Generally Accepted Accounting Principles defines a troubled debt restructuring, as a restructuring where the borrower is experiencing financial difficulties and the credit union or other financial institution grants a concession to that borrower that the credit union would not have otherwise considered, based on economic or legal reasons related to a borrower's financial difficulties. After a loan is classified as a TDR, a credit union must periodically determine impairment, which can be complicated.
To help us understand this principle better, we will discuss aspects of the October 2013 interagency guidance, "Addressing Certain Issues Related to Troubled Debt Restructurings." This guidance addresses the classification and determination of impairment in TDRs. It also defines collateral dependent TDRs and discusses their charge-off treatment, which we will discuss in more detail.
As noted in the guidance, any loan modified through a TDR is an impaired loan, and impaired loans must be evaluated for collateral dependency. An impaired loan is collateral dependent if repayment is expected to be provided solely by the underlying collateral, which includes repayment from the proceeds of the sale of the collateral, cash flows from the continued operations of the collateral, or both.
Generally, repayment of an impaired loan is expected to be provided solely by the sale or continued operation of the underlying collateral if the cash flows available to repay the loan from all other sources are limited. A loan may not be collateral-dependent if resources from other borrower cash flow sources are available to service the debt.
If a loan that has undergone a TDR is not collateral dependent, impairment is based on the present value of expected future cash flows, discounted at the loan's original effective interest rate or the loan's observable market price.
Impairment and charge-off treatments for loans that are collateral dependent and those that are not are a little different. Let's look at each element separately.
Collateral Dependent
An impaired, collateral-dependent loan must be measured for the amount of impairment based on the fair value of the collateral regardless of the probability of foreclosure. When the fair value of the collateral is used to measure impairment and repayment of the loan is dependent on the sale of the collateral, the fair value of the collateral must be adjusted for the estimated costs to sell the collateral. If repayment is dependent only on the operation of the collateral, then the fair value would not factor in the estimated costs to sell.
Under GAAP, a credit loss on a loan, which may be for all or part of a particular loan, should be charged-off in the period in which the loan is deemed uncollectible. When an impaired loan is dependent solely on the sale of the collateral for repayment, a credit union should apply the following formula: any portion of the recorded investment in the loan exceeding the amount adequately secured by the fair value of the collateral, less the estimated costs to sell, is uncollectible and should be charged off. Any remainder of the loan generally should be adversely classified—no worse than substandard.
Determining loss in a partial charge-off requires judgment, and may not be warranted for a collateral-dependent TDR loan if repayment is dependent only on the operation of the collateral, provided a credit union has modified the loan in accordance with a prudent workout strategy.
A prudent workout strategy has current financial information that supports the collectability of the debt under reasonable, modified terms and expected future cash flows that are sufficient to repay the loan. The expected future cash flows should be fully supported by a complete analysis and underwriting of the financial capacity and willingness of the borrower to repay the debt.
Not Collateral Dependent
When measuring impairment on an impaired loan, including a TDR loan, that is not collateral-dependent, a credit union must use the present value of expected future cash flows method, except that as a practical expedient, the creditor may measure impairment based on the loan's observable market price.
A credit union should determine its best estimate of these cash flows based on reasonable and supportable assumptions and projections. The contractual payments required by the newly modified loan may not represent the best estimate of the expected cash flows. As a result, a credit union should consider default and prepayment assumptions, as well as existing environmental factors relevant to the collectability of the loan.
Consistent with GAAP, for an impaired loan, including a TDR loan, that is not collateral-dependent, when available information confirms that a specific loan, or a portion of the loan is uncollectible, the amount should be charged-off against the allowance for loan and lease losses.
Summary
In sum, a key aspect in assessing impairment for a TDR is determining if the loan is collateral dependent. Collateral dependent loans are impaired based on the fair market value of the underlying collateral less cost to sell. If dependent on the operation of the collateral, cost to sell would not be considered. If a TDR is not collateral dependent, then impairment would be based on the present value of expected future cash flows. When using this estimate, the credit union should consider default and prepayment assumptions, as well as existing environmental factors.
Finally, GAAP requires a credit loss on a loan, either in whole or in part to be charged-off in the period the loan is deemed uncollectible. Determining loss requires judgment and may not be warranted for a collateral-dependent TDR loan if repayment is dependent only on the operation of the collateral.
For more information on this and other aspects of troubled debt restructurings, go to NCUA Accounting Bulletin 13-01 at http://go.usa.gov/cNvm5.
