CFOs are finding themselves in uncharted territory these days. For many, the thought of restructuring in some capacity might have seemed worlds away just a few months ago. But, lo and behold, with the sudden and drastic impact of the coronavirus creating an avalanche of seemingly endless risk, once rock-solid companies are now struggling just to tread water.
Of course, the fact that many companies lack experience with restructuring only exasperates the stress of these challenges times. If you happen to fall into that camp – or maybe just want to put a few insights in your pocket in case you need them down the road – then we have some good news...you came to the right place. So join us as we dive into accounting for restructuring, what to look for, and a few tips to set you on the right path.
The Restructuring Spectrum
The term restructuring is one of the most pliable in accounting, encompassing everything from lease contracts and debt modifications for distressed companies to more dire processes like Chapter 11 filings. Put another way, restructuring occurs across a spectrum of circumstances and needs, and can mean different things to different companies at different times.
Obviously, in 2020, it's the repercussions of the coronavirus pandemic and an oil price war driving the bulk of the restructuring trend. But in the future, it could be any number of forces, both micro and macroeconomic, that make companies look for ways to shore up their cash flow, revisit their obligations and workforce, and refine their operations. In other words, restructuring is top-of-mind in 2020, but is in no way relegated to these particular times.
Therefore, whether it's COVID-19, a collapse in oil prices, an industry-specific change in demand, or something else, restructuring is an evergreen need. Here at Embark, we look at the topic as a spectrum of different processes and actions, where the further a company finds itself along that spectrum, the more severe and far-reaching the restructuring will likely be.
If you're a CEO, CFO, or controller, then the critical first step is identifying where you fall on the restructuring spectrum based on your company's needs, financial circumstances, and future viability. From least severe to most, the following restructuring actions each involve a unique set of accounting considerations that your team will have to address:
- Debt restructuring
- Lease modifications
- Employee terminations
- Pre-bankruptcy actions and reporting
- Formal bankruptcy filing
Contract Modifications & Creditor Negotiations
This highest, least aggressive form of restructuring really stems from two different factors:
- The availability of liquidity, driving debt modification or expanding your borrowing capacity
- Deteriorating financial conditions, leading to an inability to satisfy certain debt covenants and risk default
Naturally, these two factors aren't mutually exclusive of each and typically work hand-in-hand. Other factors like a more favorable interest rate environment could also be involved but, particularly when there's an economic shock to the system like COVID-19, liquidity and default prevention are the two primary drivers.
We previously discussed accounting for debt restructuring due to the impact of COVID-19. However, since the topic is pertinent to an overall look at restructuring and helping leadership hit the ground running, we still want to cover the high-level points in these insights.
When it comes to the financial reporting implications of debt restructuring, it's critical you take into account the different considerations of debt covenant waivers for violations – or potential violations – as well as evaluate the troubled debt restructuring criteria.
First and foremost, remember that covenant waivers don't necessarily constitute a full restructuring of your debt agreement. If there's a particularly restrictive covenant that is the primary source of potential default, then you can request a waiver from your lender specifically on reducing that individual burden.
From an accounting perspective, if you have a covenant violation at the balance sheet date and the lender could demand repayment, then how you account for that violation depends on the circumstances. For instance, if you don't obtain a covenant waiver and the debt agreement provides no grace period, then the debt is obviously current. However, if you receive a waiver after the balance sheet date for a current violation that relaxes the requirement for 12 months, then the debt is noncurrent.
There are other possible scenarios as well, so we urge you to review our previous summary on accounting considerations for debt covenant waivers for a more granular look. Just remember, before you even request a waiver, make sure it extends far enough into the future so that you can address the issues at hand and avoid potential issues around going concern. Otherwise, you might find yourself in the same boat soon after the waiver expires.
Troubled Debt Restructurings (TDRs)
A debt modification is considered a TDR when a lender grants you a concession due to financial difficulties that it wouldn't otherwise consider. This will require borrowers to assess their situation both quantitatively and qualitatively to determine if the restructuring qualifies as a TDR. As you might guess, the accounting considerations from a TDR can be quite burdensome and require expertise, experience, and a whole lot of high-octane coffee.
For obvious reasons, there has been a sudden and dramatic rise in such financial difficulties during the coronavirus pandemic, primarily stemming from severe cash flow restraints. Thankfully, given the extraordinary circumstances surrounding the pandemic, if you have a clean and clear payment history, then a short-term restructuring won't qualify as a TDR, as announced collectively by the FDIC, FASB, and various state bank regulators.
Once again, in light of COVID-19, we've already discussed many of the lease accounting considerations that should be on a company's radar. But given the significant rise in rent concessions in recent months, it only makes sense to revisit the subject as it pertains to restructuring.
While ASC 842 is usually the new lease accounting gospel, the FASB has issued additional guidance concerning the accounting for rent concessions stemming from the coronavirus pandemic. The guidance instructs companies to evaluate if an enforceable right or obligation exists for any rent concessions in leasing contracts. However, given the sheer volume of modifications occurring right now, the FASB has provided an additional option that forgoes the assessment detailed in ASC 842.
If total cash flows of the modified lease will remain substantially the same – or even less – than the original lease, you can account for rent concessions in one of two ways:
- As if the enforceable right or obligation exists – regardless of whether it does or does not – under the original lease agreement or, put another way, as a variable lease payment in the period a concession is granted
- As a lease modification
No matter which route you choose, you want to apply the same election to all leases with similar circumstances. Also, since this may result in diversity in practice, you must provide additional disclosure over your selected approach to account for rent concessions, especially ones that are significant to your business.
If the concessions do not stem from the pandemic, you'll still want to use the process outlined in ASC 842. That begins by determining if you have an enforceable right to a rent concession under your lease contract. If you don't, then account for the concession as a modification of the original lease.
If you do have such an enforceable right, you must then determine if other changes or amendments to the original lease terms were made during your negotiations. If they were, then consider it a modification of the original lease. If not, then consider the concession a variable lease payment under the original contract. In this case, you would account for it as a negative lease payment.
Other Contract Modifications
Debt restructuring and lease modifications might be the most timely and relevant contract modifications right now, but they’re certainly aren't the only ones. For modifications not specifically addressed under GAAP, then ASC 420, Exit or Disposal Cost Obligations, is close to the guidance catch-all.
The accounting standards under ASC 420 are pretty straightforward, where you measure any liability associated with other contract terminations at fair value and as you incur it. Our advice is to avoid recognizing such liabilities too early. Even if you have a restructuring plan in place and intend on canceling various contracts with termination penalties and other costs, the guidance states that you don't account for them until the event that actually gives rise to the corresponding liability occurs.
Granted, aside from debt and leases, other items like contractual termination benefits, asset retirement obligations, and impairment-related items are outside the scope of ASC 420. Still, for the most part, the vast majority of contract modification issues outside of those specific topics will fall under ASC 420.
Employee Termination Benefits
We mentioned termination benefits, which, of course, are very top-of-mind right now given the number of layoffs and furloughed employees recently. But it's a complex topic that veers in different directions, depending on the circumstances. So before we proceed to other forms of restructuring, we wanted to provide a bit of detail on the accounting for various termination costs and employee benefits.
ASC 420 does, in fact, provide guidance on one-time termination benefits given to current employees that are involuntarily terminated. The key here is that those benefits are not part of an ongoing benefit arrangement. A typical severance payment is the most obvious example of this type of restructuring charge.
Alternatively, the termination benefits could be contractual, either stated explicitly in an employee's contract, part of an overarching severance policy, or mutually understood – generally based on consistent past practices warranting a “substantive plan.” In these cases, you would then account for these restructuring costs according to ASC 712, Compensation, Nonretirement Postemployment Benefits.
Let's say you've implemented some – maybe even all – of the restructuring actions we've discussed thus far, but cash flow remains tight and finances shaky. While you haven't passed the point-of-no-return yet, it's time to start making some preparations if Chapter 11 now seems more likely. And that process begins with your financial reporting.
As you know, management is obligated to keep a constant eye on the road ahead, most notably by performing interim and annual going concern assessments. This is where management evaluates events or conditions that may give rise to substantial doubt within twelve months of the expected issuance date of your financial statements.
Given the amount of uncertainty surrounding the COVID-19 crisis, most SEC companies included some sort of risk factor disclosure in their Q1 FY20 filings. However, a simple risk factor disclosure is a far cry from disclosure requirements around going concern.
In other words, if you initially raised substantial doubt around going concern but created a plan to mitigate the risk, there are disclosure requirements to provide the financial statement users with essential details on what gave rise to the initial doubt along with your actions to alleviate the doubt. Likewise, if your plan is unsuccessful and substantial doubt festers, then you're still going to face significant disclosure requirements, just from the other side of the going concern coin. In this scenario, you must include language stating that substantial doubt about the reporting entity’s ability to continue as a going concern exists. Either way, ASU 205-40 provides the guidelines you'll need.
Formal Bankruptcy Filing
Obviously, you would prefer things not to get this far, but, depending on the environment and circumstances, formal bankruptcy is sometimes inevitable. But that's not to say that Chapter 11 is the death knell for your company. In fact, if you emerge from the process with a clear understanding of your responsibilities going forward, bankruptcy really could be a springboard to a brighter future.
From an accounting perspective, your team must be well acquainted with fresh start accounting, if you even qualify for it, the considerations involved, and what it entails for your company emerging from bankruptcy. And just as before, although we have provided in-depth insights on fresh start accounting, we still want to review it at a high level to demonstrate how it fits into our restructuring discussion.
Fresh Start Accounting: An Overview
As you emerge from Chapter 11, the FASB allows you – in most cases – to essentially create a new reporting entity that, for the most part, is completely separate from the entity you've left behind. You establish and work from a new reorganization value that becomes the starting point for your accounting going forward.
However, as beneficial as a "fresh start" is to the future viability of your company, the severity of Chapter 11 means that you shouldn't confuse a fresh start with a simple one. Your reorganization – which is essentially a massive restructuring – will likely affect everything from your capital structure and asset valuations to your obligations and taxes. And as you would expect, your disclosures will play an instrumental role in helping the public make sense of the significant changes occurring within your financial reporting.
While we urge you to read over our specific thoughts on Chapter 11 and fresh start accounting, most companies find it best to bring in third-party experts to help with the process, particularly regarding asset valuations and tax considerations.
Remember, as a distressed company that isn't necessarily familiar with these new surroundings, the critical first step is to get your bearings and identify a game plan that works best for you. Restructuring could be as simple as modifying a debt obligation or two, but it could also mean a complete reorganization in bankruptcy court.
However, as we discussed, there are several nuanced levels between those two polar opposites. Wherever you find yourself on the restructuring spectrum, just be sure to enter into it fully informed of your requirements and don't hesitate to bring in specialists if needed. The stakes are simply too high to cut any corners.