Debt refinancing and restructuring, along with a million other things, are often at the top of a CFO's mind these days. Sure, given the current status of, well, everything, that notion makes perfect sense. After all, the coronavirus pandemic has turned countless companies and entire industries inside-out. However, the need to address debt in some way isn't exclusive to the path of destruction caused by COVID-19.

For that reason, we're going to take a look at both debt refinancing and debt restructuring for companies, what they mean for their accounting and finance functions, and throw in a few key best practices as well. As you'll see, while the recent surge in distressed companies might be what's driving this trending topic, debt restructuring and debt refinancing are common needs under a variety of economic conditions and circumstances.

Corporate Debt Was Already a Bubbling Issue

Before honing in on what's happening today, let's start by going back in time a few years. Since the recession in 2008, interest rates have been hovering at historic lows, making credit cheap for both the public and private sectors. Further, when you factor in a booming economy in recent years, you're left with a level of corporate debt that had more than a few people concerned.

So that's the tinder box that was waiting for ignition. Now we're not trying to say that the sudden jump in debt restructuring was somehow inevitable, because no one saw these current conditions on the horizon. However, the immense amount of debt obligations already on the books has undoubtedly added to the scope and severity of today's issues.

Refinancing vs. Restructuring

Also, you might see people use the terms "refinancing" and "restructuring" interchangeably. Under a different context, that might not pose too much of a problem since, although not identical twins, the terms are certainly first cousins. However, we're sticklers here at Embark and wouldn't feel right if we didn't point out the not-so-subtle differences between the two, particularly when it comes to the accounting considerations involved.

Debt Refinancing

Let's use recent monetary policy to illustrate refinancing. The Fed recently cut its overnight rate to zero, an action that won't necessarily have an immediate impact on corporate borrowers, but could very well drive both fixed and variable rates down in the near future. Naturally, such a drop would be attractive for companies interested in refinancing their fixed debt at lower rates, thus, easing cash flow at a time when many companies could really use it due to depressed demand. Therefore, just as a consumer might refinance their mortgage when rates drop, so does a company with an existing loan.

Debt Restructuring

Restructuring is a different animal. Distressed companies often have liquidity issues, lacking sufficient cash flow to meet their obligations. This is an instance where they'll want to restructure those obligations with their lenders to improve their liquidity position and hopefully be able to continue their operations.

To use an example, many consumers cut down on their leisure activities during a recession, negatively impacting restaurants, airlines, and hotels. If hit sufficiently hard enough and not able to meet their debt obligations or even their debt covenant requirements, these types of companies might attempt to restructure their loans. Municipalities can also get hit during a recession with a rapid and significant drop in tax revenues, forcing them to take similar action.

Violating debt covenants – or just the risk of violating them – is one of the most significant catalysts for debt restructuring. When a distressed company seeks relief from a lender, it could try to negotiate changes to debt payments or even request a waiver on some or all of their debt covenants. Granted, most companies keep a very close eye on key ratios and KPIs, so covenant violations are rarely something that just pop up out of nowhere and surprise a CFO and their team. Because restructuring is under a particularly bright spotlight during times of economic hardship, we'll narrow our focus to the various accounting considerations for restructuring from here on out.

Accounting Considerations of Debt Restructuring

Once an organization seeks relief through debt restructuring, there are obviously going to be financial reporting implications, including considerations of debt covenant waivers for violations or potential violations as well as evaluation of the relief as a troubled-debt restructuring. A company must have a game plan for these considerations and think everything through before proceeding.

Debt Covenant Waivers

Keep in mind that receiving a waiver doesn't necessarily mean a full restructuring of the debt agreement is necessary. In fact, in the case of an especially restrictive covenant, it could just be a matter of reducing the burden of that particular covenant requirement. However, if a company has a covenant violation at the balance sheet date where the lender could demand repayment of its debt, its classification will depend on different facts and circumstances, as shown in the scenarios below:

On a related note, if a covenant violation occurs after the balance sheet date, a company would generally still present its debt as noncurrent as of the balance sheet date. However, as we will highlight below, this could have other implications to consider.

Before requesting a waiver, management should look at both short and longer-term needs to ensure the waiver is long enough to give the company enough time to right the ship. Otherwise, if it receives a waiver for a quarter but needs a full-year to get back on track, it risks failing a future covenant. Of course, sometimes a lender isn't willing to extend things that far, meaning a company must take what it can get. However, management should invest sufficient time and effort to accurately assess its needs before requesting any waiver.

Companies must also be cognizant of their future covenant requirements, including risk of any potential violations, that may impact their future obligations when performing their interim and annual going concern assessments. As a reminder, these assessments require management to evaluate events or conditions that may give rise to substantial doubt 12 months from the date the financial statements are expected to be issued.

Accounting for Troubled Debt Restructurings (TDRs)

We're not going to take a terribly deep dive into the accounting principles on troubled debt restructurings (TDRs), but certainly want to hit on a few high-level points. First and foremost, a debt modification is considered a TDR when the borrowing company is experiencing financial difficulties and the lender grants a concession that it would not otherwise consider.

Due to the extreme volume of restructurings during the coronavirus pandemic, the FDIC, FASB, and many state bank regulators came to a joint agreement on short-term restructurings. Because of the rapid onset and significant impact of the coronavirus pandemic on the economy, many companies have suddenly run into difficulty meeting their obligations due to cash flow restraints stemming from, amongst other things, a severe drop in demand.

As a result, a business might have a clear history of meeting its obligations with no past issues paying interest expense or principal payments, but still need to seek short-term restructuring because of the current economic environment. As a small but not insignificant form of relief, that restructuring will not qualify as a TDR and, therefore, will avoid the burden of accounting considerations that come with them.

But even during a significant economic downturn, there is still an opposite side of the coin with companies and industries not significantly impacted by reduced demand. For instance, the supermarket industry is thriving during the COVID-19 crisis while others are struggling to stay afloat. If a grocery store chain refinances some of its existing debt or amends current debt facilities to take advantage of the low interest rate environment, it would still have to go through the determination of whether that non-troubled debt transaction is considered a modification or an extinguishment of debt under ASC 470-50.

Other Considerations

Lastly, there are a few other high level considerations to keep in mind around the accounting implications of debt restructuring:

• A company will have additional considerations if the debt restructuring, specifically a TDR, includes an equity holder in the business. In these cases, a company needs to determine if any transactions with investors that benefit the borrower should be accounted for as a capital transaction within equity.
• Regarding debtor-in-possession (DIP) financing or pre-structured bankruptcy issues, if a company is in the process of filing bankruptcy – or already in it – it will trigger the financial difficulty criteria for a TDR. Companies will still need to evaluate whether a concession has been granted to determine if the TDR model applies. However, if you think your company might fit the criteria for the TDR model, we encourage you to familiarize yourself with the associated accounting standard in ASC 470-60, Troubled Debt Restructurings by Debtors, or guidance from the FDIC.

We understand that companies looking to restructure their debt might feel as if they’re juggling 100 different things with just two hands. However, by using these insights as a starting point, you can prevent your accounting team from needlessly spinning their wheels at a time when you need those resources elsewhere. And as always, Embark will be here to provide additional guidance along the way.