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Loan Modifications Under Current Expected Losses

This article was originally published in September 2022 by Chad Scott, Senior at The Bonadio Group


Accounting Standards Update (ASU) 2022-02, Troubled Debt Restructurings and Vintage Disclosures reconsiders loan modifications under the current expected loss model to determine the allowance for credit losses. This ASU was issued in March 2022 and its primary focus was to modify the accounting treatment and disclosures for loan modifications.

As loan modifications do not need evaluation of whether a Troubled Debt Restructuring (TDR) has occurred under the current expected loss model, the most critical decision for all modifications is whether the modification should be accounted for as:

  1. The continuation of an existing loan receivable, or
  2. A new loan receivable.

To determine the type of modification, institutions must consider the Effective Interest Rate (EIR) and possibly a present value of the discounted cash flows using the EIR. It is important to note that the EIR is the rate of the modified loan receivable rather than the rate of the loan prior to the modification.

& More Insight: Previously for TDRs, it was important to determine if borrowers were experiencing financial difficulty and whether a concession had been granted by the lender. Consequently, for both accounting and reporting purposes, the population of such loans that could require TDR accounting would generally not be that large.

However, under the new ASU, the entire volume of modifications is going to require some degree of individual analysis to determine whether the modification represents an existing loan receivable or a new loan receivable. Consequently, record keeping and tracking of modifications may need to be far more robust than under the incurred loss model for many institutions.

Modified Loans Chart

Disclosures

The disclosure requirements under this ASU will be far more robust than previous TDR disclosures required under the incurred loss method. The disclosure requirements will require segmentation by loan class and modification type (i.e., rate reduction, term extension, payment holiday, etc.).

The types of information to be disclosed for the modified loans as segregated above will include:

  • Pre-modification amortized cost basis of the modified loans.
  • Percentage of modifications as a percentage of the total loans included in each loan segment at the end of the reporting period.
  • The financial effect of the modification by type of modification, which will include information about the modifications made and may include:
    • The incremental effect of any principal forgiveness on the amortized cost basis of the modified loans.
    • The weighted-average reduction in interest rates for interest rate reductions and the range of the same.
  • Loan performance status for the 12 months following the modification

The disclosures regarding modifications that default within 12 months have not changed significantly as compared to the previous incurred loss model requirements for TDRs that default within 12 months.

Additionally, the disclosures, as proposed, will require qualitative information, by loan segment, about how the loan modifications and the debtors’ subsequent performance are factored into the expected credit loss methodology.

Treatment of Unamortized Deferred Fees and Costs and any Prepayment Penalties

  1. For continuation of an existing loan receivable, existing deferred fees and costs as of the modification date will be carried forward and re- amortized on the modified loan along with any additional new deferred fees and costs associated with the modification.
  2. For a new loan receivable, any unamortized fees and costs associated with the original loan should be recognized in interest income at the time of modification. Further, any prepayment penalties associated with the modification should be recognized in interest income at this time.

Measurement of Expected Credit Losses

  1. For both continuation of a new loan receivable and for a new loan receivable, the EIR for the modified loan is used when a Discounted Cash Flow (DCF) method is used to measure expected credit losses.
  2. Also note for both scenarios, above, that a DCF method is not required for the measurement of expected credit losses.

Effective Dates and Transition Guidance

For entities that have not yet adopted the current expected loss model under ASC 326, the adoption date is annual and interim periods for fiscal years beginning after December 15, 2022. For these entities, the ASU can be adopted on a prospective basis, only.

For entities that have previously adopted the current expected loss model under ASC 326, the adoption date is annual and interim periods for fiscal years beginning after December 15, 2022. Early adoption is permitted for these entities. For these entities, the ASU can be adopted on a prospective basis or a modified retrospective basis that will require a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption.

& More Insight: What does this mean on day one of adoption of the current expected loss model?

  • TDRs no longer exist.
  • Your institution will need to begin tracking all modifications in a robust manner to ensure that disclosure requirements can be met. All modifications will need to be flagged in the system and fields that will need to be included for the modifications include:
    • Standard loan information including borrower information, loan type, loan terms of the modified loan.
    • Modification type
      • Rate reduction
      • Term extension
      • Payment holiday
      • Principal reduction
      • Any other modification types used by your institution.
    • Pre-modification amortized cost
    • Post-modification amortized cost
    • Pre-modification interest rate
    • Post-modification interest rate
    • Post-modification effective interest rate
    • Modification date (keep in mind, one loan could have multiple modification dates)
    • Pre-modification loan number
  • Additionally, planning will be needed to determine how the institution will handle modifications that are continuations of existing receivables and modifications that will be new loan receivables.
    • Will loans that are continuations of existing receivables continue as the same loan number or will these loans be given a new loan number and will a new loan type be created for these loans? (i.e., there could be a 1-4 family residential mortgage type code and a Modified 1-4 family residential mortgage type code. Or, there would be no change in type code and all modifications would require a flag)
    • There will likely need to be significant care, planning and coordination with the Bank’s core system vendor to determine the best way to provide the data necessary for these disclosures.
    • If the institution is using software for the current expected loss model capable of producing these disclosures, discussions with these vendors may be necessary, as well.
  • An institution may need to re-visit its current expected credit loss model if TDRs are treated differently than similar loans that were not modified.