The financial position of money-center commercial banks and savings and loan associations throughout the country has become an important concern of the business community, as evidenced by the deteriorated quality of loans to Third World countries, agricultural producers, real estate enterprises, and the oil and gas industry. In recognition of the severity of these economic hardships, federal bank regulatory agencies are encouraging lenders to work with borrowers to restructure problem loans and to account for such transactions in accordance with SFAS 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings. "(1) Recently enacted laws providing financial assistance to agricultural lenders and savings and loans also contain provisions encouraging debt restructuring and the use of SFAS 15. (2) Table 1 shows that, as of December 31, 1987, the amount of restructured loans at insured commercial banks amounted to $4 billion, of which $2.8 billion were in compliance with the new terms.

(1) SFAS 15 does not cover accounting for allowances for estimated uncollectible amounts and does not prescribe or proscribe particular methods for estimating amounts of uncollectible receivables. In addition, the standard does not allow a bank to avoid charging off uncollectible loans or to avoid providing for such losses by a charge against income. With regard to federal bank regulatory agencies' announcements on SFAS 15, see Federal Deposit Insurance Corporation, BL 15-86, "Accounting for Restructured Loans and Sales of Foreclosed Property," April 11, 1986; Office of the Comptroller of the Currency, BC 195, "Accounting for Restructed Loans and Sales of Foreclosed Property," May 1, 1985; and Federal Reserve System, SR-86-23, "Guidelines for Collateral Evaluation and Classification of Troubled Commercial Real Estate Loans," April 28, 1986.

(2) Two such laws enacted during the 100th Congress are the Competitive Equality Banking Act of 1987 (Public Law 100-86; Aug. 10, 1987), and the Agricultural Credit Act of 1987 (Public 100-233; Jan. 6, 1988).

Practitioners and users of financial statements of financial institutions should be aware of the accounting and financial reporting implications relating to the bank regulators' commitment to follow SFAS 15. This article addresses the important issue of whether the rules prescribed by SFAS 15 reflect the underlying economic events of transactions involving modification of loan terms, and whether the disclosure requirements provide external users with information that is useful for analytical review and decision-making needs.

SFAS 15 does not always require the lender (creditor) to record an accounting loss where restructuring results in an economic loss, and, as a result, financial statements may not communicate the long-term credit risks of a bank's loan portfolio to stockholders, creditors, or its depositors. The restructuring as provided in SFAS 15 is not designed and is often unlikely to be the appropriate accounting to be followed by a lender when a loan is found to be "troubled" and is then restructured. The standard allows lenders to avoid reducing the recorded investment in the loan unless the total future cash payments for both principal and interest (not discounted to their present value) specified by the modified terms are less than the recorded investment in the loan. The appropriate accounting would incorporate carrying forward only the present value of future receipts, with the lender recognizing a loss equal to the decrease in the present value of the restructured loan.

Although this article focuses on the accounting for troubled debt restructuring from the creditor's viewpoint, SFAS 15 also sets forth guidelines that debtors are to follow in accounting for restructured payables. Gains or losses on restructured payables are required to be aggregated and included in measuring net income for the period of restructuring. If material, such gains or losses are to be classified as an extraordinary item, net of related tax effect, in accordance with SFAS 4, "Reporting Gains and Losses from Extinguishment of Debt."

* The views expressed in this article are those of the author and not necessarily those of the General Accounting Office.

1 SFAS 15 does not cover accounting for allowances for estimated uncollectible amounts and does not prescribe or proscribe particular methods for estimating amounts of uncollectible receivables. In addition, the standard does not allow a bank to avoid charging off uncollectible loans or to avoid providing for such losses by a charge against income. With regard to federal bank regulatory agencies' announcements on SFAS 15, see Federal Deposit Insurance Corporation, BL 15-86, "Accounting for Restructured Loans and Sales of Foreclosed Property," April 11, 1986; Office of the Comptroller of the Currency, BC 195, "Accounting for Restructed Loans and Sales of Foreclosed Property," May 1, 1985; and Federal Reserve System, SR-86-23, "Guidelines for Collateral Evaluation and Classification of Troubled Commercial Real Estate Loans," April 28, 1986.

2 Two such laws enacted during the 100th Congress are the Competitive Equality Banking Act of 1987 (Public Law 100-86; Aug. 10, 1987), and the Agricultural Credit Act of 1987 (Public 100-233; Jan. 6, 1988).

Modification of Loan Terms: Creditors' Perspective

According to SFAS 15, a troubled debt restructuring occurs when the creditor, for reasons related to the debtor's financial difficulties, grants a concession to the debtor that it would not otherwise consider. The standard goes on to say that the creditor's objective, whatever the form of concession that may be granted, is to make the best of a difficult situation. That is, the creditor expects to obtain more cash or other value from the debtor or to increase the probability of receipt, by granting the concession than by not granting it. A troubled debt restructuring may include one or any combination of the following three forms: 1. A modification of terms, including: a) reduction of the stated interest rate for the remaining original life of the debt; b) extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk; c) reduction of the maturity value (principal amount) of the debt; d) reduction of accrued interest. 2. Transfer from the debtor to the creditor of receivables from third parties, real estate, or other assets at fair market value to satisfy a debt fully or partially. 3. Issuance or granting of an equity interest to the creditor by the debtor to satisfy a debt fully or partially, except for convertible debt.

According to SFAS 15, creditors are required to apply certain rules in accounting for troubled debt restructuring involving a modification of terms, without a transfer of assets or grant of equity interest. The rules are: 1. The creditor is to account for the effects of restructuring propectively (over future years). 2. The creditor is not to change the recorded investment in the receivable (i.e., principal plus accrued interest) at the time of restructuring unless that amount exceeds future principal and interest payments as restructured, and the difference is to be amortized as interest income over the life of the receivable by using the effective interest method. Interest income is computed by applying a new constant interest rate, determined by the creditor, to the recorded investment in the receivable at the beginning of each period. 3. The effective interest rate used by the creditor is the discount rate that equates the present value of future cash payments as specified by the modified terms with the recorded investment in the receivable. 4. If future cash payments (principal and interest) as specified by the modified terms are less than the recorded investment in the receivable before restructuring, the creditor is to reduce the recorded investment in the receivable to an amount equal to the total future cash payments specified by the modified terms, and the difference is recognized as a loss at the time of restructuring. Subsequently, all cash payments are to be accounted for as recovery of the investment, and no interest income is recognized. This results in the economic loss (i.e., the decrease in the present value of the receivable) being deferred over the remaining term of the receivable.

Reduced Principal and Interest (Loss Situation)

To illustrate the application of SFAS 15 to situations involving a modification of loan terms, a hypothetical case is presented from the creditor's point of view. The original loan is for $100,000, due in two years (payable annually), having a stated interest rate of 10%. Under the restructuring agreement, the creditor grants concessions to the debtor including a reduction in principal to $75,000, an extension of due date from two to four years, and a reduction in the interest rate to 6%. On the basis of the modified loan terms, the accounting loss under SFAS 15 is calculated as follows:

Future principal payment $ 75,000

Plus: Future interest payments (.06 x

$75,000 x 4) 18,000

Total cash payments under modified

terms93,000

Less:Recordedamountofloan(100,000)

Excess of recorded amount over future

payments (loss) $ (7,000)

The restructured loan will be recorded on the creditor's books at $93,000, and the creditor will recognize an accounting loss of $7,000 on the date of restructuring. No interest income is recognized over the life of the restructured loan since future payments will be applied against the recorded amount of the restructured loan. However, the economic loss at the time of restructure would equal the difference between the carrying amount of the loan ($100,000) and the present value of cash payments after restructure. This approach measures the economic gain or loss of each party, and is consistent with the conceptual approach to valuation of receivables as required in APB Opinion No. 21 "Interest on Receivables and Payables."

Assuming that the going market rate of interest on loans of similar risk is 12%, the economic loss at the time of restructuring is calculated as follows:

Carrying value of loan $ 100,000

Present value of the payments as specified by the

modified terms ($75,000 X .6355*) + ($4,500 X

3.0373**)$61,330

Economicloss($38,670)

* Present value of $1 in 4 years, 12%

** Present value factor of an annuity of $1, four years, at 12%

Financial Reporting Implications

These prescribed rules of accounting for troubled debt restructuring are controversial because SFAS 15 does not treat modification of loan terms as a negotiated exchange transaction requiring accounting recognition. The FASB reasoned that since a modification of loan terms does not involve transfers of resources or obligations but unilateral concessions granted by the creditor, and the debtor is viewed as a passive beneficiary of the restructuring, no transaction has occurred. Thus, the FASB concluded that a modification of terms "is neither an event that results in a new asset or liability for accounting purposes nor an event that requires a new measurement of an existing asset or liability." Thus, from a creditor's standpoint, SFAS 15 calls for a modification of the terms of a loan to be accounted for prospectively, unless the recorded investment (book value) exceeds the total future cash payments for both principal and interest (not discounted to their present value) specified by the new loan terms.

Several accountants have noted that the response from financial institutions about potential economic consequences of the FASB Discussion Memorandum (DM) circulated for public comment prior to the issuance of SFAS 15 significantly influenced the Board's decision not to require loss recognition when troubled loans are modified. The DM proposed an alternative accounting method under which creditors would recognize a loss at the time a loan's terms are modified. SFAS 15 has also been controversial because its underlying theory gives the perception that it is an accounting gimmick designed along the lines of regulatory accounting practices, and because of its impact on bank auditors and their reports on the fair presentation of financial statements.

Nondisclosure of Economic Loss

SFAS 15 does not require a creditor to disclose the economic loss (i.e., the decrease in the present value of the restructured loans) associated with a troubled debt restructuring at the time the restructuring occurs. Disclosure of information relating to the amount of economic loss most likely would be relevant to capital market participants and their decision-making needs, since such information would reveal the long-range impact of restructured loans on an entity's financial position, results of operation, and quality of its earnings.

Although SFAS 15 does not require disclosure of economic loss at the time of loan restructuring, it does require creditors and debtors to make certain other disclosures. Creditors having outstanding receivables whose terms have been modified are required to disclose the following information as to the date of each balance sheet presented. . The aggregate recorded investment (receivable). . The gross interest income that would have been recorded in the period if the receivables had been current in accordance with their original terms and had been outstanding throughout the period or since origination, if held for part of the period. . The amount of interest income on those receivables that was included in net income for the period. . The amount of commitments to lend additional funds to debtors owing receivables whose terms have been modified.

Debtors are required to disclose, either in the body of the financial statements or in the accompanying notes, the following information about troubled debt restructurings that have occurred during a period for which financial statements are presented: . For each restructuring, a description of the principal changes in terms, the major features of settlement, or both. . Aggregate gain on restructuring of payables and the related income tax effect. . Aggregate net gain or loss on transfers of assets recognized during the period. . Per share amount of the aggregate gain on restructuring of payables, net of related income tax effect. . Information on amounts contingently payable that are related to restructured payables.

Recognition of Loan Losses

GAAP requires business entities to report receivables at net realizable value. Net realizable value represents the amount the entity expects to collect, and it is equal to the face amount of the receivables less an amount that is estimated to be uncollectible. Thus, an analysis of the collectibility of loan portfolio may result in a financial institution having to recognize a loss under SFAS 5, "Accounting for Contingencies," before and/or after restructuring a loan. Under GAAP, banks are required to maintain an adequate allowance for credit losses. The maintenance of an adequate allowance for credit losses is management's responsibility. The allowance is an estimate based on subjective judgment and is difficult to audit. The responsibility of a bank's independent auditor in auditing the adequacy of the allowance for loan losses is addressed in the AICPA's Audits of Banks and Auditing the Allowance for Credit Losses of Banks. The objective of the audit is to evaluate the reasonableness of the recorded allowance. The CPA is responsible for obtaining reasonable assurance that management has recorded a reasonable allowance to cover the estimated amount of loss in the loan portfolio at the date of the financial statements, based on available information and all relevant factors bearing on loan collectibility.

The recognition of loan losses due to uncollectibility subsequent to restructuring is an issue separate from recognizing a loss at the time a troubled loan is restructured. Under SFAS 5, creditors should recognize loan losses due to uncollectibility when it is probable that the carrying value of the loan has been impaired and the amount of loss can be reasonably estimated. Thus, when a debtor becomes unable to comply with the terms of the restructured loan, the creditor should recognize an additional loss.(3) The federal bank regulatory agencies also view the financial reporting of a restructuring as one matter and the collectibility of the restructured loan as another. That is, the restructuring of a borrower's debt does not assure collectibility of the loan, and restructuring under the guise of SFAS 15 should not be used by a bank's management simply to avoid the recognition of a loss on a troubled debt.

Regulatory Reporting Requirements

With regard to the evaluation of loan portfolios, federal bank regulatory reporting policies require banks to regularly review the credit quality of restructured loans. Along these (3) SFAS 5, paragraphs 22 and 23. According to FASB Technical Bulletin 79-6, "Valuation Allowances Following Debt Restructuring," SFAS 15 does not specifically proscribe subsequent provisions for anticipated losses on assets modified in a troubled debt restructuring. The bulleting also states that since SFAS 5 requires recognition of anticipated losses whenever they are probable and reasonably estimable, an assessment of the collectibility of the receivable with modified terms is necessary for a troubled debt restructuring subject to SFAS 15. lines, the instructions to prepares of Consolidated Reports of Condition and Income state the following:

"A credit analysis should be performed for a restructured loan in conjunction with its restructuring to determine its collectibility and probable credit loss. Losses that are evident from this analysis should be charged to the allowance for loan and lease losses at the time of restructuring. Thereafter the bank should periodically evaluate the collectibility of the restructured loan so as to determined whether any additional amounts should be charged to the allowance for loan and lease losses or, if the restructuring involved an asset other than a loan, to another appropriate account."

To encourage commercial banks to work with borrowers to restructure problem loans in accordance with SFAS 15, the federal bank regulatory agencies revised the reporting requirements of such loans.(4) Previously, banks were required to classify the full amount of restructured loans along with past-due and nonaccrual loans regardless of the amount of delinquent payments.(5) The revised reporting forms require banks to disclose restructured loans and leases in two memoranda schedules depending on the status of collectibility.

First, in a memorandum to Schedule RC-C ("Loans and Lease Refinancing Receivables") banks are to report a line item entitled "Loans and Leases Restructured and In Compliance with Modified Terms." For purposes of this item, restructured loans and leases are those whose terms have been modified to provide for a reduction of either interest or principal. Once an obligation has been restructured because of a deterioration in the financial position of the borrower, it continues to be considered restructured until paid in full or until such time as the terms are substantially equivalent to terms on which loans with comparable risks are being made.

Second, those restructured loans and leases excluded from the memorandum to Schedule RC-C are reported in a memorandum to Schedule RC- N ("Past Due and Nonaccrual Loans and Leases"). Banks report the amount of restructured loans and leases in the following categories: past due 30 to 89 days, past due 90 days or more, and the amount of nonaccrual status. The regulatory agencies treat the amount past due 30 to 89 days as confidential, and do not release this information for individual banks although the aggregated amount in this category for all insured banks is released to the public. Table 2 shows the amount of restructured loans and leases past due and nonaccrual, as of December 31, 1987 and 1986.

Impact on Financial Ratios

Practitioners should be aware of the potential impact SFAS 15 rules could have on the calculation and interpretation of commonly used financial ratios for evaluating capital adequacy (capital/asset ratio) and profitability (return on equity and return on assets) of financial institutions. These financial ratios may be rendered less meaningful to accountants and auditors as they attempt to assess the performance of an entity. That is, in addition to whatever reporting distortions occur under current regulatory accounting practices, the financial reporting implications stemming from the application of SFAS 15 rules may make financial ratios even more difficult to interpret. This particularly becomes a problem when comparing an entity's current ratios with those of prior periods and against similar ratios of other entities in the same or different industries.

Further, users may be unable to properly adjust ratios, on the basis of information presented in financial statements alone, to compensate for the impact of SFAS 15 rules. The disclosures under the standard do not provide the kind of information that external users would consider useful in making adjustments to conventional financial ratios. For example, SFAS 15 does not require disclosure of economic loss on restructurings during the period, and the current value of receivables whose terms have been modified is not made available through existing disclosure rules.

Concluding Remarks

Current financial accounting and disclosure rules covering troubled debt restructuring are controversial, because they may result in the long term risks of a bank's loan portfolio not being disclosed to a bank's stockholders, creditors, or its depositors. Of particular concern is that SFAS 15 does not treat a modification of loan terms as an economic event or as an accounting transaction, despite the possibility that a financial institution may be substantially worse off under the modified terms. As a result, users of financial statements are not being provided important information relevant to their decision- making needs. The application of the rules results in deferring recognition of loan losses to future periods which is contrary to existing accounting pronouncements such as SFAS 5.

While SFAS 15 often precludes a reduction in the recorded amount of a troubled loan at the time it is restructured, SFAS 5 requires periodic provisions for bad debts including loans whose terms have been modified, and there appears to be no bar to providing for write offs by credits to the reserve for loan losses. If this is correct, and an appropriate reserve provision has been made for a troubled loan, then the purpose and significance of SFAS 15 is brought into question. The effect of SFAS 15 is only to charge a specific recorded amount of a troubled loan to the loss reserve at the time such a loan is restructured. This may have an effect on certain financial ratios but it would not change either the lender's net income or net assets. Thus, in light of the financial reporting implications discussed, this may be an appropriate time for the FASB to think about placing SFAS 15 on its agenda for reconsideration. 4 See Federal Financial Institutions Examination Council, "Instructions: Consolidated Reports of Condition and Income for Insured Commercial Banks with Domestic and Foreign Offices," Reporting Form FFIEC 031 (September 30, 1986), pp. RC-28a and RC-64a. 5 The meaning of nonaccrual loans is discussed in the consolidated reports of condition and income for insured commercial banks, as prescribed by the Federal Financial Institutions Examination Council. Loans are to be reported as being in nonaccrual status if: (a) they are maintained on a cash basis because of deterioration in the financial position of the borrower, (b) payment in full of interest and principal is not expected, or (c) principal or interest has been in default for a period of 90 days or more unless the obligation is both well secured and in process of collection. A nonaccrual loan may be restored to an accrual status when none of its principal or interest is due and unpaid or when it otherwise becomes well secured and in the process of collection.

Table : RESTRUCTED LOANS AND LEASES REPORTED BY INSURED COMMERCIAL BANKS, DECEMBER 31, 1987 AND 1986 (in Million of Dollars)