Troubled Debt - Settlement, Modification 1

Wood Corp., a debtor-in-possession under Chapter 11 of the Federal Bankruptcy Code, granted an equity interest to a creditor in full settlement of a $28,000 debt owed to the creditor. At the date of this transaction, the equity interest had a fair value of $25,000. What amount should Wood recognize as a gain on restructuring of debt?

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.

Describe the debtor's recording of a settlement restructure.

1. Gain = book value of debt + unpaid accrued interest - market value of consideration transferred; 2. Gain/loss on disposal of assets transferred; 3. Remove debt from books; 4. Record any stock issued at market value.

SUMMARY FOR LOAN IMPAIRMENTS AND TDRS for CREDITOR

(bv = book value of the liability including unpaid accrued interest) Creditor Loan impairment - Write down note receivable to new present value and recognize loss TDR (1) Settlement - Creditor accepts assets with market value < bv. Record loss TDR (2) Modification of terms: sum of new flows < bv - Loan Impairment TDR (3) Modification of terms: sum of new flows > bv - Loan impairment

SUMMARY FOR LOAN IMPAIRMENTS AND TDRS for DEBTOR

(bv = book value of the liability including unpaid accrued interest) Debtor Loan impairment - No accounting TDR (1) Settlement - Gain TDR (2) Modification of terms: sum of new flows < bv - Gain, new debt bv = sum of new flows (not pv) TDR (3) Modification of terms: sum of new flows > bv - No gain; recognize interest at lower rate

Describe the creditor's reporting of a debt settlement restructure.

1. Records loss equal to book value of receivables less market value of consideration received; 2. Remove receivables from books; 3. Record assets received at market value.

Describe the debtor's recording when the nominal sum of restructured flows is less than or equal to book value (BV) of debt + accrued interest.

1. Reduces carrying value of debt to nominal sum of flows; 2. Records gain for difference between book value and nominal sum; 3. No future interest recorded; 4. All restructured flows are principal payments.

Debtor Reporting of Modification of Terms Troubled Debt Restructure Continued

2. In modification of terms restructures in which the nominal sum of the restructured flows is greater than the book value of the debt plus accrued interest, the debtor: a. Records no gain or loss and does not change the carrying value of the debt; b. Computes the new rate of interest equating the present value of restructured cash flows and the book value of the debt; c. Records interest expense based on the new rate for the remainder of the loan term.

A Troubled Debt Restructure (TDR)

A Troubled Debt Restructure (TDR) : Occurs when a debtor is unable to make the required payments under the loan agreement and the creditor grants a concession that would otherwise not be made.

Debtor and Creditor Recording and Reporting of Settlement Troubled Debt Restructures

A. Debtor -- In settlement restructures, the debtor: 1. Records a gain equal to the book value of the debt, including any unpaid accrued interest, less the market value of consideration transferred in full settlement of the debt; 2. Records an ordinary gain or loss on the disposal of nonmonetary assets transferred in full settlement of the debt; 3. Removes the debt from the books; 4. Records any stock issued in settlement at the market value. B. Creditor -- In settlement restructures, the creditor: 1. Records an ordinary loss equal to the difference between the book value of the receivable and the market value of assets or stock of the debtor received; 2. Removes the receivable from the books; 3. Records assets received at market value.

Debtor Reporting of Modification of Terms Troubled Debt Restructure

A. For debtor accounting purposes, there are two very different cases for modification of terms TDRs. The cases are distinguished by the relationship between the pre-restructure book value of the debt, and the nominal sum of restructured future cash flows. The book value of the original debt always includes unpaid accrued interest. 1. In modification of terms restructures in which the nominal sum of the restructured flows is less than or equal to the book value of the debt plus accrued interest, the debtor: a. Reduces the carrying value of the debt to the nominal sum of restructured cash flows; b. Records a gain for the difference between the book value and the nominal sum of restructured cash flows; c. Records no further interest; all future cash payments are returns of principal.

Troubled Debt Restructure (TDR) --Background

A. In a troubled debt restructure, the creditor is attempting to make the best of a bad situation. The debtor is having difficulty living up to the terms of the initial debt agreement. In order to salvage the case, the creditor works with the debtor to restructure the debt agreement.

Troubled Debt Restructure (TDR)

A. The accounting for the restructure depends on whether the debt is settled (a settlement) or whether it continues (a modification of terms). The accounting for settlements by the creditor and debtor is parallel, but is significantly different for a modification of terms. A TDR is a formal restructure. A loan impairment is recorded by the creditor for TDRs and whenever the creditor believes it will receive less than under the original agreement.

Loan Impairment

A. The creditor accounts for all modification of terms troubled debt restructures as a loan impairment. This topic is covered in the lessons on receivables. The creditor will calculate the present value of future cash flows (under the restructured agreement), using the original interest rate (interest rate in the initial loan agreement) as the discount rate. If the present value of future cash flows is less than the investment in the receivable, the difference is recorded as an impairment loss by the creditor.

What is the amount of interest to be recognized after a troubled debt restructure that modifies the terms of the original debt such that the sum of restructured cash flows is less than the book value of the original debt?

Amount to be recognized is zero.

Troubled Debt Restructure (TDR)

B. In all TDR cases, the present value of the consideration paid under the restructured agreement is less than the carrying value of the debt at date of restructure. 1. If the debt is settled, the market value of consideration transferred is less than the carrying value of the debt at date of restructure (creditor grants a concession); 2. If the debt is modified, the present value of the restructured cash flows is less than the carrying value of the debt at date of restructure (creditor grants a concession).

Troubled Debt Restructure (TDR) --Background

B. The creditor makes a concession that would not otherwise be made. The creditor typically believes that more is to be gained by voluntarily reducing the payments required under the agreement, or by extending the terms, than by forcing the debtor into bankruptcy. 1. In a settlement restructure, the concession is the acceptance of assets, or equity securities, with a market value less than the book value of the receivable from the debtor, in full payment of the debt; 2. In a modification of terms restructure, the concession is the acceptance of revised debt terms that result in a new present value of remaining cash flows that is less than the book value of the receivable from the debtor.

What requirement must exist for a debt restructuring to be troubled?

Creditor makes a concession.

Troubled Debt Restructure (TDR) --Background

Either way, the creditor accepts consideration with a value less than the liability's book value. Debt restructuring is common. But only when the creditor makes a concession is the restructuring a "troubled" debt restructuring. A settlement TDR is simply an extinguishment of debt at a gain and is not inconsistent with normal noncurrent debt accounting. However, accounting for modification of terms TDRs diverges from the usual procedure.

Examples of Modification of Terms TDRs

Example: Debtor accounting for modification of terms. Nominal sum of restructured flows less than book value. On January 1, Year 1 a debtor owed a creditor a $10,000 note due on this date. In addition, $1,000 of unpaid interest from the previous year was also due. The debtor could not pay the entire amount and the two parties agreed on a restructure in which the debtor would make the following payments: Restructured cash flows December 31, Year 1 Interest 400 Principal 3,000 December 31, Year 2 Interest 400 Principal 3,000 Total restructured cash flows 6,800 The "interest" cash flows are not really interest because all flows are returns of principal in this case. However, restructuring agreements may refer to such smaller flows as interest. The nominal sum of $6,800 is less than the $11,000 book value of debt. Entries for Debtor: January 1, Year 1 Dr:Interest Payable 1,000 Dr:Note Payable 10,000 Cr: Gain 4,200 Cr:Note Payable 6,800 This entry reduces the carrying value of the debt to $6,800. The gain is the difference between the book value of the old debt plus interest ($11,000) and the nominal sum of restructured flows. The old debt accounts are closed and a new note payable is recorded. An alternative is to simply reduce the old note account $3,200 and close the interest payable account. December 31, Year 1 Dr:Note Payable 3,400 Cr: Cash 3,400 December 31, Year 2 Dr:Note Payable 3,400 Cr:Cash 3,400 The accounting for this case (sum of new flows < book value) is a significant departure from the normal procedure for noncurrent debt accounting which would report the new note payable at present value, rather than nominal value as in this situation.

Debtor and Creditor Recording and Reporting of Settlement Troubled Debt Restructures Example

Example: On January 1, a debtor owed a creditor a $10,000 note due on this date. In addition, $1,000 of unpaid interest from the previous year was also due. (A 10% original interest rate is implied.) The debtor could not pay the entire amount and the two parties agreed on a restructure in which the debtor would transfer land (cost, $4,000; market value, $2,000) and issue stock (market value and total par value, $5,000) in full settlement of the debt. Debtor Dr:Note Payable 10,000 Dr:Interest Payable 1,000 Dr:Loss on Land Disposal 2,000 Cr:Gain 4,000 Cr:Capital Stock 5,000 Cr:Land 4,000 Creditor Dr:Investment in Stock 5,000 Dr:Loss on Debt Restructure 4,000 Dr:Land 2,000 Cr:Note Receivable 10,000 Cr:Interest Receivable 1,000 The debtor's gain is the difference between the book value of the debt settled ($11,000 which includes interest) less the market value of items transferred ($2,000 land + $5,000 stock). This equals the creditor's loss on restructure (and equals the concession) because the two parties reported the same book value for the debt and receivable plus interest. The debtor's loss on disposal is the loss that would be recorded had the land been sold for cash.

During 2005, Colt Co. experienced financial difficulties and was likely to default on a $1,000,000, 15%, three-year note dated January 1, 2004, payable to Cain National Bank. On December 31, 2005, the bank agreed to settle the note and unpaid 2005 interest of $150,000 for $820,000 cash payable on January 31, 2006. What is the amount of gain, before income taxes, from the debt restructuring?

Gain = book value of note plus interest - cash paid Gain = $1,000,000 + $150,000 - $820,000 = $330,000 The gain is not classified as extraordinary.

For a troubled debt restructuring involving only a modification of terms, which of the following items specified by the new terms would be compared to the carrying amount of the debt to determine if the debtor should report a gain on restructuring?

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.

On October 15, 2004, Kam Corp. informed Finn Co. that Kam would be unable to repay its $100,000 note due on October 31 to Finn. Finn agreed to accept title to Kam's computer equipment in full settlement of the note. The equipment's carrying value was $80,000 and its fair value was $75,000. Kam's tax rate is 30%. What amounts should Kam report as disposal gain (loss) and restructuring gain for the year ended September 30, 2005?

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. The $25,000 recognized restructuring gain is the difference between the book value of the note ($100,000) and the fair value of the equipment ($75,000). The fair value is used because it represents the current sacrifice to retire the debt. Again, had the equipment been sold first, Kim would have had $75,000 to pay off the debt. When debt is retired for less than its book value, a gain results.

What is the nature of restructured cash flows for a troubled debt restructure that modifies the terms of the original debt such that the sum of restructured cash flows is less than the book value of the original debt?

Principal payments.

The following information pertains to the transfer of real estate pursuant to a troubled debt restructuring by Knob Co. to Mene Corp. in full liquidation of Knob's liability to Mene: Carrying amount of liability liquidated $150,000 Carrying amount of real estate transferred 100,000 Fair value of real estate transferred 90,000 What amount should Knob report as a gain (loss) on restructuring of payables?

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.

On December 30, 2004, Hale Corp. paid $400,000 cash and issued 80,000 shares of its $1 par value common stock to its unsecured creditors on a pro rata basis pursuant to a reorganization plan under Chapter 11 of the bankruptcy statutes. Hale owed these unsecured creditors a total of $1,200,000. Hale's common stock was trading at $1.25 per share on December 30, 2004. As a result of this transaction, Hale's total stockholders' equity had a net increase of

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).

Nu Corp. agreed to give Rand Co. a machine in full settlement of a note payable to Rand. The machine's original cost was $140,000. The note's face amount was $110,000. On the date of the agreement, the note's carrying amount was $105,000, and its present value was $96,000. The machine's carrying amount was $109,000, and its fair value was $96,000. What amount of net gain (or losses) should Nu recognize?

The net loss listed is the difference between the carrying amount of the liability and the carrying amount of the machine. Nu has a gain of $9,000 on the note settlement, which is the difference between the liability carrying value ($105,000) and the fair value of the consideration given to extinguish the debt ($96,000). Nu also has a disposal loss on the machine. An ordinary loss of $13,000 is recognized and equals the difference between the machine's carrying value ($109,000) and its fair value ($96,000).

The following information pertains to the transfer of real estate pursuant to a troubled debt restructuring by Knob Co. to Mene Corp. in full liquidation of Knob's liability to Mene: Carrying amount of liability liquidated $150,000 Carrying amount of real estate transferred 100,000 Fair value of real estate transferred 90,000 What amount should Knob report as an ordinary gain (loss) on transfer on disposal?

The real estate transferred in settlement of the debt is worth $10,000 less than its carrying value. Thus, an ordinary loss is recognized on the transfer. It is as if Knob first sold the real estate for $90,000 causing a loss of $10,000, and then used the cash for settlement of the debt.

Describe the creditor's accounting treatment for the modification of a troubled debt restructuring.

Treat as a loan impairment.