By Colin Hannifin, CPA, Business Assurance & Advisory Services Senior Manager
Appropriate Accounting for Debt Modifications as a Result of COVID-19
This article is Part 1 of two articles to assist business owners and managers with debt and lease modification guidance.
As 2020 draws to a close, many entities are looking back at the year while also looking forward to the process of closing their books and moving into 2021. 2020 has been one of the most disruptive years in recent memory; virtually all entities have felt the impact of the ongoing COVID-19 pandemic –from both the lockdowns to contain the spread of the virus and the relief efforts to offset the impact of the lockdown. Many entities received relief from their creditors and lessors in the form of deferred payments, waived fees, and adjusted amortization schedules. As the recipient entities close their books, they will want to ensure that the accounting applied is appropriate.
Debt Modification or Extinguishment?
The first consideration in accounting for a debt modification is to determine if the modification should be considered troubled debt restructuring. A modification may be troubled debt restructuring if the lender grants a concession to a borrower it otherwise would not due to a borrower’s economic or legal situation. The Financial Accounting Standards Board (FASB) did confirm that short-term modifications made in good faith to borrowers experiencing operational or financial problems as a result of the COVID-19 pandemic won’t automatically be considered troubled debt restructuring if the borrower was current on payments prior to the relief being applied.
To determine the appropriate accounting, an entity will need to determine whether an adjustment to a debt agreement should be accounted for as a modification or an extinguishment. The guidance for this comes from Accounting Standards Codification (ASC) 470 and has not changed as a result of the pandemic.
Generally, debt is considered to be extinguished if either of the following conditions is met:
- The debtor pays the creditor and is relief of its obligation; or
- The debtor is legally released from primary obligation under the liability.
While some debts may have been forgiven during the pandemic, more often the repayment schedule has been adjusted to allow for cash flow relief. Modification guidance says, however, “…a substantial modification of terms shall be accounted for like an extinguishment.” (ASC 470-50-40-6). The guidance also provides the method by which determining whether a modification is significant: if the present value of future cash flows under the terms of the modified agreement is at least 10% different from the present value of future cash flows under the terms of the original agreement, a modification is considered to be extinguishment. The guidance further prescribes how to calculate the present value of future cash flows for the purpose of this analysis (ASC 470-50-40-10), addressing variable interest rates, conversion features, and whether the debt is callable or puttable.
If the modification is considered and accounted for as an extinguishment, the existing debt is written off and the new debt is recognized; any difference is recognized as a gain / loss on extinguishment. Further, any existing loan costs would be written off; fees paid to the lender are expensed as part of the gain / loss on extinguishment. However, fees paid to third parties (such as attorneys) would be capitalized and amortized over the term of the new debt.
If the modification is not considered an extinguishment, the changes from the modification – whether it is an adjusted payment schedule or are applied prospectively. Any existing loan costs are maintained, but the amortization may be adjusted if the term of the loan is extended. Any fees paid to the lender would be capitalized and amortized over the remaining term of the loan; fees paid to third parties would be expensed as incurred.
For further reading: In October, the FASB published a paper regarding a borrower’s accounting for debt modifications.
The impact of the COVID-19 pandemic is still being felt and will continue for years to come. Entities should ensure that they are comfortable with the debt modification guidance referenced above; as 2020 activity winds down and financial statements are prepared and reviewed, these will be areas of emphasis for users of the financial statements.
Debt and Lease Modification Guidance – Part 2
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.