FASB Targets Loan Loss Allowances With New Guidance

Companies may soon have some new rules to follow to determine when a loan modification or an adjustment in credit terms constitutes a “troubled debt restructuring” for accounting purposes.

The Financial Accounting Standards Board has published a proposed update to accounting standards that is intended to make it clearer to any company that extends credit when a change in terms meets the specific criteria of a troubled debt restructuring. The determination is important because it indicates when a creditor must acknowledge to investors that it may not collect everything owed on the debt and make an allowance in the financial statements for a possible loss down the line.

FASB said companies are following different practices in determining when a modification to an outstanding loan constitutes a troubled debt restructuring. The new rule proposed by FASB would result in more consistent approaches across different companies, FASB said, leading to more consistent accounting and disclosures.

“Investors, regulators, and practitioners asked the Board to clarify what types of loan modifications should be considered troubled debt restructurings for accounting and disclosure purposes,” stated FASB Acting Chairman Leslie Seidman. She said the board welcomes comments on how well the guidance achieves the objective of creating greater consistency and transparency.

The Public Company Accounting Oversight Board specifically mentioned the allowance for loan losses as one of several problem areas it spotted in its inspections of audit reports prepared at the peak of the financial crisis. The PCAOB said the allowance for loan losses is one of the most significant estimates made by companies in the financial services industry, and the uncertainty created by the economic crisis made the estimate all the more difficult.

The difference between a loan modification and a trouble debt restructuring for financial reporting purposes is tricky. A loan modification is any change to an existing lending arrangement, but a trouble debt restructuring indicates a lender has made some concessions that wouldn’t otherwise be accepted if the borrower were on good financial footing.

The proposed new guidance specifies that companies may not use the borrower’s “effective rate test” specified in ASC 470-60-55-10 to evaluate whether a restructuring constitutes a troubled debt restructuring. The effective rate test compares the borrower’s effective rate immediately before and after restructuring.

Instead, the analysis should focus on four specific criteria, according to FASB’s proposal. They include whether a borrower otherwise has access to funds at a market rate, whether a restructuring results in a temporary or permanent increase in the contractual interest rate, whether payment default is deemed probable in the forseeable future, and the delay that results in contractual cash flows as a result of a restructuring.

FASB is accepting comments on the proposal through Dec. 13. The target effective date for the new guidance is for interim and annual reporting periods ending after June 15, 2011.