Companies restructuring debt and renegotiating leases are sometimes encountering accounting surprises when they explain the new terms to auditors.
Working out new terms for debt or leases is becoming a common chore for companies these days, as they search for cash to ride out the economic storm. While the accounting literature itself has nothing new to say about the consequences of such restructurings, it is an exercise companies aren’t accustomed to navigating. Hence the confusion.
“Whenever you have restrictions or renegotiations, the accounting is not straightforward,” says Dwayne Cook, practice leader for consulting firm Tatum. “These rules have been out for a while now, but the environment is changed. In normal times you don’t see it that often, but in the past 18 months I’ve seen it with more frequency than in the previous 10 years.”
Gary
Companies trying to restructure debt or lease obligations typically are driven by cash flow concerns, says Dan Gary, a partner in the transactions and restructuring group at KPMG. Sometimes companies explore and weigh the accounting and financial reporting consequences of a restructuring they are pursuing, especially larger companies or those that have been down the path before, he says.
“But it happens more and more that companies in trouble today have never really be in trouble in the past, so they didn’t see this coming,” he says.
What they encounter usually is a gain or a loss where they didn’t expect one, or confusion over whether restructuring costs should be expensed in the current period or written off over the life of the renewed obligation, experts say. They also may get blindsided by tax consequences that they hadn’t foreseen.
Even when companies explore the consequences, however, they may not rise to a level of concern that would alter the transaction, Gary says. “The restructurings are difficult enough that companies are probably not trying to restructure to get an accounting result,” he explains. “The primary concern is cash.”
The accounting for a debt restructuring is different than the accounting for an altered lease agreement, but they have one important element in common, Cook says: “If it’s material, then they’re both disclosure items as it relates to financial reporting.”
The first question with a debt restructuring is determining whether the transition is a “troubled” restructuring, Gary says. The guidance for this determination is found in the Accounting Standards Codification Topic 470, Debt, especially Subtopic 60, Troubled Debt Restructurings by Debtors. (That guidance existed in a previous life as Financial Accounting Standard No. 15, before its renaming in the Codification.)
“If it’s troubled, you account for it one way, but if it’s not you account for it a different way,” Gary says. “If the lender gives any kind of concession that they wouldn’t normally give, it’s going to be a troubled debt restructuring. Most of the time today it’s a troubled debt restructuring.”
Jay Hanson, national director of accounting for McGladrey & Pullen, says the accounting requirements around a trouble debt restructuring often seem counterintuitive; that leads to some confusion for some companies. Generally, the rules require that when the payable terms for troubled debt are adjusted, that should be construed as an adjustment of the “yield,” or the effective interest rate, of the loan.
In other words, if the ultimate amount to be paid both in principal and interest isn’t less than the carrying amount of the original loan, then the company is considered to be paying only a lower yield over the life of the restructured debt—and therefore has no gain to report from the restructuring. If the renegotiated deal results in a reduced liability overall, however, then the company will have a gain to report.
Reporting a gain on a liability is a big red flag to investors, Gary warns. “Gains almost always indicate trouble,” he says. “It’s almost counterintuitive, but if someone lets me pay less than I owed them, it means there’s significant risk around my ability to pay, so I’m in trouble.”
Companies also need to determine whether accounting rules would classify their restructuring as a modification or an extinguishment, Hanson says. What’s the difference? “You can have a modification to a loan and you’re just tweaking the features but not substantially changing the terms,” he explains. An extinguishment is more draconian: wiping the old loan off the books and recording a new one, along with the related gain or loss of doing so.
“If someone lets me pay less than I owed them, it means there’s significant risk around my ability to pay, so I’m in trouble.”
—Dan Gary,
Partner,
KPMG
Accounting rules do provide a bright line between the two, Hanson adds. If a new debt deal results in change to cash flow of 10 percent or more, that’s an extinguishment. “Companies don’t want to count it as an extinguishment,” he said. “It’s hard to do.”
Companies also need to take into account whether they modify a debt instrument more than once in a reporting year. If they do, Hanson says, they must aggregate the effects of the changes when reporting the modifications in a single reporting year.
Pete Bible, a partner at accounting firm Amper, Politziner & Mattia, said the 10-percent threshold often crops up as the biggest accounting surprise when restructuring debt. “Companies go to their lenders and say they want to lower their interest rate and spread out the amortization. Then the auditors say that’s a 10-percent change in cash flow, so you have a gain or a loss on the modification,” he says.
And About Leases
In lease restructuring, the biggest accounting issue is whether the new lease agreement would change the classification of a lease from operating to capital or vice-versa, says David Grubb, a partner with regional accounting firm Plante & Moran. An operating lease is reflected as an expense as lease payments are made, with no asset or liability appearing on the balance sheet; a capital lease appears as an asset and a liability over the life of the lease. ASC Topic 840 addresses lease accounting, and generally tells companies what to do if the terms of a lease are modified. It’s also an area of complexity, Grubb says.
Montague
Chris Montague, a managing partner with Plante & Moran, says companies should pay attention to whether a change in lease terms could trip changes in metrics that are important to other loan covenants, such as debt-to-equity ratios or capital requirements, among others. “If you’ve not thought that through, you could end up with an issue in your banking relationships that you weren’t counting on,” Montague says.
John Hepp, a partner in the national professional standards group at Grant Thornton, says lease accounting has plenty of complexity generally, and accounting for modifications is no different. “If you modify a lease, some of the debits and credits don’t work out intuitively,” he says. “You need to be careful.”
Companies renegotiating leases now would be wise to consider not only existing rules, but also new lease standards that are percolating in both the United States and internationally, Hepp says. In a few years, it’s won’t be so easy to keep leases off the balance sheet, he says.
There may be good business reasons to lease property or equipment rather than to buy, “but if keeping the obligation off the balance sheet is one of those, you have to start anticipating that that will go away,” Hepp says. “Even the whole decision of whether to lease or buy may change. If it’s going to be on the balance sheet, particularly in today’s market, you may be able to purchase that asset at relatively favorable terms.”
Grubb
According to Grubb, companies will typically pursue lease modifications after they’ve exhausted other debt modifications that might produce some cash relief. “If the economic turnaround is slow, we’ll see more” companies pursuing new leases, he says.
Gary says retailers, who typically lease a lot of property, likely will ride out the holiday shopping season and see how that improves their situation before pursuing new lease agreements.
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