Accounting for Debt Modifications: Understanding What’s Material and How to Get It Right – Expert Q&A

Riveron experts sat down with Accounting Advisory professional and Managing Director Patrick Garrett to discuss debt modifications, why the topic matters for the office of the CFO, and how accounting teams can ensure accurate financial reporting.

Financing arrangements are getting more complex than ever — causing a need for more frequent updates by CFOs and company accounting teams. What is driving this?

Companies often need to modify their debt to address financial challenges, like a restructuring scenario or dealing with economic downturns. These debt modifications can be triggered by a variety of factors such as the need for additional funding of operations, upcoming maturity dates, interest rate changes, mergers, or the need to improve capital structure. Two common reasons that come to mind that may be at opposite ends of the spectrum: (1) a company is experiencing financial difficulty or distress causing a need to change terms, adjust its debt covenants, extend the maturity date of a loan, obtain critical funding for the business, etc.; or (2) an organization is upsizing its debt to invest in the business, meaning it obtains incremental debt to mobilize an acquisition or fund a large capital project.

Accounting for these changes is crucial for accurate financial reporting, which can ensure a smooth audit cycle and better decision-making. By accurately accounting for debt modifications, the office of the CFO can support a fuller understanding of a company’s overall financial health.

Why should CFOs and accounting professionals be paying close attention to this topic today?

Regulatory guidance is always evolving, and accounting teams need to be able to respond accordingly. For instance, in the past two to three years, many companies have had to navigate the change from LIBOR to SOFR (a change in the methods for setting the benchmark rate), and the FASB issued specific guidance for that change.

Over the past two years, higher interest rates have significantly impacted activity related to capital markets, divestitures, and acquisitions. Where private equity buyers had financed an acquisition with an expected exit timeline in the years prior to the increase in rates, that timeline has likely changed. With that change in timing, investors are forced to rethink their financing, including extensions of their existing debt or expansions to further fund business activities. As finance professionals know the interest rate “is what it is,” they may seek a lower interest rate in exchange for other instruments in the transaction, such as giving warrants or throwing in some other type of “sweetener,” which is an incentive for the lender to allow the borrower to make changes or receive a lower interest rate. This is increasingly common for distressed companies that need to rework debt.

Also, it’s worth mentioning the increasing variety of sweeteners we have seen in this environment. The evolving variety of financial instruments require CFOs and their accounting teams to carefully examine the terms of individual instruments. From simple agreements for future equity (SAFEs), warrants with contingent exercise provisions that may trigger the issuance of additional warrants, or preferred stock instruments that function as a type of kicker when they payout on liquidity events, finance professionals continue to look for ways to optimize returns while protecting their initial investment in this environment. Due to the nuances of many of these provisions, separate accounting may be required, and the valuation considerations related to that accounting may require sophisticated modeling, which really means that CFOs and their teams want to identify these provisions early to give time for adequate analysis and potential valuation and avoid last-minute fire drills.

In your observation, what are some of the common terms currently being refinanced by companies?

When companies change debt terms, common examples include extending the maturity dates; increasing the principal; refinancing of interest rates; adding a revolver or increasing the capacity on the revolver; or adding a delayed draw component to the term debt. For example, in a common private-equity backed scenario, a PE firm might be planning a string of acquisitions —with perhaps one acquisition about to close and three in the pipeline. Instead of incrementally negotiating new debt with each acquisition, they will try to do it all at once and set up the ability to draw a certain amount in the future to fund each subsequent acquisition.

As CFOs and accounting professionals tackle debt refinancings, where should they start in determining how to account for the refinancing?

First, it’s important to ask whether the transaction is a troubled debt restructuring (TDR). Here, teams should evaluate if the transaction meets two criteria: (1) demonstrating that financial difficulty exists, which means the borrower could not obtain financing at the current market rate. Here, the finance and accounting team should look to see if the audited financial statements have a going concern; consider whether the company could borrow from other lenders at market rates—which means that the company has to negotiate with the current lender; evaluate overall company performance and whether the organization is growing or if there is difficulty like not being able to meet debt covenants; and (2) determine whether the lender granted a concession. The accounting guidance dictates a specific test for whether there is a concession that determines whether the investor’s ROI has decreased. Things that would likely be considered a concession include: forgiveness of debt; exchanging principal for equity that has a lower fair value; or a debt or interest “holiday” (in which the borrower defers interest or principal payments). These factors inherently drive a lower ROI based on the time value of money – and likely lead to a lender concession. Any decrease in interest rate could also drive a concession, but this is rare.

Here, companies should pay attention to the effective borrowing rate and the calculation of return on investment (ROI). If your company has met both of the above conditions you have a troubled debt restructuring, and that scenario follows a different accounting model and disclosures compared to a debt modification or extinguishment. Depending on the terms of the TDR, the accounting methods can be significantly different, or it might be a relatively simple disclosure issue.

If the transaction is not a troubled debt restructuring, then the accounting and finance team needs to evaluate whether debt should be modified or extinguished.

Debt modification versus extinguishment is typically based on the application of the “10% test.”

Simply put, a debt modification accounts for the debt instrument as though it has been changed (going forward). An extinguishment considers the old instrument to be “gone” and you account for the changed terms as a new instrument going forward.

What do accounting professionals need to know about the 10% test?

There are already many step-by-step guides out there on conducting the 10% test, so I want to focus on the top nuances that I have seen materially impact the evaluation of the 10% test. These include:

1. Syndication versus participation – this distinction drives the analysis and accounting approach. If your company has a loan syndication (a loan composed of several lenders in which each lender is considered to have a loan directly with the company), then you have to perform the 10% test on a lender-by-lender basis. This requires you to compare the syndication before the modification to the syndication immediately after. If you have a loan participation, then you treat the loan as one loan between one lender and the company, in which pieces of the loan have been sold off by the lender. In practice, this scenario is more rare, and most term loans are syndications that require a 10% test on a lender-by-lender basis.
2. A revolver test is different from a term loan test – If your organization has a credit facility that has both a term loan and a revolving credit facility, the modification versus extinguishment test for a revolving credit facility is much different than the 10% test for the term loan, so accounting professionals have to look at those differently. A revolving credit facility test looks at the borrowing capacity, which is the remaining term of the revolver multiplied by the amount available under the revolver, and this still has to be performed on a lender-by-lender basis, but it’s a simpler test.
   Example: if you had a revolver that had $20 million available under the revolver, with a remaining 5-year term, the borrowing capacity of that instrument would be $100 million under this test.
3. Prepayment options – This factor is pretty critical when you’re doing a 10% test for a term loan. The accounting and finance team should evaluate if there is the ability for the debt to be prepaid. If so (which is typically the case), assume that the debt would be prepaid on Day-1, and you generally treat any increases/decreases in principal as a Day-1 cash inflow or outflow. The change in principal is effectively canceled out (for purposes of the 10% test) because if you have an increase in principal, you treat it as an inflow and assume it’s prepaid on Day-1, meaning it comes in and goes out. Here, your cash flows are really only changed by any fees to the lenders incurred as part of the transaction—or any assumed prepayment penalties. Because of this feature in the guidance (where you assume any prepayment options are exercised), and the fact that you will always take the lowest percent change, most refinancings will be accounted for as debt modifications.
4. Identification of third-party versus lender fees and how they impact the 10% test – Because of the previously mentioned prepayment option, you’re going to want to take a close look at what will ultimately drive the accounting conclusion —the amount of fees paid to the lenders and how they’re allocated— it’s critical to look at all the transaction fees and determine if they’re lender or third-party fees and whether/how they should be allocated to the individual lenders. Two nuanced areas in identifying the lender fees are: (1) when you have fees that are paid to service providers on behalf of the lenders (e.g. attorneys, diligence providers), those are considered lender fees and not third-party fees; and (2) if you have a fairly common scenario in which one lender or a subset of lenders is acting as the underwriter or arranger of the debt, and those parties receive some related fee, if that fee is received in a capacity as an underwriter/arranger, it’s treated as a third-party fee, which wouldn’t be included in the 10% test even though the fee is paid to a lender. In essence, the substance of the payments matter more than strictly who received the fees.
5. The treatment of sweeteners and existing derivatives/warrants, etc. – In a debt refinancing, to the extent that new warrants exist (or other sweeteners incentivizing the lender to refinance the debt, which are not as typical) your accounting team would treat the fair value of those new warrants/sweeteners as a Day-1 cash outflow for the purposes of the 10% test. This is fairly similar to the treatment of a lender fee. To the extent that existing derivatives or warrants exist, you need to determine if they’re accounted for separately from the debt and whether they are revised as a result of the transaction. If they were separate from the debt and not revised, there’s no related accounting impact. If warrants were modified as part of the debt restructuring (a lowered strike price, for example), then your accounting team would include the change in the fair value related to that modification of the warrant as a Day-1 cash outflow. It’s important to remember that any time a company is dealing with warrants and derivatives, the accounting guidance can be highly dependent on the facts and circumstances, and the accounting can get highly complex.
6. Fair value determination in a debt extinguishment transaction – In the circumstance where the 10% test indicates that a debt was extinguished as a result of refinancing, effectively writing off the old debt, and if that lender wasn’t fully repaid, the accounting team will need to reestablish that lenders’ balance at the fair value of the new debt (which may be different than the carrying value). Then, any difference between the carrying value and that fair value would be accounted for as part of the loss on that extinguishment.
   Example: if the debt owed to a lender was determined to be extinguished (based on 10% test), and the carrying value of the principal balance was $10 million, and the fair value of that debt was $10.5 million, the borrower’s accounting team would recognize $500,000 as a loss on the extinguishment in order to reestablish the debt balance at fair value.

Ultimately, a debt refinancing transaction can not only be complex to negotiate but also challenging to accurately reflect in a company’s financial statements. In this current era of economic uncertainty, accounting teams unfamiliar with these types of transactions can pay special attention to the areas noted and—with careful attention to detail—complete the financial reporting for these transactions in a timely and effective manner.