Loan Modifications, Round Two: Accounting and Reporting Considerations
By now, you are likely familiar with the guidance related to loan modifications that was issued in response to the COVID-19 pandemic back in March (feels like a lifetime ago, doesn’t it?). Section 4013 of the CARES Act, Temporary Relief from Troubled Debt Restructurings (“Section 4013”), and the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus (the “Interagency Statement”), are the two overarching sets of guidance addressing COVID-19-related loan modifications and related reporting considerations. With many financial institutions in the midst of offering borrowers a second round of loan relief, what better time than now for a brief refresher?
Section 4013 allows institutions to avoid classifying a loan modification as a troubled debt restructuring (TDR) as long as the modification is (1) related to COVID-19; (2) executed on a loan that was not more than 30 days past due as of December 31, 2019; and (3) executed between March 1, 2020 and the earlier of (A) 60 days after the termination of the National Emergency or (B) December 31, 2020. This guidance is, in effect, a congressional override of the existing accounting rules for TDRs contained in Accounting Standards Codification (ASC) 310-40 for those modifications meeting the above criteria. Institutions that elect to apply Section 4013 to certain modifications are instructed to maintain records of the volume of such loans for regulatory reporting purposes.
The Interagency Statement, originally issued on March 22, 2020, was intended to encourage financial institutions to work with borrowers affected by COVID-19 in a prudent manner and to outline the accounting considerations for loans modified for these borrowers. Importantly, the Interagency Statement notes the joint regulatory agencies confirmed with the Financial Accounting Standards Board staff that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief (i.e. less than 30 days past due at the time a modification program is implemented) are not TDRs. This includes short-term (e.g. six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant.
Due to the passage of the CARES Act on March 27, 2020, the Interagency Statement was modified on April 7, 2020 to address the relationship between the TDR guidance set forth in Section 4013 and the Interagency Statement. Specifically, the modified guidance notes that institutions should apply the guidance under the original Interagency Statement above to modifications that are either ineligible under Section 4013 or for which an institution elects not to apply Section 4013. It is important to note that the Interagency Statement guidance is an interpretation of ASC 310-40 and not an override of said guidance as is the case with Section 4013 modifications. Institutions will need to conduct a careful assessment of the terms of a modification to determine whether a TDR designation is appropriate.
Additional Loan Modifications
Most financial institutions implemented a loan modification program earlier in the year to provide relief to borrowers impacted by the pandemic. These modifications often came in the form of payment deferrals, commonly for periods of 3-6 months. With these deferral periods coming to an end, certain government-mandated restrictions remaining in place and continuing high levels of unemployment, some borrowers are seeking additional relief from their lenders. How are additional loan modifications under Section 4013 and the Interagency Statement treated?
On August 3, 2020, the Federal Financial Institutions Examination Council issued a Joint Statement on Additional Loan Accommodations Related to COVID-19 (the “Joint Statement”) which provided some clarity on the subject. For loan modifications where Section 4013 is being applied, subsequent modifications could also be eligible under Section 4013 and therefore not be a TDR as long as the aforementioned criteria under Section 4013 have been met. For loan modifications where Section 4013 is not being applied, any additional modifications need to be considered on a cumulative basis in determining whether the subsequent modification is a TDR. The Joint Statement notes that if the cumulative modifications are all COVID-19-related, are short-term in nature (i.e. six months or less in the aggregate), and the borrower is contractually current (i.e. less than 30 days past due) at the time of the subsequent modification, management may continue to presume the borrower is not experiencing financial difficulties at the time of the modification for purposes of determining TDR status, and the subsequent modification would not be considered a TDR.
For all other subsequent modifications, institutions are instructed within the Joint Statement to refer to the applicable regulatory reporting instructions and their own internal accounting policies in order to determine whether the additional modifications should be accounted for as a TDR under ASC 310-40. While this provides some direction, a solid understanding of the guidance contained within ASC 310-40 is critical to ensuring TDRs are properly identified. An article on this subject published by my colleague, Jeff Skaggs, is recommended reading for anyone looking to enhance their understanding of ASC 310-40. Among other things, the article highlights certain considerations in evaluating whether a restructuring results in a delay in payment that is insignificant, which is a critical component of a TDR assessment.
Capturing Loan Accommodation Risk
Beyond the TDR assessment, institutions providing loan accommodations to their borrowers should consider the impact of such accommodations on their allowance for loan and lease losses (ALLL) or allowance for credit losses (ACL), as applicable. Institutions should consider all information available when assessing the collectability of cash flows such as changes in the borrower’s financial condition, collateral values and economic conditions resulting from COVID-19. Generally Accepted Accounting Principles require loans to be segmented into a separate portfolio when they share similar risk characteristics for purposes of estimating credit losses, unless they are evaluated on an individual basis. Does your institution have a meaningful number of borrowers facing financial difficulties as they near the end of their accommodation periods? If so, consider whether these loans should be segmented into a separate portfolio when assessing credit losses.
In the real estate world, it’s all about location, location, location. When it comes to supporting the level of your institution’s ALLL or ACL, it’s all about documentation, documentation, documentation. The extent of documentation supporting an appropriate ALLL or ACL should be commensurate with the size and complexity of the loan portfolio and should memorialize a thoughtful assessment by management of the relevant information available to them in evaluating the risk in the portfolio. Auditors and regulators will expect this. Although this is nothing new, the importance of strong supporting documentation is amplified given the unique environment we’re in.
We are all doing our best to navigate our way through exceptionally challenging times and to forecast what’s yet to come. There’s no playbook for this. With an uncertain timeline as to when we can finally say we’re past the pandemic and the uncertainty as to what the post-pandemic world looks like, institutions’ borrowers will continue to face financial challenges that adversely impact their repayment capacity. With knowledge of this, institutions continue to work with their borrowers to mitigate losses for the borrower and the institution. It is important for institutions to understand the accounting and reporting implications of providing borrower accommodations to achieve this end, and we will do our part by guiding you every step of the way.
If you would like to discuss these matters further, contact Joe Jalbert or your BNN advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.