At the risk of further wearing out an already well-worn topic, it seems worth a few moments to review what was new in the world of Troubled Debt Restructurings (TDRs) during 2012 and provide some thoughts on how best to interpret and implement the new FASB and regulatory guidance. For some time now, the industry has been working to interpret and implement Accounting Standards Update (ASU) 2011-02 — A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring. SEC registrants were required to implement the new guidance during the second quarter of 2011, and non-public institutions were required to adopt it for fiscal years ending after December 15, 2012 (essentially, for December 31, 2012, financial reporting for calendar-year institutions). Along with the new accounting guidance from the FASB, the Office of the Comptroller of the Currency (OCC) issued contemporaneous regulatory guidance in April 2012. It is safe to assume that other regulators will likely apply TDR guidance that is very similar to that put forth by the OCC.
One of the most important facts to keep in mind is that neither the new accounting nor regulatory guidance amended the definition of what constitutes a TDR. Instead, the new guidance attempts to clarify what constitutes borrower financial difficulty and lender concessions, the two elements that need to be present in order for a loan modification to be considered a TDR. As such, most institutions have found that the TDR policies they previously had in place are still relevant and accurate (albeit, in need of some clarification and expansion, in many cases). The most significant changes brought about by the new guidance have been within the detailed documentation that institutions use to support the TDR decision and to calculate required specific reserves and charge-offs, particularly when interest rate concessions have been made. True, the new guidance has made it more difficult for a troubled loan modification to avoid the TDR designation; and some old standbys that were previously called upon to refute the TDR presumption, such as the debtor’s effective interest rate test, are now prohibited. Yet, in working through TDR issues with our clients over the past 12–18 months, it seems the most significant new burdens on institutions are the nature and level of documentation required by the guidance and in practice by regulators and auditors.
A review of ASU 2011-02 will quickly prove that some of the subjectivity has been taken out of the TDR identification process. Circumstances that are now considered strong indicators of borrower financial difficulty and the types of lender actions that qualify as concessions (as well as insignificant actions that do not qualify as concessions) are more clearly defined. Despite this, the identification of TDRs and the overall accounting treatment for modified loans is still a highly subjective exercise. Whether determining if a payment delay is “insignificant,” attempting to decide if a revised interest rate is akin to a “market rate,” or if a loan structure is comparable to that which would be offered by another institution, the path is indeed perilous. The nature of lending and loan structuring, particularly to small businesses and real estate ventures, makes the challenge even greater, as each deal has its own nuances that make it difficult to compare it to another deal. If only it were that easy.
The solution, or at least the most successful solution seen to date, has been to significantly enhance the nature and volume of documentation supporting the TDR determination. Logically, when dealing with a highly subjective matter, the more one can explain and support their decision with empirical data and tie it to the applicable guidance and rules, the more likely one’s argument and position are to stand in the face of challenge. Those institutions whose TDR identification processes and documentation have passed muster with the regulators and auditors tend to have the following in common:
- Clear TDR identification and measurement policies and procedures have been established and are clearly followed. Don’t forget the importance of the mechanical procedures; deciding who will analyze the data, prepare the documentation, and review and approve the final decisions is critical.
- Proper personnel have been included in the process. For better or worse, the TDR identification and measurement process is a multidisciplinary activity. Lenders and accountants must work together so that the facts are presented completely and accurately and those facts are properly interpreted in light of the applicable guidance. Processes that reside exclusively in the lending or accounting areas will almost certainly fall short.
- Quality tools are available to aid those involved in the process. Whether using a detailed TDR checklist to document if a modification qualifies as a TDR or relying on an accurate discounted cash flow calculation template, implementing and consistently using standard tools is imperative. There are myriad quality tools publicly available, and your Plante Moran advisors are always happy to provide a template if you need one or would like to consider alternatives. Please don’t hesitate to ask.
- Senior management must dedicate the necessary resources to make sure the process is completed properly and timely. As previously mentioned, working with TDRs is a time-consuming and highly subjective process. The tone at the top of the institution must be supportive of personnel doing the detail work and provide them with the time and materials necessary to do the job right.
In conclusion, it’s worth mentioning that a complex process like TDR identification and measurement can always benefit from a “second look,” particularly if that look comes from an independent source. We’ve heard some clients and friends in the industry bemoan the fact that despite their best and most meticulous efforts related to TDRs, they still feel that they’ll be (or have been) second guessed and have their conclusions unreasonably challenged by regulators and auditors. Unfortunately, there’s no magic bullet to completely defend against that reality. However, some additional credibility has been gained by institutions that call upon internal auditors (whether outsourced or in-house) to execute a targeted audit of TDR processes, documentation, and conclusions. In cases where this additional level of review and internal challenge has been performed, external auditors have been able to rely, to varying degrees, on the internal audit work product and regulators have considered the results of the review and modified their approach accordingly. To date, a review of this nature seems to be the best insurance policy an institution can buy regarding TDRs.