ELECTRONIC SUPPLEMENT TO CHAPTER 17

C H A P T E R 17 ELECTRONIC SUPPLEMENT TO CHAPTER 17 TROUBLED DEBT RESTRUCTURINGS Accounting requirements for troubled debt restructuring fall under the jurisdiction of two different FASB statements. The creditors utilize FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan. However, the debtor still uses the older FASB Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructuring. These statements primarily apply to troubled debt restructurings arranged through direct negotiations between a debtor company and its creditors. They do not apply to a general restatement of a debtor s liabilities under the bankruptcy act or in a quasi-reorganization. Concept A troubled debt restructuring occurs when a 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. The concept of troubled debt restructuring includes satisfaction of a debt by foreclosure, repossession, transfer of assets, or granting an equity interest in the debtor corporation. Troubled debt restructurings are classified for accounting purposes as follows: 1. Transfer of assets in full debt settlement 2. The grant of an equity interest in full debt settlement 3. A modification of terms (for example, reduction of interest rates, extension of maturities, reduction in amounts of principal or interest) 4. Some combination of the above types A debt restructuring is not a troubled debt restructuring if the fair value of assets received or equity interest transferred at least equals the carrying value of the creditor s receivable (creditor s viewpoint) or the debtor s payable (debtor s viewpoint). The carrying amounts of the debt (payable and receivable) may be different, so a restructuring can be a troubled debt restructuring for the debtor but not for the creditor. Differences can stem from the write-down of a receivable to its expected net realizable value (either directly or through an allowance account) or from the sale of a receivable to a third party at an amount that reflects the debtor s financial difficulties. A debt restructuring is also not a troubled debt restructuring if an interest rate reduction reflects decreased market interest rates, if new debt securities are issued to the creditor that reflect current market rates of interest, or if the restructuring involves changes in lease agreements. Electronic Supplement to Chapter 17 1

Debtor Accounting A debtor that transfers third-party receivables, real estate, or other assets to a creditor in full settlement of a payable recognizes a gain on restructuring for the excess of the carrying value of the payable over the fair value of the assets transferred. For example, if a $100,000 loan is settled by transferring land with a $90,000 fair value, the debtor reports a $10,000 extraordinary gain. The debtor also recognizes a gain or loss on the difference between the book value and fair value of assets transferred to the creditor (this is not a restructuring gain or loss). For example, if the land had a book value of $85,000, the debtor would report a $5,000 gain on appreciation of land. Foreclosures and repossessions are accounted for in the same manner as asset transfers. When a debtor issues or grants an equity interest (such as issuing common stock) to a creditor in full settlement of a payable, the excess of the carrying value of the payable over the fair value of the equity interest is recognized as a gain on restructuring. The debtor accounts for the equity interest issued at its fair value. Modifications of the debt terms include reducing the stated interest rate, extending the maturity date, reducing the face amount or accrued interest on the debt, or some combination of these adjustments. The debtor in a troubled debt restructuring accounts for a modification of terms prospectively. This means the carrying amount of the payable does not change unless it exceeds total future cash payments under the new terms. If this happens, the payable is reduced to an amount equal to future cash payments (principal and interest), and a gain on restructuring is recognized. Subsequently, all cash payments are accounted for as reductions in the payable. When total future cash payments under a modification of terms exceed the carrying value of the payable, the debtor does not reduce the payable or recognize a gain. Instead, the debtor calculates an effective interest rate that equates future cash payments and the carrying amounts of the payable, and applies that rate in determining interest expense and principal components of future payments. If a troubled debt restructuring involves a combination of asset transfers, granting an equity interest, and modification, the procedures are applied as described, but restructuring gains on asset transfers and equity interests granted are measured and recorded before the modifications are considered. A debtor s individual gains on troubled debt restructurings are aggregated and reported as an extraordinary item on a net-of-tax basis if the effect is material. Direct costs incurred in a restructuring, other than those associated with granting an equity interest, are deducted in measuring gains on the restructurings of payables. Disclosures are required for aggregate gains on restructurings and related per-share amounts, aggregate gains or losses on asset transfers, and principal changes and terms involved in each restructuring. Creditor Accounting Third-party receivables, real estate, other assets, or equity securities received from a debtor in a troubled debt restructuring are recorded by the creditor at their fair values at the time of restructuring. The excess of the satisfied receivables recorded amount over the fair value of assets received is recorded as a loss. Creditor repossessions or foreclosures are accounted for in the same manner as other assets received from the debtor. When the receivable s terms are modified in a troubled debt restructuring, the creditor measures the loan according to the provisions of FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan. The loan is impaired when it is probable that the creditor will not be able to collect all amounts owed according to the original loan agreement including both principal and interest. The creditor measures the loan impairment using the loan s expected future cash flows discounted at the loan s effective interest rate. The effective interest rate is the original market rate for the loan, not the rate in the restructuring agreement. If the present value of the modified cash flows is less than the recorded investment in the loan 1 (including accrued interest, net deferred loan fees or costs, and unamortized premium or discount), a valuation allowance is credited with a corresponding debit to bad debt expense. If there is a significant change in the market price or underlying collateral for the loan, the creditor adjusts the 1 The net carrying amount of a loan is net of a valuation allowance; the recorded investment in the loan does not consider a valuation allowance, but does reflect any direct write-down of the loan [FASB Statement No. 114, footnote 2]. 2 ADVANCED ACCOUNTING

valuation account. However, the net carrying amount of the loan cannot exceed the recorded investment in the loan. For troubled debt restructurings that involve a combination of asset transfers, equity interests, and modifications of terms, asset transfers and equity interests received by the creditor are measured and recorded before the modifications are considered. Otherwise, the procedures described are applicable. A creditor s losses on restructuring are included in income in the period of restructuring to the extent that they are not offset against allowances for uncollectible amounts. Legal fees and direct costs incurred by a creditor are treated as expenses when incurred. A creditor is required to disclose: 1. The recorded investment in impaired loans, including (a) the amount for which there is a related allowance for credit losses and the amount of the allowance and (b) the amount of that recorded investment for which there is no related allowance for credit losses 2. The creditor s policy for recognizing interest income on impaired loans 3. The average recorded investment in impaired loans for each period and the time the loans were impaired within the period ILLUSTRATION OF A TROUBLED DEBT RESTRUCTURING Slump Corporation is a financially distressed corporation with assets and liabilities as of January 1, 2003, as follows: Book Value Assets Cash $ 5,000 Accounts receivable $28,000 Less: Allowance for uncollectible receivables 3,000 25,000 Inventory 60,000 Plant and equipment net 360,000 Total assets $450,000 Liabilities and Stockholders Equity Accounts payable $ 72,500 15% note payable due December 1, 2002 50,000 Interest on note payable 7,500 10% note payable due January 1, 2004 100,000 Interest payable on note 5,000 Capital stock, $100 par 200,000 Retained earnings 15,000 Total liabilities and stockholders equity $450,000 Transfer of Assets Slump Corporation enters into an agreement with one of its suppliers, Kile Corporation, to transfer its accounts receivable (fair value $23,000) as payment in full for a $30,000 account payable owed to Kile. The concession was granted by Kile in order to make the best of a difficult situation. Slump and Kile record the troubled debt restructuring as follows: SLUMP S BOOKS Loss on transfer of accounts receivable (+LO, SE) 2,000 Allowance for uncollectible receivables 3,000 Accounts receivable ( A) 5,000 To restate receivables at fair value. Accounts payable Kile ( L) 30,000 Accounts receivable ( A) 23,000 Gain on restructuring of debt (+G, +SE) 7,000 To transfer receivables to Kile in full settlement of an account payable. Electronic Supplement to Chapter 17 3

KILE S BOOKS Investment in accounts receivable (+A) 23,000 Loss on settlement of receivables (+LO, SE) 5,500 Allowance for uncollectible receivables 1,500 Accounts receivable Slump ( A) 30,000 To record acceptance of receivables of Slump in full settlement of account. The entries on Slump s books reflect a loss on transfer because the fair value of the receivables was less than book value at the time of restructuring. Slump also records a gain from cancellation of a $30,000 liability to Kile by transferring accounts receivable with a fair value of $23,000. This $7,000 gain is a gain from a troubled debt restructuring and is reported on Slump s income statement for 2003 as an extraordinary item, if material. Kile s entry to record the restructuring assumes that a $1,500 provision for uncollectible accounts receivable has been provided. Thus, Kile s loss is only $5,500, the $28,500 book value of the receivable from Slump less the $23,000 fair value of receivables accepted in full settlement. Kile s loss is included in its income for the period in accordance with APB Opinion No. 30 s tests for unusual nature and infrequency of occurrence. Grant of an Equity Interest Slump corporation issues 500 shares of its stock to Equity Finance Company in full settlement of the 15% note payable and accrued interest. The shares have a fair value of $50,000, and the debt is carried at its $40,000 cost by Equity Finance, which purchased the note from the original payee. This qualifies as a troubled debt restructuring for Slump Corporation because $57,500 liability is satisfied in exchange for an equity interest worth $50,000. Slump records the restructuring as follows: SLUMP S BOOKS 15% note payable ( L) 50,000 Interest on note payable (+E, SE) 7,500 Capital stock, $100 par (+SE) 50,000 Gain on restructuring of debt (+G, +SE) 7,500 To record grant of equity interest in full settlement of note. Equity Finance does not treat this as a troubled debt restructuring because there is no loss to Equity Finance. Equity Finance should record a $10,000 ordinary gain and enter the equity investment at its fair value when the stock is received. Modification of Terms Bussy Bank, holder of Slump s 10% note, agrees to a modification of terms such that the bank will accept $55,000 on December 31, 2003, and December 31, 2004, in full settlement of the debt, including interest. The carrying value of the debt on both Slump s books and Bussy Bank s books is $105,000, indicating that Bussy Bank has not provided for the previous impairment of the note receivable. Total payments in the new agreement exceed $105,000, so Slump records no gain or loss when the agreement is consummated. In accounting for the debt in subsequent periods, however, an effective interest rate has to be computed to equate the two future payments of $55,000 with the $105,000 carrying value of the debt. The calculation is as follows (P = present value of an annuity): $55,000 P 2 years? interest = $105,000 $105,000 $55,000 = 1.909091 present value factor 1.909091 = annuity factor for two periods at 3.158% effective interest 4 ADVANCED ACCOUNTING

Payments of $55,000 at December 31, 2003 and 2004, are recorded by Slump as follows: December 31, 2003 Note payable ( L) 46,684 Interest payable (January 1, 2003) ( L) 5,000 Interest expense (+E, SE) 3,316 Cash ( A) 55,000 To record payment to Bussy Bank. Interest for 2003 is computed as $105,000 3.158% effective interest rate = $3,316. December 31, 2004 Note payable ( L) 53,316 Interest expense (+E, SE) 1,684 Cash ( A) 55,000 To record payment to Bussy Bank. Interest for 2004 is computed as $1,684 ($105,000 $55,000 + $3,316) 3.158% effective interest rate = $1,684. Bussy accounts for the modification of terms under the provisions of FASB Statement 114. Bussy determines that the loan is impaired because it will not collect the 10% contractual rate of interest for the two years. Bussy measures the impaired loan based on the present value of future cash flows of two receipts of $55,000 each at the end of 2003 and 2004. These cash payments are discounted by the original effective interest rate (in this case, the 10% contractual rate). At the time of the restructuring, Bussy Bank computes the present value of its restructured note receivable from Slump as follows: Present value of $55,000 in one year at 10% interest: Present value factor = (1 + i) N = (1 + 10%) 1 = 0.909091 $55,000 0.909091 = $50,000 Present value of $55,000 in two years at 10% interest: Present value factor = (1 + i) N = (1 + 10%) 2 = 0.826446 $55,000 0.826446 = $45,455 The Bussy Bank makes the following entry on January 1, 2003, to recognize the restructuring of its loan to Slump: Note receivable from Slump (+A) 95,455 Loss on restructured note (+LO, SE) 9,545 10% note receivable from Slump ( A) 100,000 Interest receivable ( A) 5,000 To record loss from restructuring Slump s loan. Bussy Bank would record receipt of the $55,000 in the following manner: BUSSY BOOKS 2003 2004 Cash 55,000 55,000 Mortgage receivable 45,455 50,000 Interest revenue 9,545 5,000 ASSIGNMENT MATERIAL W 17-1 What is a troubled debt restructuring? Is it possible for an extinguishment of debt to be a troubled debt restructuring for the debtor corporation but not for the creditor? Electronic Supplement to Chapter 17 5

W 17-2 W 17-3 W 17-4 W 17-5 When does the debtor corporation recognize a loss on the restructuring of debt? If the terms of a debt are modified such that future payments of the debtor are greater than the carrying value of the debt, how does the debtor company account for the modification? 1. A troubled debt restructuring does not require: a. A concession imposed by law or a court b. A debtor company with financial difficulties c. A creditor to grant a concession to the debtor d. A creditor concession related to the debtor s financial difficulties 2. Which of the following debt restructurings could be a troubled debt restructuring? a. Interest rate reductions that reflect decreased market interest rates b. Restructuring as part of a general restatement of liabilities under the Bankruptcy Act c. Book value of assets transferred exceeds the carrying value of the debt d. New debt securities issued to the creditor reflect current interest rates 3. Modification of terms of a debt in a troubled debt restructuring does not result in a gain for the debtor at the time of restructuring unless the: a. Principal amount of the debt is reduced b. Present value of future cash payments is less than the carrying value of the debt c. Absolute amount of future cash payments (principal and interest) is less than the carrying value of the debt d. Modification is required by law or action of a bankruptcy court 4. In accounting for troubled debt restructurings that involve a combination of asset transfers, granting of equity interests, and modifications of terms: a. Asset transfers and equity interests granted are measured and recorded before modifications b. Modifications are recorded before asset transfers c. Equity interests granted are recorded before asset transfers d. Modifications are recorded first, equity interests next, and then asset transfers 5. Which statement with respect to gains and losses on troubled debt restructurings is correct? a. Debtor gains on restructuring and gains or losses on asset transfers are combined and the net amount is reported as an extraordinary item. b. Creditor losses on restructurings are extraordinary only if they meet the requirements of APB Opinion No. 30 for extraordinary items. c. Debtor gains and creditor losses on restructurings are extraordinary items, if material. d. Debtor gains on restructurings are treated as extraordinary, and losses on restructurings are included in income in the period of restructuring. Deadtrack Corporation is being liquidated under Chapter 7 of the Bankruptcy Act. After all noncash assets have been liquidated, $40,000 cash remains to pay the following approved claims: Administrative expenses including trustee fees $ 10,000 Salaries (includes CEO s salary of $8,000) 20,000 Property taxes 16,000 Claims between filing of the involuntary petition and appointment of the trustee 5,000 Accounts payable, unsecured 15,000 Notes payable, unsecured 30,000 Interest on unsecured notes payable 4,000 Total unpaid claims $100,000 REQUIRED: Determine the amount to be paid to unsecured priority creditors in settlement of their claims. W 17-6 Kassum Company experienced cash flow problems during 2003, and on June 30, 2003, was unable to pay principal and interest on a $50,000 debt to its principal supplier, Genair Corporation. In view of Kassum Company s distressed financial condition, Genair agreed to accept machinery with a book value of $52,000 and a fair value of $45,000 in full satisfaction of the $50,000 debt and $7,500 accrued interest. REQUIRED: Prepare journal entries on the books of Kassum Company and Genair Corporation to record the troubled debt restructuring that was consummated on July 30, 2003. 6 ADVANCED ACCOUNTING

W 17-7 On January 1, 2003, Second National Bank sold its $25,000, 15% note receivable from Milan Company to Stable Finance Company for $20,000, in anticipation of Milan s default on the loan. Stable did not accrue interest on the note during the first half of 2003 because of the uncertain financial condition of Milan and the speculative nature of the investment. Milan Company was unable to pay the note and $1,875 accrued interest on its June 30, 2003, due date. During August 2003, Stable Finance and Milan negotiated an agreement under which Milan was to issue 1,000 shares of its $10 par common stock to Stable Finance in full satisfaction of the debt. The restructuring was consummated on August 31, at which time the stock had a fair value of $23,000, and accrued interest on the debt was $2,500 ($25,000 15% N year). REQUIRED 1. Is this a troubled debt restructuring? Discuss. 2. Prepare journal entries on the books of Milan Company to record the restructuring, assuming that it is a troubled debt restructuring. W 17-8 Crash Corporation was unable to pay its $100,000, 12% note and $6,000 interest to Crimp Bank on December 31, 2007. Due to the financially distressed condition of Crash, Crimp Bank agreed to extend the due date on the note for two years and to reduce the interest rate from 12% to 3% simple interest payable when the loan is due, provided that the $6,000 accrued interest was paid immediately. This agreement was consummated on December 31, 2007, on which date Crash paid the $6,000 interest due. The present value of $1 due in two periods at 12% interest is 0.7972 and at 3% interest is 0.9426. REQUIRED 1. Is this a troubled debt restructuring for Crash? For Crimp Bank? 2. Calculate the gain or loss on restructuring to be recorded on December 31, 2007, by Crash and by Crimp Bank. W 17-9 [AICPA adapted] 1. On December 31, 2003, Marsh Company entered into a debt restructuring agreement with Saxe Company, which was experiencing financial difficulties. Marsh restructured a $100,000 note receivable as follows: Reduced the principal obligation to $70,000. Forgave $12,000 of accrued interest. Extended the maturity date from December 31, 2003, to December 31, 2005. Reduced the interest rate from 12% to 8%. Interest will be payable annually on December 31, 2004 and 2005. The present value of $1 due in two periods at 8% interest is 0.8573 and 12% interest is 0.7972. The present value of an ordinary annuity of $1 for two periods at 8% interest is 1.7833 and at 12% interest is 1.6901. At December 31, 2003, Marsh computes a loss on the receivable from Saxe Company of (rounded): a. $65,269 b. $46,731 c. $42,002 d. $34,731 2. During 2003, Peterson Company experienced financial difficulties and is likely to default on a $500,000, 15%, three-year note dated January 1, 2002, payable to Forest National Bank. On December 31, 2003, the bank agreed to settle the note and unpaid interest of $75,000 for 2003 for $50,000 cash and marketable securities having a current market value of $375,000. Peterson s acquisition cost of the securities is $385,000. Ignoring income taxes, what amount should Peterson report as a gain from the debt restructuring in its 2003 income statement? a. $65,000 b. $75,000 Electronic Supplement to Chapter 17 7

c. $140,000 d. $150,000 3. Carr Company is indebted to Apex Company under a $700,000, 12%, four-year note dated December 31, 2003. Annual interest of $84,000 was paid on December 31, 2004 and 2005. During 2006, Carr experienced financial difficulties and is likely to default on the note and interest unless concessions are made. On December 31, 2006, Apex agreed to restructure the debt as follows. Interest for 2006 was reduced from $84,000 to $40,000, payable on January 31, 2007. Interest for 2007 was waived. The $700,000 principal amount was reduced to $600,000. Ignoring income taxes, how much should Carr report as extraordinary gain on debt restructuring in its income statement for the year ended December 31, 2006. a. 0 b. $60,000 c. $100,000 d. $144,000 4. Hull Company is indebted to Apex under a $500,000, 12%, three-year note dated December 31, 2003. Because of Hull s financial difficulties developing in 2005, Hull owed accrued interest of $60,000 on the note at December 31, 2005. Under a troubled debt restructuring on December 31, 2005, Apex agreed to settle the note and accrued interest for a tract of land having a fair value of $450,000. Hull s acquisition cost of the land is $360,000. Ignoring income taxes, on its 2005 income statement Hull should report its troubled debt restructuring as: Other Income Extraordinary Gain a. $200,000 0 b. $140,000 0 c. $ 90,000 $ 50,000 d. $ 90,000 $110,000 W 17-10 The creditors of Downy Corporation agreed to the following financial concessions in recognition of Downy s deteriorating financial condition: 1. Freshline Company, one of Downy s suppliers, agrees to accept merchandise at its normal selling price of $30,000 in full satisfaction of its $32,400 overdue account receivable from Downy. The cost of the merchandise to Downy was $24,000. Freshline s account receivable from Downy included a $3,000 allowance for doubtful accounts. 2. Downy Corporation s bank, Glidden Fidelity, agrees to accept 2,000 shares of Downy s $10 par common stock with a current market price of $20 per share in full satisfaction of a $45,000 note and $4,000 accrued interest due from Downy. Glidden Fidelity Bank has provided a $10,000 bad debt allowance for this note. REQUIRED 1. Prepare journal entries on Downy s books to account for the restructuring transaction. 2. Prepare journal entries on the books of Freshline Company and Glidden Fidelity Bank to account for the restructuring transactions. W 17-11 Garbo Corporation is a financially distressed corporation with assets and liabilities at book value on June 30, 2006, as follows: Assets Liabilities Cash $ 70,000 Accounts payable $ 50,000 Accounts receivable less $5,000 15% note payable 100,000 uncollectible receivables 45,000 Interest on note payable 15,000 Inventory 80,000 15% mortgage payable 300,000 Plant and equipment net 405,000 Interest on mortgage payable 30,000 Total assets $600,000 Total liabilities $495,000 8 ADVANCED ACCOUNTING

ADDITIONAL INFORMATION 1. On July 1, 2006, Nappy Supply Corporation, Garbo s sole supplier, accepted all of Garbo s accounts receivable with a fair value of $38,000 in full settlement of the accounts payable liability. 2. On July 5, 2006, Onze Finance Corporation accepted 1,000 shares of Garbo Corporation s $10 par common stock with a fair value of $80 per share in full settlement of the note payable and interest. 3. Also on July 5, 2006, Lateral Bank agreed to accept $45,000 per year for eight years in full settlement of the mortgage payable and interest. The current interest rate on July 5 was 12%, and the present value of the eight future payments on that date was $223,544. REQUIRED: 1. Calculate Garbo Corporation s gain or loss on restructuring its debt in accordance with the provisions of FASB Statement No. 15. 2. How much gain or loss should Nappy, Onze, and Lateral bank recognize on the troubled debt restructuring? W 17-12 Stewart Corporation experienced financial difficulties during the current year and was able to obtain concessions from several of its creditors to enable continued operations. Information relating to each of the concessions is as follows: 1. Stewart transfers inventory items with a normal selling price of $21,000 (cost $15,000) to Renner Corporation in full satisfaction of a $20,000 note and $3,000 accrued interest. The book value of the note and interest on Renner s book was $22,000 ($23,000 less $1,000 allowance for uncollectible notes). 2. First Piedmont Finance Company accepts 3,000 shares of Stewart Corporation s $10 par common stock in full satisfaction of a $50,000 note and $2,500 accrued interest. The stock has a book value of $60,000 and a fair value of $40,000. First Piedmont acquired the note and accrued interest for $35,000 just before the restructuring. 3. The First National Bank of Danville extends the $100,000 mortgage on Stewart s plant for two years and reduces the interest rate from 15% to 6% in order to make the best of a difficult situation. In return, Stewart pays the $3,750 accrued interest immediately. The present value of $1 due in two periods at 15% interest is 0.7561 and at 6% is 0.8900. The present value of an annuity of $1 for two periods at 15% is 1.6257 and 6% is 1.8334. REQUIRED: Prepare journal entries on the books of Stewart Corporation and each of its creditors to account for the restructurings described. Electronic Supplement to Chapter 17 9