Credit unions certainly were not immune from the affects of the Great Recession. As a result of the downturn, many members have become delinquent on outstanding loans. Over the past few years, many credit unions have been forced to either reduce or renegotiate the debt owed to them by numerous members.
As a result, credit unions are now grappling with the issue of troubled debt restructuring and its impact on their bottom lines. TDRs have become quite the buzz word in the credit union industry. It's an accounting issue that many credit unions have not dealt with since the early 1990s–the last significant economic downturn in the United States–and some not at all.
TDR accounting has some of the most difficult accounting rules to interpret, primarily because they are subjective in nature. To further complicate matters, there are little regulatory or industry best practice guidelines. The lack of clear and concise guidance has created a great deal of confusion in regard to TDR accounting. To help make some sense out of this situation, let's start by separating some common myths from reality as it relates to TDRs.
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Myth No. 1: All modified loans are TDRs.
While many are under the impression that all modified loans are TDRs, the reverse is true: all TDRs are modified loans.
To set the record straight, a TDR occurs when a creditor grants a concession (a relief) to the borrower because the borrower is experiencing financial difficulties. Concessions can be a lower interest rate on the loan or extending the payoff date. Regardless, the goal of the creditor is always the same: to increase the chances of collecting the debt.
Simply modifying the terms of a loan does not always equate to a TDR, hence the confusion. Lowering the interest rate for a member who has lost employment and is unable to make the contractual monthly payments is most certainly a TDR. However, lowering the interest rate for the same member (who is now unemployed) because he or she is able to get a better rate from another institution may not be a TDR. It all boils down to intent. Why did the credit union grant the concession?
According to the Financial Accounting Standards Board, the following instances do not constitute a TDR.
The fair value of the assets or equity interest accepted by the creditor in full satisfaction of its receivable is at least equal to the creditor's recorded investment in the loan. The creditor reduces the interest rate to reflect decreases in market rates. The debtor issues new debt at current market rates in exchange for the old debt (the fact that the debtor can obtain new financing at market rates indicates the restructuring is not troubled).
Myth No. 2: TDR impairments are treated differently than other loan impairments.
All TDRs are inherently impaired and will have a negative impact on the credit union, resulting in lower earnings and additional regulatory and financial reporting disclosure requirements.
Creditors should account for a TDR that involves modification of debt terms in exactly the same way as it would any other loan that is considered impaired. The credit union should measure impairment based on the present value of expected future cash flows, discounted at the loan's effective interest rate. As an alternative (and more practical standpoint), impairment may be measured based on the fair value of the collateral if the loan is collateral-dependent.
In instances where foreclosure is probable (or already in progress), impairment must be measured based on the fair value of the collateral. In addition, the credit union should consider estimated costs to sell the collateral when measuring impairment.
Myth No. 3: Once a loan is modified as a TDR, it should be removed from nonaccrual status.
This one is a maybe. Usually when a member is having financial hardship their loans become delinquent and the credit union, in an effort to avoid potentially overstating interest income, will place the loan on nonaccrual status. The question becomes, when does a credit union start recognizing that interest income again?
Once a loan has been formally restructured, it does not need to be maintained on a nonaccrual status provided the restructuring is supported by a current, well- documented credit evaluation of the member's financial condition and prospects for repayment under the revised terms. If the credit analysis indicates the member has the ability and intent to pay the loan under the revised terms, then the loan can be removed from nonaccrual status. Otherwise, the restructured loan must remain on nonaccrual status.
Remember though, the game has changed for both regulators and auditors, and if you didn't document it, you didn't do it. The credit union should be sure to maintain the credit analysis to support any decision to take a loan off nonaccrual status.
If a TDR retains its nonaccrual status, the credit union should not restore it to accruing status until the debtor can demonstrate an ability to comply with the modified terms for a minimum of six months.
While troubled debt restructurings had been prevalent during the economic downturn of the early 1990s, many in the industry today had never faced such a deluge of trouble loans. And with few regulations or best practices to use as guidance, it's no wonder so much confusion surrounds TDRs. The current economy requires an understanding of how to appropriately identify and account for TDRs.
Harvey L. Johnson, CPA is an audit manager at Witt Mares PLC.
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