reform.

• Early adoption of ASU 2020-06. An organization that modifies a convertible debt instrument might want to consider early-adopting ASU 2020-06, which simplifies the accounting for convertible debt instruments. However, before early-adopting the standard, organizations should weigh the effort of doing so because, if adopted, ASU 2020-06 must be applied to all existing instruments that fall in its scope.

In closing

The surge in debt modifications that occurred in 2020 remains with us in the new year. To successfully navigate the accounting for debt modifications in 2021, organizations should start by bringing the accounting team along for the ride, becoming aware of complex modification scenarios, and learning from past mistakes.