Loan modifications have always been burdensome for banking systems to deal with. And this difficulty has resulted in many manual on-top processes and journal entries to allow for flexibility in loan terms, which can vary tremendously from one modification to the next, one loan product to the next and one borrower situation to the next. And while TDR (troubled debt restructuring) accounting is punitive to banks, it was a known quantity with known impacts. Banks could largely get away from the major/minor mod tests because TDR accounting swept up a majority of these loans.
But in recent months, the FASB has discontinued TDR accounting, which was previously suspended as part of the CARES Act to try to get away from penalizing banks for working with distressed borrowers. However, this has left banks in a position of having to build a process to determine whether a mod is major and results in a new loan, or minor and a continuation of the existing contract under ASC 310-20 and the resulting accounting.
Major or Minor Modification
Under the guidance in ASC 310-20, a loan modification or refinancing results in a new loan if:
- the terms of the new loan (including its interest rate) are at least as favorable to the lender as the terms with customers with similar collection risks that are not refinancing or restructuring their loans.
- the modification to the terms of the loan is more than minor.
The 10% test (in which new modified cash flows are compared to the cash flows under the original terms, and a change exceeding 10% is considered a major modification and a new loan) is often the method used to determine whether modifications are minor or major. But regardless of the specifics of the method used, banks need to 1) develop policies around the specifics of the test and 2) set up systems to account for it and the subsequent accounting. And this test can be complex, as the loan modifications themselves can be complicated, offering multiple changes to terms and potentially adding recourse options, guarantors, debt covenants, option features, etc.
To appropriately address the major/minor modification test, banks will need to develop a test that is applied consistently, is defensible and done in a controlled environment. This will be especially true as the population of borrowers seeking loan modification grows amid continued economic volatility and the materiality of this population continues to grow.
Recognition and Subsequent Accounting
If the modification is deemed to be a new loan, unamortized net fees or costs from the original loan and any prepayment penalties are recognized in interest income when the new loan is granted. In addition, a new effective interest rate will be determined. If the refinancing or restructuring is deemed to be a continuation of an existing contract:
- The investment amount will be comprised of the remaining net investment in the original loan, any additional funds advanced to the borrower, any fees received, and direct loan origination costs associated with the refinancing or restructuring.
- The effective interest rate of the loan will be recalculated based on the amortized cost basis of the new loan and its revised contractual cash flows.
Bringing it Together
This accounting guidance means that even after loans are classified as either a major or minor mod, the institution will still need to calculate the effective yield considering the complexities of the modifications granted and all fees and costs that both arose as a part of the modification process and that previously existed. Next, banks will need to track the new basis for each loan depending on the modification type and will need to carry that information forward from period to period.
Most servicing systems cannot handle this type of technical accounting (both the major/minor modification test and the subsequent accounting) and either have very simplified modules for modification or do nothing at all. Banks will be left to create processes to allow them to do this accounting, and as the population grows, the scrutiny of these processes will increase.
The changes are not limited to calculations and journal entries. The changes also include enhancements to the disclosures around loans—especially those related to troubled borrowers or related to modifications of loans to borrowers experiencing financial difficulty in the form of principal forgiveness, an interest rate reduction, an other-than-insignificant payment delay or general term extensions (although covenant waivers and modifications of contingent acceleration clauses are not considered term extensions). These disclosures are required regardless of whether a modification is considered major or minor.
- The types of modifications utilized by an entity, including the total period-end amortized cost basis of the modified loans and the percentage of modifications of loans made to debtors experiencing financial difficulty relative to the total period-end amortized cost basis of loans in the class.
- The financial effect of the modification by type of modification, providing information about the changes to the contractual terms because of the modification.
- Loan performance in the 12 months after a modification of a loan made to a borrower experiencing financial difficulty.
- Disclosure of qualitative information, by portfolio segment, about how those modifications and the borrower’s subsequent performance are factored into determining the allowance for credit losses.
For a loan modified within the previous 12 months and experiencing a payment default in the period covered by a presented income statement, the following qualitative and quantitative information, by class of loan, is required for the defaulted loan:
- The type of contractual change that the modification provided.
- The amount of loans that defaulted, including the period-end amortized cost basis for loans that defaulted.
- Disclosure of qualitative information, by portfolio segment, about how those defaults are factored into determining the allowance for credit losses.
Finally, disclosures must address significant changes in the type or magnitude of modifications, including those modifications that, for example, were caused by a major credit event, even if the modifications otherwise would not require the disclosures above.
These comprehensive changes require a system that is built to account for and report on loans and modifications specifically and can handle an increased volume within a controlled platform. EVOLV is that system.
EVOLV Features for Loan Modifications
|✓ Embedded major/minor mod testing||✓ Ability to track and report the concession type|
|✓ Configurable data rules engine to identify modification type||✓ Post-modification performance tracking and reporting|
|✓ Calculation of the post-mod effective yield for amortization||✓ Best-in-class business intelligence for disclosure and insights|
|✓ Amortization of cost basis adjustments|
Written by Theresa Meawad
Senior Director & Head of Solutions Consulting, SS&C EVOLV