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The practical application of Trouble Debt Restructuring (TDR) accounting guidance has been a long-standing discussion topic between Doeren Mayhew’s Financial Institutions Group and our clients. This is because TDR guidance needs to be interpreted and appropriately pared down based on a financial institution’s operating and reporting size and complexity. Therefore, this article was written to guide practitioners working through the implementation of the new Current Excepted Credit Loss (CECL) standard, by addressing how the new forward-looking expected loss model partially alters TDR accounting, while revisiting critical TDR accounting concepts that have been calibrated specifically for the average credit union or community bank.
For a loan modification to be considered a TDR, two criteria must be met: (1) the debtor is experiencing financial difficulty. (2) the creditor has granted a concession (considered “more than insignificant” in nature).
A TDR is not a new loan, but rather the restructuring is part of a creditor’s ongoing effort to recover its investment in the original loan. This is why discounted cash-flow (DCF) models, used to calculate the instruments discount or allowance for loan losses balance, use the loans “original interest rate” as the discount rate.
Below we listed the three most critical changes to TDR accounting based on the new CECL standard, in our opinion:
Timing of recognition – CECL requires “current expected credit losses” to be measured over the expected life of the loan. Therefore, an entity should consider a loan a TDR for purposes of the allowance for loan losses estimate at the time a loan is considered “reasonably expected” to become a TDR. This may be after a member’s financial difficulties have surfaced, but before concessions have been granted.
Impaired or Not Impaired? – Topic 326 or “the CECL Standard” no longer explicitly refers to TDR loans as impaired loans. Therefore, just because a loan is TDR does not mean it should be considered impaired for financial reporting.
DCF model is no longer required. – However, loan concessions (i.e., interest rate reductions or principal forgiveness) are generally measured using a DCF approach. Therefore, concession related impairments will likely continue to be measured using a DCF approach.
Breaking Down TDR Accounting – Practical Application
As noted above, the accounting for TDRs has not changed significantly. Therefore, below will serve as a review of fundamental concepts critical to understand when determining the most practical application of TDR accounting at your financial institution. We break TDRs into two categories: 1) Performing and 2) Non-performing.
Performing TDRs may have two sources of “impairment” that should be considered when estimating the allowance for loan losses: 1) Concession related impairment 2) Risk of redefault.
Concession related impairment – There is a measurable cash-flow impairment that results when a TDR is modified with a reduced interest rate or principal forgiveness. When performing a DCF calculation, remember to consider the average or expected life of a similar loan. Using the contractual life of a loan – not considering prepayments – may result in an overstatement of the allowance.
Risk of redefault – The risk a TDR loan defaults again. One method to measure the risk of redefault would be to collectively evaluate pools of similar loans using a loss-rate approach or another approach. It’s important to note, if a loan does not result in a concession-related impairment, the allowance methodology may be calculated similar to non-TDR loans.
Nonperforming TDRs may be reserved for using a collateral dependent approach. At the point in time a loan is collateral dependent, the concession related allowance is no longer required.
TDR accounting is not changing substantially, although it almost did. The Financial Accounting Standards Board discussed booking concession related impairments as a basis adjustment – a logical notion as concession-related impairments are more relatable to discounts than credit risk valuation amounts. Thankfully, the board decided all TDR activity should be recorded as an allowance valuation to provide more flexibility and measurement options to practitioners. An interesting consideration point found in the Background Information and Basis for Conclusions section of the Accounting Standard Update. For questions regarding implementation at your credit union or community bank, reach out to our team of Financial Institutions Group advisors.
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