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What is troubled debt restructuring?
A troubled debt restructuring can be defined as the renegotiation of terms between a debtor and creditor in an effort to reduce or delay repayments while avoiding bankruptcy. A borrower may be facing financial difficulties because of cash-flow problems, market conditions, financial mismanagement, or for reasons beyond their control such as natural disasters. A troubled debt restructuring will generally result in a reduction in the total debt a debtor owes. This occurs when a borrower is unable to meet interest and principal payments. This is common in both business and consumer finance agreements.
Troubled debt restructuring (TDR) is a type of debt restructuring that is initiated with the assistance of creditors or debt holders. Creditors/debt holders may initiate TDRs to dispel any potential for default and restore loan repayment. Troubled debt restructuring is a financial solution used in order to make it easier for businesses and individuals to repay their debts.
Troubled debt restructuring generally consists of some or all of these types:
- A reduction in the stated interest rate on the loan.
- An extension of maturity beyond the original date at which time full repayment was expected, allowing for payment over a longer period, so that the borrower can better afford repayment.
- A change in financial covenants, involving some relaxation or removal of restrictions on current or future operations
The concept behind a troubled debt restructuring is straightforward: when a borrower’s financial condition deteriorates significantly, it may need time during which it can focus on paying down existing obligations before being able to fully resume repayment of all outstanding debt. In this situation, a bank may choose to forego immediate collection of amounts owed, provided the borrower pledges sufficient collateral to ensure repayment. There are two basic types of modifications that can occur when a bank renegotiates with its existing borrower: rescheduling and forgiveness. A modification is considered a TDR if it either causes “rescheduling” or “forgiveness.”
Rescheduling is defined as extending the maturity date of all or part of an existing loan, regardless of whether interest continues to accrue on the modified portion during this extended period. Rescheduling does not entail any forgiveness in principal balance nor loss recognition for creditors.
Forgiveness occurs when a creditor-initiated restructuring involves:
- a concession such as granting concessions including interest rate reductions;
- forgiveness in principal amount — that is, the creditor grants a concession in connection with a modification of terms that results in an impairment in expected future cash flows to the extent it exceeds the present value of the borrower’s estimated future cash flows discounted at the original effective interest rate;
- or both.
When a company is experiencing financial problems and will likely go bankrupt, they essentially have three options: mergers & acquisitions ( M&A ), debt restructuring, and liquidation bankruptcy. There are several types of debt restructurings that can help ward off insolvency for companies facing the loss of their underlying asset value. In general, most types of distressed debt restructures involve reducing or stretching out payment schedules via either a short sale or a loan modification. But these types aren’t suitable for every debtor in every situation. This is where a few types of alternative distressed debt restructures come into play.
Types of troubled debt restructuring
- Bondholder-initiated TDR
- Debtor-initiated TDR
- Stockholder-initiated TDR
- Forced restructuring
The types of troubled debt restructurings are important because they can determine who is affected by changes in payment terms, how widespread the effect will be on other creditors, and whether creditors have any decision-making power over the process.
Bondholders approach the financially distressed company with an offer that would change the terms of the bond contract, usually reducing interest rates or lengthening maturity dates. Usually initiated by large investors who hold significant proportions of outstanding bonds in companies in financial difficulties.
The financially distressed company approaches its creditors with an offer that would change the terms of debt contracts, usually reducing interest rates or extending maturities. This type of debt restructuring is sometimes referred to as “debt for equity swaps.” Often initiated by a financially distressed company that wants to avoid declaring bankruptcy.
Stockholders approach the company with an offer that would change the terms of the share contract, often reducing interest rates or extending maturities. Usually initiated by large investors who hold significant proportions of outstanding shares in companies in financial difficulties.
The Federal Deposit Insurance Corporation (FDIC) can intervene if a bank is believed to be near failing and it will force changes on the bank’s debt contracts–for example, lower interest rates or extend maturity dates. This type of strategy has not been used yet because most banks today are healthy enough to repurchase their own stock without suffering too much damage, according to Carl Steckbeck and David Wheelock of the Federal Reserve Bank of St. Louis.
Troubled debt restructuring guidance
There are guidance issued by federal banking regulators to guide financial institutions in determining whether a loan modification is a troubled debt restructuring (TDR). These TDR guidance are found in the Accounting Standards Codification (ASC) 310-40.
The troubled debt restructuring guidance helps creditors or financial institutions to:
- Identifying a loan that can be termed as a TDR
- Account for the reason why a loan is termed as a TDR
Identifying a Loan as a TDR
All TDRs are loan modifications, but not all loan modifications are TDRs. For a loan to be termed as a troubled debt restructuring, two criteria must be fulfilled:
- A debtor must be experiencing financial difficulties
- The creditor is willing to grant a concession to the debtor because of economic or legal reasons that relate to the financial condition of the debtor. If it were not for the economic or legal reason, the creditor wouldn’t have granted the concession.
A loan should be properly identified before being termed as a TDR because once a TDR, always a TDR.
Accounting for Troubled Debt Restructuring
There are various TDR guidance provided for the financial reporting of TDRs by various regulators. The accounting requirements provide banks with options on how to account for these transactions by allowing them discretion whether or not to recognize the impact on regulatory capital of certain troubled debt restructurings. These guidance are issued by a country’s regulators of accounting standards as the the Financial Accounting Standards Board (FASB) of the United States of America which is the sole source of the US Generally Accepted Accounting Principles (GAAP). The TDR guidance provided by FASB is contained in the ASC 310-40.