Troubled Debt and Debt Covenant Compliance Flashcards
KEY Troubled Debt Items
Gain = book value of note plus interest - cash paid
The gain is not classified as extraordinary.
The gain is the difference between the debt book value of $28,000 and the fair value of the equity interest transferred ($25,000) or $3,000.
IFRS: Both sets of standards treat settlements as extinguishments with a gain to the debtor for the difference between debt book value and fair value of consideration paid.
Kam recognizes an ordinary loss of $5,000 on disposal of the equipment. This is the difference between the equipment’s $80,000 carrying value, and its $75,000 fair value. If Kam had sold the equipment before using it to settle the debt, this amount of gain would have resulted. Being an ordinary gain, it is reported on a pre-tax basis.
Troubled Debt Restructuring (TDR) with only Modification of Terms
In a troubled debt restructuring involving only a modification of terms, the debtor will recognize a gain only if the total undiscounted future cash payments for principal and interest under the new terms are less than the current amount payable for principal and accrued interest.
When the future payments under the new terms are less than the current obligation, the debtor writes down the carrying amount of the liability by the amount of the difference and thus recognizes a gain.
How to tell if a restructuring is troubled.
If the present value of the restructured flows using the original interest rate is less than the book value of the debt at the date of the restructure.
This is one of the ways to determine if a restructuring is troubled. Under the terms of this answer, the creditor is receiving a stream of cash flows with a present value less than what is currently owed and is making a concession.
Debt Extinguishment Gain
The gain on debt restructure recognized by the debtor Knob is the difference between the book value of the debt ($150,000) and the market value of the asset transferred in settlement ($90,000). Thus, the gain equals $60,000.
It represents the increase in net worth, measured at market value, from extinguishing debt at less than its carrying value. The carrying value of the asset transferred is not relevant to the determination of the restructuring gain.
Issuing Stock to pay off unsecured creditors (TDR)
The market value of the stock issued to the creditors is $100,000 (80,000 x $1.25).
The fair value of consideration paid to settle the debt therefore is $500,000 ($400,000 cash + $100,000 of stock). The gain on settling the debt therefore is $700,000 ($1,200,000 - $500,000 total consideration).
The gain increases owners’ equity by way of net income.
The issuance of stock is recorded at market value, $100,000. Thus, the total owners’ equity increase is $800,000 ($700,000 + $100,000).
Note that this amount is also the difference between the amount of debt retired ($1,200,000) and cash paid ($400,000).
In a modification of the terms, troubled debt restructure of type II (sum of new flows > book value of debt), what amount of gain is recognized by the debtor?
Although the debtor has an economic gain (the creditor is making a concession), GAAP requires that the debtor compute the new rate of interest based on the restructured cash flows and recognize interest expense over the note term. No gain is recognized by the debtor.
Modification of Terms where New CF > BV
The debtor in a modification of terms troubled debt restructuring for which the sum of restructured cash flows exceeds book value computes interest after the restructure at the rate equating the restructured flows and the book value.
Restructuring Gain
The restructuring gain to the debtor in a troubled debt restructuring is the difference between the book value of the debt and the market value of consideration accepted by the creditor in full settlement.
Loan Impairment for Creditor
NEEDS REVIEW
Changing to the successful efforts method of accounting for natural resource exploration costs.
This accounting change would cause earnings to be reduced, possibly significantly. The successful efforts method expenses the cost of all unsuccessful exploration efforts immediately. Full costing capitalizes the cost of all efforts of expensing that take place when the resource is sold. Thus, the full costing method is the method of choice. This firm should use accounting methods that increase earnings. Higher earnings improve several quantitative measures used in debt covenants, including any measure of earnings, owners’ equity balances, debt to equity ratio, and rates of return such as return on assets and return on equity.
Choose the correct statement concerning the classification of a liability when a firm is subject to a debt covenant.
If the covenant includes a subjective acceleration clause and there is only a remote chance that debt will be called, then the liability is classified as noncurrent.
It must be at least possible that the liability will be called in order for the classification to downgraded to current.
A firm’s debt to equity ratio (total debt to total owners’ equity) cannot exceed 3.0 without allowing a major creditor to call a loan to the firm. The ratio is currently at the maximum before any of the transactions are listed. Which of the following transactions would not subject the firm to an immediate call by the creditor?
Retire a different loan by issuing common stock.
This transaction reduces total liabilities and increases OE by the same amount. The numerator of the ratio is reduced and the denominator is increased. Both factors cause the ratio to decrease below the maximum.
A deferred tax liability increase causes the numerator of the ratio to increase, thus increasing the ratio. It can also be argued that an increase in the deferred tax liability is associated with an increase in income tax expense, which decreases earnings, retained earnings, and owners’ equity. The decrease in the denominator also serves to increase the ratio.
Appropriating R/E and Covenants
Appropriating retained earnings is an action that typically signals a future reduction in dividends, albeit on a temporary basis. As a result, total retained earnings is maintained at a higher level.
Helps a firm to maintain compliance with a debt covenant that includes a minimum current ratio and a minimum retained earnings balance
