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Accounting for troubled debt restructurings by debtors: deleveraging during turbulent times.

The global economic downturn has presented significant challenges to many debt-laden companies seeking to meet interest and principal payments on a timely basis, satisfy existing loan covenants, and otherwise deleverage to adapt to changing circumstances. Though the significant growth in loan modifications related to residential mortgages has captured the most media attention, lenders have also experienced increased activity in workouts and restructurings of commercial real estate. For corporate borrowers, Fitch Ratings reports that default rates on high-yield bonds reached 6.8% in 2008 and peaked at 13.7% in 2009 as companies struggled to survive during turbulent times. These rates decreased to 1.3% in 2010 and 1.5% for 2011, and Fitch's forecast for 2012 is that high-yield default rates will rise, to a range of 2.5% to 3.0%. Many companies have opted for more conservative leverage ratios and sought to rebalance their capital structures, leading to a greater volume of loan modifications and restructurings.



The underlying accounting principles concerning debt restructurings are complex, and the resultant impact on the financial statements can vary significantly depending on the nature of the transaction. Given the present economic environment, it is particularly important that accounting professionals remain aware of the salient issues specific to troubled debt restructurings (TDR) by debtors.

This article provides CPAs with an overview of the existing literature, the fundamental accounting issues, and relevant complexities in this area. The unique characteristics that distinguish TDRs from other types of debt restructurings are examined, along with the types of TDRs addressed in the literature and applied in practice. Illustrations and excerpts from financial statement disclosures by companies reveal the diverse nature of TDRs, and the exhibits demonstrate the relevant accounting principles while examining the financial statement impact to the debtor.

A Brief Overview

Accounting and reporting requirements for TDRs by debtors are set forth in FASB Accounting Standards Codification (ASC) 470-60, "Debt: Troubled Debt Restructurings by Debtors" (formerly Statement of Financial Accounting Standards [SFAS] 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings). Under this guidance, a restructuring of debt represents a TDR "if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider" (ASC 470-60-15-5). These concessions can stem from an agreement between the creditor and the debtor or can be imposed by law or by a court. Concessions may take many forms, but the key objective for the creditor is to realize the most value from its investment by granting a concession to the debtor. The TDR could also enable the borrower to survive its present financial difficulties and perhaps stave off bankruptcy.

TDRs can take a number of forms, but often consist of two primary types (ASC 470-60-15-9). In the first type, existing debt is fully or partially settled; the creditor's claim is satisfied by accepting the debtor's assets or an equity interest in the debtor. The second form involves the continuation of the debt agreement, but with modified terms. In such cases, the creditor agrees to reduce the principal, lower the interest rate, forgive accrued and unpaid interest, or extend the remaining term of the loan (or a combination of these elements).

Identifying a TDR

CPAs must exercise judgment and carefully consider all relevant facts and circumstances before concluding that a debt restructuring contains both distinguishing characteristics necessary in a TDR: 1) the debtor is experiencing financial difficulties and 2) the concession granted by the creditor is the direct result of the debtor's financial difficulties and would not have been considered otherwise.

Financial difficulties of the debtor. If a borrower has experienced a deterioration in its credit risk since the inception of the loan, certain factors should be evaluated before concluding that a debtor is experiencing financial difficulties. These indicators include the following: ^ The debtor is currently in default on any of its debt.

* The debtor has declared, or is in the process of declaring, bankruptcy.

* There is significant doubt concerning the debtor's ability to continue as a going concern.

* The debtor's securities have been delisted, or are under threat of being delisted, from an exchange.

* The debtor forecasts that its future cash flows, based on its present business capabilities, will not be sufficient to service the debt according to its contractual terms through maturity.

* Without the modification, the debtor is unable to obtain financing from other lenders at equivalent interest rates on similar debt available to a nontroubled debtor (ASC 470-60-55-7 and 8).

Even if the above indicators are present in the debtor's financial difficulties, the existence of two particular exculpatory fators would lead a professional to conclude that the debtor is not experiencing financial difficulties and that the modification does not qualify as a TDR. One factor is present if the debtor is servicing the existing debt and has access to financing from other lenders to pay off the debt at effective interest rates equivalent to those for nontroubled debtors. The second factor is present if the creditor agrees to restructure the existing debt in response to a decrease in market interest rates or improvement in the debtor's credit risk (ASC 470-60-55-9).

Concessions by the creditor. Essentially, if the debtor's effective borrowing rate on the restructured debt is less than the effective rate on the old debt, the creditor is deemed to have granted a concession. The new effective rate should reflect any new or revised sweeteners, such as options, warrants, guarantees, or letters of credit (ASC 470-60-55-10). But despite evidence that the debtor is having financial difficulty, ASC 470-60-15-12 cautions that any one of the following transactions would preclude the restructuring from qualifying as a TDR:

* The fair value of the assets or equity interest transferred in full satisfaction of the receivable or debt equals or exceeds either the creditor's recorded investment in the receivable or the debtor's carrying amount of the debt.

* The creditor reduces the effective interest rate on the debt to reflect a decrease in market rates or a reduction in the debtor's credit risk in order to maintain the business relationship.

* The debtor issues new marketable debt in exchange for its old debt, at an interest rate equivalent to current market rates available to nontroubled debtors.

Other Transactions Included or Excluded from TDR Treatment

Certain transactions are specifically excluded from the scope of a TDR in ASC 470-60. These include changes in lease agreements and changes in employment-related agreements (e.g., pension plans and deferred compensation arrangements). Also excluded are cases where a debtor fails to pay trade payables according to their terms, or where the creditor delays taking legal action to collect overdue amounts of principal and interest, unless they involve an agreement between the parties to restructure the debt.

Conversely, TDR accounting is applicable when the debtor is involved in bankruptcy proceedings that do not result in a general restatement of its liabilities. The TDR accounting model is not applicable, however, in a quasi reorganization, or when bankruptcy statutes require the debtor to restate its liabilities (ASC 470-60-15-10 and 11).

After a thorough analysis of the facts and circumstances of a debt modification, exchange, or restructuring, a CPA may conclude that the transaction does not qualify for TDR accounting treatment. In such cases, a professional should consult ASC 470-50, "Debt: Modifications and Extinguishments," or "ASC 405-20, Liabilities: Extinguishments of Liabilities." The analysis, considerations, and accounting results in those ASC subtopics differ considerably from those in ASC 470-60.

Common TDR Transactions

ASC 470-60-15-9 describes the types of transactions that are characteristic of TDRs, although it is important to note that they may take other forms or include a combination of different types. The following is an analysis of transactions discussed in the literature and the accounting requirements for the debtor:

* Transfer of assets. The debtor transfers assets (receivables, real estate, or other assets) to the creditor to fully or partially satisfy the debt. This also includes transfers that result from foreclosure or repossession.

* Grant of an equity interest. The debtor issues or grants equity to the creditor to fully or partially satisfy the debt, unless the equity interest is granted in accordance with existing terms for converting debt into equity.

* Modification of terms. The parties agree to contractual changes in the terms of the original debt. Modifications include any one or a combination of: l) a reduction of the stated interest rate for the remaining original term of the debt, 2) an extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk, 3) a reduction or forgiveness of the face amount of the debt, and 4) a reduction or forgiveness of accrued interest.

It is important to stress that the accounting consequences to the debtor from a modification of terms is directly related to its effect on the debtor's future total cash flows, and not how the cash flows are characterized or labeled (e.g., as principal or interest) in the underlying agreement (ASC 470-60-10-1). This distinction is highlighted in the examples that follow.

Accounting by the Debtor

The discussion below examines the underlying GAAP for typical TDR transactions, including examples of actual transactions. The exhibits demonstrate the considerations and accounting practices that are particular to debtors.

Transfer of assets in full settlement. ASC 470-60-35-2 and 3 stipulate that a debtor that transfers third-party receivables, real estate, or other assets to a creditor to fully settle outstanding debt recognizes 1) an ordinary gain or loss on the transfer of assets, measured as the difference between their fair value and their carrying amount; and 2) a gain on the restructuring of debt, measured as the excess of the carrying amount of the debt over the fair value of the assets transferred. The carrying amount of the debt includes any unamortized discount or premium and issuance costs, as well as the accrued interest payable. Fair value is measured in accordance with the relevant guidance in ASC 820, "Fair Value Measurement." Note that the fair value of the debt may be used to measure the gain on restructuring if it is more clearly evident than that of the assets (or equity interest) transferred. Example A in Exhibit 1 presents a TDR transaction scenario where a debtor transfers real estate to a creditor in full settlement of its debt.

Disclosure example. Behringer Harvard REIT I Inc., a real estate investment trust with several years of operating losses facing financial distress from the economic downturn, reported a $6.5 million gain on a debt restructuring from a transfer of foreclosed property to a lender. Previous impairment charges had likely reduced the carrying amount of the property to its fair value. The following excerpts from the company's Form 10-K filing for the year ending December 31, 2010, describe the transaction:
  In February 2010, pursuant to a deed-in-lieu of foreclosure,
  we transferred ownership of KeyBank Center to the lender
  associated with the property. This transaction was accounted
  for as a full settlement of debt and resulted in a gain on
  troubled debt restructuring of approximately $6.5 million
  which is included in loss from discontinued operations. On
  both a basic and diluted income per share basis the $6.5
  million gain was approximately $0.02 per common share for
  the year ended December 31, 2010. ...

  Prior to the transaction, the loan had an outstanding
  balance of approximately $27.1 million and a scheduled
  maturity date of August 2012.

Grant of an equity interest in full settlement. A debtor who grants an equity interest to a creditor in full settlement of debt in a TDR must account for the equity interest at its fair value. The excess of the carrying amount of the debt settled over the fair value of the equity interest granted is recognized as a gain on restructuring (ASC 470-60-35-4). Example B in Exhibit 1 illustrates this type of settlement.

Disclosure example. Georgia Gulf Corporation, a manufacturer of chemical, building, and home improvement products, experienced significant losses in 2007 and 2008 and was saddled with a heavy debt load. The company granted an equity interest to a lender in exchange for complete satisfaction of certain notes payable. The TDR resulted in a $401 million gain on the restructuring. The company reported the following in its Form 10-K for 2009:
  On July 29, 2009, we consummated our private exchange
  of equity for approximately $736.0 million of our
  outstanding notes. In accordance with ASC subtopic
  470-60, Troubled Debt Restructuring by Debtors, this
  debt for equity exchange was a troubled debt restructuring
  and thus an extinguishment of the notes for which we
  recognized a net gain of $400.8 million. This gain included
  $731.5 million of principal debt, net of original issuance
  discounts, $53.7 million accrued interest, $14.1 million in
  deferred financing fees written off and $12.4 million of
  third party fees which was exchanged for the $357.9 million
  fair value of our common and preferred stock.

Modification of debt tams. ASC 470-60-35-5 and 6 discuss TDRs that involve only a modification of terms. In such situations, the accounting consequences are handled prospectively and are dependent upon whether the total future undiscounted cash flows under the restructured debt are greater or less than the carrying amount of the original debt. Total future cash payments represent the undiscounted amounts designated as either interest or the face amount under the agreement and include any related accrued interest that continues to be payable under the new terms. As noted previously, the characterization of the future payments under the modified terms is not the critical factor; it is instead the total amount of such payments that determines the accounting results.

Modification: future cash payments are less than the carrying amount. If the undiscounted future cash payments specified by the new terms of the modified debt are less than the carrying amount of the debt, the debtor recognizes a gain on the restructuring equal to the difference. The carrying amount of the debt is reduced to an amount equal to total future cash payments. Subsequently, all cash payments - regardless of their characterization in the agreement - will reduce the carrying amount of the debt, and no interest expense is recognized throughout the remaining term. Example A in Exhibit 2 illustrates a modification of terms where the future payments are less than the carrying amount of the debt.

Disclosure example. In 2008, Comstock Homebuilding Companies Inc. entered into several debt restructuring agreements to deleverage its existing obligations, given the housing crisis. In one such transaction, the lender forgave a portion of the company's outstanding debt and accrued interest. Comstock reported a gain of $3.1 million, because the future undiscounted payments were less than the carrying amount of the debt. Comstock reported this transaction in its 2008 Form 10-K as follows:
  On December 10, 2008, the Company executed a loan modification
  and forbearance agreement with Wachovia Bank to restructure
  approximately $21,625 outstanding under a borrowing base
  facility secured by properties in the Company's Washington,
  D.C., Raleigh, N.C. and Atlanta, Georgia markets. As part of
  the agreement, Wachovia agreed to cancel $4,288 of the original
  outstanding principal balance related to the Company's Tribble
  Road project in Atlanta, Georgia.

  This transaction was accounted for as a TDR modification of
  terms pursuant to SFAS 15. Under SFAS 15, the debt under the
  modification and forbearance agreement was recorded at the
  principal amount plus the total estimated future interest
  payments of $1,025. In December 2008, the gain resulting
  from the execution of the loan modification agreement,
  calculated in accordance with SFAS 15, was determined as

Transaction costs paid in cash                     $ 93

Loan modification and forbearance agreement,
principal plus future estimated interest
payments                                         18,901

Deferred transaction costs                          104

Total consideration paid                         19,098

Amount outstanding under original indenture    (21,625)

Interest accrued under original indenture         (563)

Gain on troubled debt restructuring            $(3,090)

Modification: future cash payments exceed the canying amount. When the total undiscounted future cash payments exceed the carrying amount of the debt, no gain or loss is recognized and the debtor does not change the carrying amount of the debt. Essentially, the excess of the total future cash flows over the carrying amount of the debt represents future interest expense. Periodic interest through the maturity of the restructured debt is recognized using a new effective rate, which is computed as the discount rate that equates the present value of the future cash payments under the new terms with the carrying amount of the debt. The new rate is applied to the carrying amount of the debt at the beginning of each period between the date of the restructuring and maturity. Example B in Exhibit 2 illustrates a TDR involving a modification of terms where the future payments exceed the carrying amount of the debt. It demonstrates how the new effective interest rate is computed and shows the debtor's journal entries during the remaining term of the restructured debt.

Disclosure example. Texada Ventures Inc. is an exploration stage company (as defined by ASC 915, "Development Stage Entities") whose principal business is the acquisition and exploration of mineral and resource properties. Faced with cash flow problems, the company was able to restructure the terms of certain loans that qualified as TDRs. No gains were reported on the restructurings, because the future payments exceeded the carrying amount of the related debt. The company also recognized interest expense using a new effective interest rate. Exempts from disclosures related to one of the loans from the company's August 31, 2011, Form 10-Q were as follows:
  On April 10, 2007, the Company issued a 6%, convertible
  debenture with a principal amount of $200,000 which was
  due and payable on December 31, 2008. ...

  As at November 30, 2009, the Company had not made
  any interest payments and pursuant to the debenture
  has accrued default interest of 8% since September
  30, 2007. ...

  On December 18, 2008, the Company entered into an
  amendment to the convertible debenture to extend the
  maturity date of the note from December 31, 2008 to
  December 31, 2010. On December 31, 2010, the Company
  entered into another amendment to the convertible
  debenture to extend the maturity date of the note
  from December 31, 2010 to June 30, 2011. ...

  Pursuant to ASC 470-60, "Troubled Debt Restructurings
  by Debtors," the total future cash flows of the
  restructured debt was compared with the carrying value
  of the original debt. As the total future cash flows
  of the restructured debt were greater than the
  carrying value at the date of amendment, the carrying
  value of the original debt at the date of modification
  was not adjusted. Pursuant to ASC 470-60, a new
  effective interest rate was computed and used to
  deter-mine interest expense for the modified debenture.

Combinations of Types

Some TDRs involve a partial settlement of debt by an asset transfer or grant of an equity interest (or both), along with a modification of the terms for the remainder of the debt. In such cases, the following steps are required (ASC 470-60-35-8):

* The assets transferred or the equity interest granted should be measured at fair value and the carrying amount of the debt reduced by the total amount. Any cash paid should also reduce the carrying amount of the debt.

* Any difference between the fair value and the carrying amount of assets transferred to the creditor should be recognized as a gain or loss on the transfer of assets.

* The future undiscounted cash payments specified by the terms of remaining unsettled debt, including contingent payments, should be computed. The total payments should be compared to the remaining carrying amount of the debt. Any differences between the future payments and the carrying amount should be accounted for in a manner similar to the modifications of debt discussed above.

TDRs with Contingent Payments

Some restructuring arrangements include contingent payments, which are defined as amounts designated as either interest or face amount by the new terms that are payable contingent on a particular event. For example, a debtor may be required to pay certain amounts if its financial condition improves to a specified degree, or it may be required to make additional interest payments based upon specific criteria.

Contingent amounts should be included in the total undiscounted future cash payments specified by the new terms, to the extent necessary to prevent the debtor from recognizing a gain at the time of restructuring. In certain cases, contingent payments will first reduce the carrying amount of the loan. Thereafter, contingent payments are recognized as a Liability and an interest expense when they become "probable" and can be "reasonably estimated" in accordance with the guidance for loss contingencies in ASC 450-20, "Contingencies: Loss Contingencies" (ASC 470-60-35-7 and 10).

Other Considerations

Legal fees and other direct costs that a debtor incurs in granting an equity interest to a creditor in a TDR should reduce the fair value of the equity interest. All other direct costs that a debtor incurs to effect a TDR should be deducted from any gain on restructuring, or recognized as an expense for the period if no gain is recognized.

When SFAS 15 was originally issued, a debtor was required to classify a gain on debt restructuring, if material, as an extraordinary item. FASB noted that because SFAS 4 "classifies a gain or loss on extinguishment of debt as an extraordinary item, the classification is appropriate for a gain on restructuring of a payable" (par. 99). The extraordinary treatment for debt extinguishments was later rescinded in 2002 by SFAS 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. The rationale for this decision was "The Board noted that at the time Statement 4 was issued, its requirement to classify all gains and losses associated with extinguishment of debt as extraordinary items was intended to be a temporary measure and that application of the criteria in Opinion 30 would seldom, if ever, require that resulting gains and losses be classified as extraordinary items" (par. A4). Accordingly, a debtor should consult ASC Subtopic 225-20, "Income Statement-Extraordinary and Unusual Items," to determine whether or not a gain on debt restructuring meets the "unusual" and "infrequent" criteria (given the entity's environment) required for disclosure as an extraordinary item.

None of the representative companies that reported gains on TDR transactions classified them as extraordinary. Two of the four received a "going concern" opinion from their auditors. Note, however, that Porta Systems Corp., which manufactures and markets telecommunications equipment, reported a $17.5 million gain on a TDR for the year ended December 31, 2008, which was classified as extraordinary. The rationale for how this transaction was unusual and infrequent given the global economic crisis at that time was not readily apparent from the company's 10-K report. However, the gain had a more significant impact relative to earnings than the other companies discussed. Management described the company's tenuous financial situation and its ability to continue as a going concern in the following footnote:
  Going Concern
  The Company is impaired by its continued losses from
  continuing operations before extraordinary gain and
  discontinued operations which was $2,352,000 for the
  year ended December 31, 2008, as well as its continued
  liquidity issues. At December 31, 2008, the Company did
  not have sufficient resources to pay the holder of the
  senior debt. Although the senior debt holder has
  extended the teens of the debt, at current production
  levels the Company is uncertain that it can generate
  the cash needed to repay this debt. Should the Company
  not meet the revised terms for the loan, we cannot be
  assured that the holder of the senior debt will continue
  to modify the terms of the repayment of the debt. If this
  should occur the Company will not be able to continue in
  business, and it is likely that the Company will seek
  protection under the Bankruptcy Code.

In 2009, Porta Systems executed a one-for-500 reverse split of its common stock and terminated its registration under the Securities Exchange Act of 1934.

Financial Statement Presentation and Disclosure

Debtors must disclose specific information concerning TDRs. This includes the following:

* For each restructuring (or each category based on the type of payable), a description of the principal changes in terms, key features of the settlement, or both

* Aggregate gain on restructuring

* Aggregate net gain or loss on transfers of assets

* Per-share amount of the aggregate gain on restructuring of debt.

Additional disclosures are also required in subsequent periods regarding the treatment and status of amounts that are contingently payable (ASC 470-60-50).

Creditor Accounting for TDRs: Recent Changes

The authoritative accounting guidance on TDRs for creditors is in ASC 310-40, "Receivables: Troubled Debt Restructurings by Creditors," which was amended in April 2011 by Accounting Standards Update (ASU) 2011-02, A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring. This update clarified the factors used by creditors to determine if a concession has been granted and established guidance similar to ASC 470-60 to determine if the debtor is experiencing financial difficulty. Though TDR accounting for creditors is beyond the scope of this article, it is important that debtors and creditors individually apply the evaluation criteria in their respective guidance to determine if a transaction qualifies as a TDR. FASB acknowledges that 'TDR accounting is not symmetrical between the debtor and creditor, and that a transaction may qualify as a TDR for one party to the transaction and not the other.

Looking Ahead

CPAs must carefully analyze the underlying facts and circumstances of each transaction before concluding that the TDR model or other literature is applicable. Most of the authoritative guidance in ASC 470-60 dates back to 1977, when SPAS 15 was issued. Accounting academics and practitioners have expressed dissatisfaction with the guidance for debtors, particularly with respect to TDRs involving a modification of debt. A major criticism is the use of undiscounted cash flows as the key driver to determine whether the debtor recognizes a gain on restructuring, leading many to question the economic reality of the reported results. (For further commentary regarding SFAS 15, see Timothy B. Forsyth, Philip R. Witmer, and Michael T. Dugan, "Accounting Standards Setting: Inconsistencies in Existing GAAP," The CPA Journal, May 2005.) In an accounting environment increasingly characterized by fair value measurements, the guidance is a vestige from a prior accounting era.

The status of TDR accounting within the context of convergence with International Financial Reporting Standards (IFRS) is uncertain. The SEC Staff Paper issued on November 16, 2011, "Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers: A Comparison of U.S. GAAP and IFRS," indicates that "U.S. GAAP contains specific guidance for applying many aspects of the debt modification and extinguishment model, including ... troubled debt restructurings. ... IFRS does not contain explicit requirements for any of these areas" (p. 33). The authors expect that this "gap" between U.S. GAAP and 1FRS will require further examination as the international convergence process continues. For now, however, no changes in debtor accounting appear on the horizon.

RELATED ARTICLE: EXHIBIT 1 Troubled Debt Restructurings Transfers by Debtors in Full Settlement of Outstanding Debt

Example It Transfer of Assets

CDL Corporation owes the Rita B. Trust Company $1,000,000, which represents the outstanding balance of a 10-year 7% loan, and $100,000 of accrued but unpaid interest. The remaining term of the loan is five years. CDL is experiencing financial difficulties and its credit rating has deteriorated since the inception of the loan. There is also significant doubt about the company's ability to continue as a going concern. Rita B. Trust agrees to fully settle the obligation by accepting a transfer of land owned by CDL as investment property. The land has a fair value of $700,000 and a book value to CDL of $400,000.

Analysis: Prior to the restructuring, the debt has a carrying amount of $1,100,000 ($1,000,000 principal plus $100,000 of accrued interest). Based on this information, CDL would report an ordinary gain of $300,000 on the disposal of the investment property used in the transfer ($700,000 fair value less $400,000 book value) and a gain on restructuring of $400,000 ($1,100,000 carrying amount of the debt less the $700,000 fair value of land).

CDL should record the settlement in two parts. Journal entry 1 records the increase in the fair value of the investment property and the ordinary gain on disposal, and journal entry 2 records the gain on restructuring:
Journal entry 1

Dr. Land                       $ 300,000
Cr. Gain on Transfer of Land              $300,000

Journal entry 2

Dr. Loan Payable              $1,000,000
Dr. Interest Payable           $ 100,000
Cr. Land                                  $700,000
Cr. Gain on Debt Restructuring            $400,000

CDL would refer to ASC 225-20 to determine if the gain on debt restructuring meets the criteria for an extraordinary item.

Example B: Grant of an Equity Interest

Assume the same facts as in Example A, except that instead of an asset transfer, CDL Corporation issues 15,000 shares of its $1 par value common stock to Rita B. Trust Company in full settlement of the loan. On the date of the grant, the shares have a fair value of $10 per share, which is down from $30 per share just two years ago. The total fair value of the equity transferred to Rita B. Trust is therefore $150,000 (15,000 shares at $10 per share). Accordingly, CDL would recognize a gain on restructuring of $950,000 ($1,100,000 carrying amount of the debt less the $150,000 fair value of the equity interest granted).
The journal entry by CDL to record the settlement is as follows:

Dr. Loan Payable               $1,000,000
Dr. Interest Payable            $ 100,000
Cr. Common Stock at Par                    $ 950,000
Cr. Additional Paid-in-Capital              $ 15,000
Cr. Gain on Debt Restructuring             $ 135,000

Again, CDL would refer to ASC 225-20 to determine if the gain on debt restructuring meets the criteria for an extraordinary item.

RELATED ARTICLE: EXHIBIT 2 Troubled Debt Restructuring Involving a Modification of Terms

Example A: Postrestructuring Cash Flows Are Less Than the Carrying Amount of the Debt

Using the fact pattern in Exhibit 1, assume that the Rita B. Trust Company agrees to a modification of terms associated with the CDL Corporation's outstanding loan of $1,000,000 and $100,000 of accrued interest. The agreed-upon terms of the restructured debt are as follows:

* Reduction in the face amount from $1,000,000 to $700,000

* Forgiveness of the $100,000 of accrued interest

* Reduction of the interest rate from 7% to 5%

* No extension of the maturity date of the loan (five years remaining).

Analysis: The undiscounted future cash flows under the modified terms total $875,000 ($700,000 principal plus $175,000 of total interest [$700,000 x 5% x 5 years]). Because the prerestructuring carrying amount of the debt ($1,100,000) exceeds the total undiscounted future cash flows, CDL will recognize a gain on debt restructuring of $225,000 ($1,100,000 minus $875,000). The new carrying amount of the restructured debt is now $875,000 (equal to the total future payments), and this balance is generally reclassified to a new general ledger account.
The journal entry by CDL to record the restructuring is as follows:

Dr. Loan Payable                $ 1,000,000
Dr. Interest Payable              $ 100,000
Cr. Loan Payable Restructured                $ 875,000
Cr. Gain on Debt Restructuring               $ 225,000

CDL will refer to ASC 225-20 to determine if the gain on debt restructuring meets the criteria as an extraordinary item. Note that the characterization of the subsequent payments as principal and interest is not relevant. The total payments of $875,000 by CDL to Rita B. Trust will reduce the carrying amount of the restructured debt to zero at maturity. CDL will not recognize interest expense on the restructured debt for the remaining term.

Example B: Postrestructuring Cash Flows Exceed the Carrying Amount of the Debt

The debtor's accounting issues are more complicated when the subsequent cash flows exceed the carrying amount of the debt. To illustrate, assume the same facts as above, except that the face value of the debt is reduced to $950,000 rather than $700,000.

Analysis: In this scenario, the total undiscounted future cash flows after modification of $1,187,500 (principal of $950,000 plus total interest of $237,500 [$950,000 x 5% = $47,500 x 5 years]) exceed the carrying amount of the debt ($1,100,000) by $87,500. Accordingly, CDL would not recognize a gain on the debt restructuring, the carrying amount of the debt remains $1,100,000, and CDL will recognize $87,500 of interest expense over the remaining term.
CDL would likely reclassify the balances of the
prerestructured debt and interest payable into a new
account for balance sheet purposes as follows:

Dr. Loan Payable               $ 1,000,000
Dr. Interest Payable             $ 100,000
Cr. Loan Payable Restructured               $ 1,100,000

In order to recognize the $87,500 of interest expense in subsequent periods, a new effective interest rate on the modified debt must be determined. The new effective interest rate is the rate that equates the prerestructuring carrying amount of the debt to the present value of future cash flows after modification. The rate is calculated in its long form as follows:

Carrying Amount = Present Value of Future Cash Flows

$1,100,000 = $950,000 x (Factor for PV of $1, n = 5 periods) + $47,500 x (Factor for PV of an ordinary annuity, n = 5 periods)

On a financial calculator, the inputs are:

n = 5 periods; PV = (1,100,000); PMT = 47,500; FV = 950,000; i = ?

The effective interest rate is 1.68108%, which is significantly lower than the rate on the original loan. With each annual payment of 847,500, CDL recognizes interest expense and reduces the carrying amount of the debt by the difference between the cash paid and the effective interest. At the end of five years, the carrying amount of the debt is reduced to $950,000 and is paid. The following table summarizes CDL's cash payments, interest expense, and carrying amount of the debt during the remaining five-year term:
Year  Annual    Interest      Reduction  Carrying
      Cash      Expense at    in         Amount of
      Payment   Effective     Carrying   Restructured
                Rate of       Amount (2)  Debt
                1.68108% (1)
                                          $ 1,100,000
1     $ 47,500      $18,492    $ 29,008     1,070,992

2       47,500       18,004      29,496     1,041,496

3       47,500       17,508      29,992     1,011,504

4       47,500       17,004      30,496       981,008

5       47,500       16,492      31,008       950,000

      $237,500      $87,500    $150,000

(1.) Equals the effective interest rate multiplied by the
beginning carrying of the debt.

(2.)  Equals the cash payment of $47,500 less the
interest expense calculates in 1.

The journal entry by CDL for the first year after the
restructuring is as follows:

Dr. Interest Expense           $ 18,492
Dr. Loan Payable Restructured  $ 29,008
Cr. Cash                                 $ 47,500

The journal entries in the fifth year after the restructuring,
to record the final annual installment and the face amount,
re as follows:

Dr. Interest Expense            $ 16,492
Dr. Loan Payable Restructured   $ 31,008
Cr. Cash                                  $ 47,500
Dr. Loan Payable Restructured   $ 950,000
Cr. Cash                                  $ 950,000

James M. Fornaro, DPS, CPA, CMA, CFE, is an associate professor in the department of accounting, taxation, and business law at SUNY at Old Westbury, Old Westbury, N.Y. Cary D. Lange, PhD, CPA, is an assistant professor and Rita J. Buttermilch, MS, CPA, is an associate professor, both also in the department of accounting, taxation, and business law at SUM' at Old Westbury.
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Title Annotation:In Focus
Author:Fornaro, James M.; Lange, Cary D.; Buttermitch, Rita J.
Publication:The CPA Journal
Article Type:Essay
Geographic Code:1USA
Date:Feb 1, 2012
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