F4 - M6 - Troubled Debt Restructuring and Extinguishment Flashcards
What is troubled debt restructuring?
This is when the creditor gives the debtor more favorable circumstances, so that way the debtor has more likely hood of paying the creditor.
A creditor would do this if they know they are not going to collect the full amount from the debtor but want to collect something. Something is better than nothing is kind of the idea.
One of the ways a debtor can satisfy their debt is by giving the creditor assets. How does this work and how is this recorded?
Let’s say that a debtor has a carrying value of a loan for 100,000 and they offer some asset to satisfy the loan, and lets say the fair value of that asset is 88,000. This would be a gain to the debtor of 12,000 and would be reported as income to the debtor.
The gain is the Carrying Value of the liability must be greater than the fair value of the asset.
There may be another gain if the fair market value of the asset given is greater then the net book value of the asset on the books. So if the asset NBV is 65,000 (Cost - Depr) then they would have another gain of 23,000 (88,000-65,000)
One of the other ways a debtor can satisfy their debt is by transferring equity to the creditor. How does this work?
So let’s say that the debtor is trying to satisfy their debt, so they give stock over to the creditor. The creditor accepts, and the stock’s FMV is valued less than the loans carrying value. The difference between the Carrying Value and the FMV would be the gain the debtor would record. The carrying value of the liability has to be greater than the FMV of the stock for the gain to go through.
What is the main difference between a transfer of asset or equity to satisfy the debt and modifying the terms of the loan for the debtor?
When you transfer an asset or equity to satisfy the loan, the loan no longer exists. The carrying value is taken off of the books, the loan obligation is no longer there, it is gone.
When you modify the terms of the loan, the loan still exists, you just changed the terms so the payment is more favorable for the debtor.
For modification of terms, what is the process when someone modifies the terms to favor the debtor? How is this recorded?
Let’s say the the creditor agrees to lower the loan to have a carrying value of 70,000 which is 60,000 principle and 10,000 interest. The original carrying value of the loan was 100,000. The difference is 30,000, that is how much the loan was decreased by. You would debit the liability and credit the gain for 30,000.
Also, all cash payments after restructuring will reduce the carrying amount. No interest expense is recognized after restructure, all payments reduce carrying amount.
What if the terms of the note are changed, and the future discounted cash flows end up being greater than the carrying value? What happens?
That means that the new agreement is not bettering the debtor and still favoring the creditor. For that reason, you would not change the carrying value or recognize a gain.
From the debtor perspective, the gain on debt restructuring are included where on the income statement?
These are non-operating section, typically with the other gains and losses.
From the creditor’s side, what they must record when they know they will not be able to collect all of the loan?
First, they have to estimate bad debts and record the following entry:
DR: Bad debt expense
CR: Allowance for losses
Then when the debt is written off, they already recorded bad debt expense, so they have to record the following entry:
Dr: Allowance for losses
CR: Receivable
From the creditor’s side, what they must record when they get asset or equity to satisfy the loan?
They have to debit the asset at its fair value
They have to then credit the full value of the receivable
Then the plug would be allowance for credit loss.
How would you find the impairment loss for the creditor?
You would first need your new effective interest rate based on the new terms of the loan, and you would need to find the present value of the principle payment and the present value of the monthly interest payment just like in bonds.
The principle and annuity payments will be based on the new terms of the loan. The old carrying amount minus the present value of the new terms subtracted is the loss the creditor would record.
