A refinancing that looks routine on the bank's term sheet can produce a loss in the income statement, or none at all. The difference is one calculation: the 10 percent cash flow test in ASC 470-50. The result decides whether the old loan stays on the books with a new yield, or disappears and is replaced with a new loan at fair value. It also decides where every fee goes.
Most small-company errors here are not about the test itself. They come from putting fees in the wrong bucket after the test is done. This guide shows the mechanics, the fee matrix and a pair of worked entries, then lists what the auditor tests. For the related classification and covenant questions, see /us/blog/asc-470-debt-classification-covenants-modifications.
When does the 10 percent test apply?
It applies when the borrower and lender change the terms of an existing loan, or exchange old debt for new debt with the same lender, and the borrower is not in financial difficulty with the lender granting a concession. If both conditions of a troubled debt restructuring are present, a different model applies, built on total undiscounted future cash payments. Screen for the TDR conditions first and document that you did.
How the test works
The test compares two present values.
- Old cash flows: the remaining cash flows of the original debt.
- New cash flows: the cash flows of the new or modified debt, plus certain day-one items.
Both are discounted at the effective interest rate of the original debt (RSM). If the present value of the new cash flows differs from the old by 10 percent or more, the terms are substantially different and the transaction is an extinguishment. If the difference is less than 10 percent, it is a modification.
Mechanics that national firm guidance flags as the usual points of failure:
- Day-one cash flows. Include fees exchanged between the borrower and the lender (Crowe, Riveron). PwC states that third-party fees should not be included in the cash flow analysis, which is consistent with the test counting only amounts paid between debtor and creditor.
- Variable rates. PwC and Crowe state that the rate in effect on the modification or exchange date is used to determine future interest payments.
- Call and put features. Analyze both an exercise and a nonexercise scenario and use the one with the smaller change.
- Repeated amendments. For repeated restructurings, PwC, Crowe and RSM measure against the terms that existed just before the earliest restructuring in the 12-month period, provided the earlier changes were accounted for as modifications.
- Embedded conversion options. PwC and RSM state that a change affecting an embedded conversion option is assessed separately from the cash flow test and can make the terms substantially different even when that test result is below 10 percent; the change in the option's fair value must be at least 10 percent of the original debt's carrying amount immediately before the change.
- Multiple lenders. Test each lender separately, including all of one lender's debt in its test. Crowe states that for a departing lender in a combined revolver and term loan facility, extinguishment accounting applies to that component.
Where do the fees go?
This is the matrix reviewers use. It holds for a lender that remains the same.
| Item | Modification | Extinguishment |
|---|---|---|
| Unamortized costs on the original debt | Stay deferred and keep amortizing | Written off in the gain or loss |
| Fees paid to the lender | Capitalized and amortized over the remaining term | Expensed as part of the gain or loss |
| Fees paid to third parties (legal, advisory) | Expensed as incurred | Capitalized and amortized as debt issuance costs |
In a modification there is no gain or loss. The company sets a new effective interest rate from the carrying amount and the revised cash flows. In an extinguishment the old debt is derecognized, the new debt is recorded at fair value and interest expense follows the new effective rate.
Worked journal entries
An illustration. A company has a $1,000,000 term note outstanding, with $20,000 of unamortized issuance costs presented as a reduction of the note. It pays the lender a $15,000 fee and pays its attorney $8,000 in connection with an amendment.
Scenario A: the test result is a 4 percent difference (modification)
| Account | Debit | Credit |
|---|---|---|
| Unamortized lender fee (contra to note payable) | 15,000 | |
| Cash | 15,000 | |
| Legal fees expense | 8,000 | |
| Cash | 8,000 |
The old $20,000 of costs stays in place. Amortize both the old costs and the new $15,000 over the remaining term using the new effective rate.
Scenario B: the test result is a 14 percent difference (extinguishment)
The new note is recorded at its fair value of $1,000,000. The old net carrying amount is $980,000, so the loss before fees is $20,000.
| Account | Debit | Credit |
|---|---|---|
| Note payable (old) | 1,000,000 | |
| Loss on extinguishment of debt | 35,000 | |
| Unamortized issuance costs (old) | 20,000 | |
| Note payable (new) | 1,000,000 | |
| Cash (lender fee) | 15,000 |
The loss of $35,000 is the $20,000 write-off of old costs plus the $15,000 lender fee. The attorney fee is capitalized.
| Account | Debit | Credit |
|---|---|---|
| Unamortized issuance costs (new) | 8,000 | |
| Cash | 8,000 |
The new fee is then amortized over the life of the new note.
Audit angle
The auditor treats the refinancing as a significant nonroutine transaction in the year it closes. A sound file contains:
- The signed amendment or new agreement, read in full, with every change in rate, maturity, principal, collateral, covenant, prepayment right and conversion feature listed.
- The management test workbook. Recompute the present values, confirm that the discount rate is the original effective rate, and confirm the lender fees feed the day-one column and the third-party fees do not.
- A fee ledger. Each fee traced to an invoice or the lender's closing statement, then to the accounting bucket in the matrix.
- The loss or the revised amortization schedule. Agree the loss to the income statement, or the new effective rate to the interest expense recalculation.
- Classification at the balance sheet date. See /us/standards/au-c-570 for how debt terms feed the going concern evaluation, and test current versus noncurrent presentation against the new maturity.
- Disclosures. Terms, maturities and any covenant matters.
Common misstatements: expensing lender fees in a modification, capitalizing legal fees in a modification, running the test with the new loan's rate as the discount rate, ignoring a conversion option change, and leaving the old issuance costs on the books after an extinguishment.
Questions auditors ask
Does a small rate change on a revolver need the full test?
Crowe notes that the guidance has separate models for term loans and revolving credit loans, so document which one applies before starting the 10 percent test. For facilities that combine a revolver and a term loan, split the analysis by lender and by instrument.
Does the test change if the borrower is in financial difficulty?
Yes. When the borrower is in financial difficulty and the lender grants a concession, the transaction is evaluated as a troubled debt restructuring on a different basis, and the fee treatment differs as well.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- PwC Viewpoint, Financing transactions guide, 3.4 Modification or extinguishment: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financing_transactio/financing_transactio_US/chapter_3_debt_modif_US/34_modification_or_e_US.html
- EisnerAmper, Accounting considerations for debt modifications: https://www.eisneramper.com/insights/real-estate/accounting-considerations-for-debt-modifications-1224/
- Crowe, FAQs about debt modification accounting: https://www.crowe.com/insights/faqs-about-debt-modification-accounting-fnrpt
- RSM, A guide to accounting for debt modifications and restructurings, May 2024 (original effective rate as discount rate, 12-month cumulative assessment, embedded conversion option test): https://rsmus.com/content/dam/rsm/insights/services/audit/1pdf/a-guide-to-accounting-for-debt-modifications-and-restucturings.pdf
- Riveron, Bursting the Corporate Debt Bubble: Accounting for Debt Modifications (10 percent test, TDR conditions): https://riveron.com/corporate-debt-bubble/
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