Beyond the Rate Cut: Navigating the Accounting Challenges of Debt Modifications

For the first time in more than four years, the Federal Reserve announced a 50-basis-point interest rate cut. According to the Associated Press, in an article issued on September 18, 2024, the Fed policymakers also indicated that they anticipate an additional half-point cut in their final two meetings of the year, scheduled for November and December. Furthermore, they foresee four more rate cuts in 2025 and two additional cuts in 2026.

Trends in Debt Financing Transactions

Over the past three years, rising interest rates have posed a significant challenge for the debt financing market. As central banks adjusted rates to combat inflation and economic conditions, companies faced higher borrowing costs, making debt financing more challenging. However, with the recent interest rate cut and expectations of further reductions, the credit market is projected to grow. According to a Market.us media report, the recent rate cut, along with anticipated additional cuts, creates a positive outlook for the coming years, indicating expected growth in credit markets. Lower borrowing costs and increased demand from businesses looking to finance operations or refinance maturing debt are expected to drive this growth.

Accounting for Debt Modifications

A debt modification may include changes in principal balances, interest features, conversion features, maturity dates, or other changes. Companies that intend to modify existing credit facilities should be aware of the unique accounting challenges associated with debt modification transactions, including:

• Determining the unit of account when there are multiple creditors: A company must assess the unit of account for applying debt modification guidance if multiple creditors are involved. This includes determining whether to treat the borrowing as a single creditor facility or as separate facilities with different creditors. Accounting Standards Codification (“ASC”) 470 – Debt, provides specific guidance on assessing the unit of account for both loan participation and loan syndication arrangements. The outcome of the debt modification accounting may be different for different creditors.

• Troubled debt restructuring: When companies adjust the terms of their outstanding debt, it may indicate that they are facing a troubled debt situation. ASC 470-60, Troubled Debt Restructurings by Debtors, outlines the appropriate accounting treatment depending on whether a troubled debt restructuring takes place. An analysis is needed to assess 1) whether the company is facing financial difficulties and 2) whether the lender has provided a concession due to such financial difficulties that it otherwise would not consider. The accounting treatment will vary based on the conclusions drawn from these two questions. If the modification does not represent a TDR, modification or extinguishment accounting must be applied.

• ‍Modification versus extinguishment accounting: A debt modification that is not a TDR will be accounted for in two ways depending on the significance of the changes made to the facility: (1) as the extinguishment of the existing debt and the issuance of new debt, or (2) as a modification of the existing debt. This determination, which is generally made using a cash flow test for term borrowings, or a borrowing capacity test for revolving borrowings, will predicate the required accounting and journal entries.

• ‍Cash flow test: The cash flow test in a debt modification analysis determines whether a modification results in a substantial change to the expected cash flows. Specifically, it assesses whether the present value of the cash flows under the modified terms are substantially different (e.g.10%) from the present value of the cash flows under the original terms. Companies must also consider several other factors, including multiple modifications within a single year, prepayment options, and changes in principal balances. This analysis can often be complex, requiring careful consideration and judgment.

• Multiple modifications within twelve months: ASC 470-50 requires that, if a debt instrument has been exchanged or modified within one year without being deemed to be substantially different, then the debt terms that existed a year ago shall be used to determine whether the current exchange or modification is substantially different. In these situations, the cash flow test can be highly complex, and the accounting conclusions may differ on a lender-by-lender basis.

• Accounting for lender and third-party fees: Companies may need to allocate lender and third-party issuance costs to each instrument within a credit facility. Additionally, the correct accounting treatment for these costs is determined by whether the debt is new, modified, or extinguished debt. For example, some fees must be immediately expensed while others are deferred and amortized into the interest expense over the term of the debt. The Balance sheet classification of fees may also change depending on whether the facility includes term loans, delayed draw term loans, or revolving loans.

• ‍Derivative analysis: The terms of any embedded features should be reevaluated in accordance with ASC 815, Derivatives and Hedging, upon a modification of a credit facility, or a modification accounted for as an extinguishment.

• Cash flow presentation: Companies will need to assess how to appropriately present the proceeds from debt issuance, debt settlements, and issuance costs on the statement of cash flows, distinguishing between operating or financing cash flows.  Additionally, companies may need to present gross constructive receipts and disbursements in situations where the company receives only net cash proceeds.

Conclusion

As interest rates are projected to decline, the likelihood of companies taking on new debt or modifying existing debt is expected to rise. Understanding the accounting implications of modifying existing credit facilities is essential for companies exploring this option. By carefully navigating these complexities, companies can make informed decisions and minimize or prepare for the financial reporting challenges associated with debt modification transactions.

Disclaimer

This article provides general information on the accounting implications of debt transactions. It is not intended to constitute professional advice. Companies considering debt transactions should consult with qualified accounting professionals to address their specific circumstances and ensure compliance with applicable accounting standards. The information provided in this article is based on guidance effective at the time of writing and may be subject to change.

Contributors

Nick Hernandez, Chris Medina, and Travis Topp

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