Small banks may miss out on a new proposed accounting rule that frees banks from onerous accounting and reporting requirements following a loan modification.
In November 2021, the board that sets U.S. accounting standards issued an exposure draft that will remove the reporting guidance around troubled debt restructurings, or TDRs, for banks that have adopted the new loan loss standard, called the current expected credit loss model or CECL. Under the proposal, banks that have adopted CECL could continue reporting any modifications they offer borrowers and leave TDR accounting behind, but excludes the many small banks that have yet to adopt CECL.
The move has its fans.
“I’m all for it, and good riddance. There’s not a true credit guy I know who spends much time worrying about TDRs anymore,” says David Ruffin, principal at IntelliCredit, a division of QwickRate that helps financial institutions with credit risk management and loan review. “TDRs stayed around well beyond their usefulness.”
The change from the Financial Accounting Standards Board, or FASB, stems directly from the combination of the new loan loss standard and the banking industry’s experience during the coronavirus pandemic. TDRs occur after a bank offers a concession on a credit that it wouldn’t otherwise make, because of a borrower’s financial difficulties or hardship. The bank offers a modification and it reports the value of the impaired credit using a complicated accounting approach called discounted cash flow analysis. Under the current guidance, a credit classified as a TDR could never be reclassified even when the modification ended and the borrower returned to financial health, giving rise to the phrase “Once a TDR, always a TDR.”
CECL and the coronavirus pandemic changed all that. CECL requires banks to set aside a lifetime loss estimate when they make a loan, and then periodically update that expected loss as the borrower’s financial condition or the economy changes. TDR guidance conflicted with CECL in several ways. CECL gives banks the flexibility to select what method to use to calculate loan losses, based on factors like the portfolio or borrower characteristics; the proscriptive TDR approach seemed to violate that spirit. And after the standard went into effect, banks and those who prepare financial statements told the FASB that the new approach to allowances captured most of the impacts from loan modifications that would be included in the TDR calculation.
“TDRs no longer provide decision useful information,” the board noted in the project description for this proposal.
Then the pandemic hit, and Congress took the dramatic step of dramatic step of suspending the TDR reporting requirements to encourage banks to work with borrowers facing unexpected financial hardship. Banks were free to offer loan modifications that normally would’ve triggered TDR classifications but didn’t need to engage in the accounting and formal reporting requirement.
What they did do was better. Banks voluntarily provided information on the percentage of borrowers that had received a modification, the amount of loans under modification, the type of modification and sometimes the industry. This became somewhat of an industry standard, which observers praised as more useful and actionable. Quarterly updates showed that at many banks, the percentage of secondary or continued modifications was declining, boosted by government stimulus programs and the gradual return of economic activity.
All that was slated to revert to TDRs at the end of 2021 with the sunsetting of the CARES Act provision, until the accounting board took up the mantel. If the proposal passes, CECL banks that offer a loan modification to a borrower that is facing financial difficulty in 2022 will need to provide enhanced disclosures.
But the relief would only be for some banks. CECL went into effect for most public filers — mostly large banks — at the start of 2020. But private companies and those defined as “smaller reporting companies” by the Securities and Exchange Commission received a delay until the start of 2023 and can still use the incurred accounting method, setting aside a reserve when a loss becomes probable. The argument against eliminating TDR treatment for banks using the incurred method is that because the bank doesn’t assign potential lifetime losses to its loans on a quarterly basis, the TDR guidance isn’t redundant and still applies.
Although banks large and small showed they could manage both borrower modifications and appropriate allowances during the pandemic, community banks should expect to revert to the existing TDR guidance at the beginning of 2022 until they adopt CECL.