How Troubled Debt Restructuring Accounted?

In a troubled debt restructuring, the debtor has financial problems and is relieved of part or all of the obligations. The concession arises from the debtor-creditor agreement, or law, or it applies to foreclosure and repossession. How troubled debt restructuring accounted? Let’s discuss these here. 

The types of troubled debt restructurings are:

1. Debtor transfers to creditor receivables from third parties or other assets.
2. Debtor gives creditor equity securities to satisfy the debt.
3. The debt terms are modified, including reducing the interest rate, extending the maturity date, or reducing the principal of the obligation.

Basically; The debtor records an extraordinary gain (net of tax) on the restructuring while the creditor recognizes a loss. The loss may be ordinary or extraordinary, depending on whether the arrangement is unusual and infrequent. Typically, the loss is ordinary. But let’s discusse these in more detail on the next section. Read on…

Debtor’s Side

The gain to the debtor equals the difference between the “fair value of assets exchanged“ and the “book value of the debt (including accrued interest)“. Furthermore, there may arise a gain on disposal of assets exchanged equal to the difference between the fair market value and the book value of the transferred assets. The latter gain or loss is not a gain or loss on restructuring, but rather an ordinary gain or loss in connection with asset disposal.

EXAMPLE: A debtor transfers assets having a fair market value of $80 and a book value of $65 to settle a payable having a carrying value of $90. The gain on restructuring is ($90 – $80) = $10. The ordinary gain is ($80 – $65) = $15

A debtor may give the creditor an “equity interest“. The debtor records the equity securities issued based on “fair market value” and not the recorded value of the debt extinguished. The excess of the recorded payable satisfied over the fair value of the issued securities constitutes an “extraordinary item“.

A modification in terms of an initial debt contract is accounted for prospectively. A new interest rate may be determined based on the new terms. This interest rate is then used to allocate future payments to lower principal and interest. When the new terms of the agreement result in the sum of all the future payments to be less than the carrying value of the payable, the payable is reduced and a restructuring gain is recorded for the difference. The future payments only reduce principal.Interest expense is not recorded.

A troubled debt restructuring may result in a combination of concessions to the debtor. This may occur when assets or an equity interest are given in partial satisfaction of the obligation and the balance is subject to a modification of terms. There are two steps:

• First Step: The payable is reduced by the fair value of the assets or equity transferred.
• Second Step: The balance of the debt is accounted for as a ‘‘modification of terms’’ type restructuring.

Direct costs, such as legal fees, incurred by the debtor in an equity transfer reduce the fair value of the equity interest. All other costs reduce the gain on restructuring. If there is no gain, they are expensed.

EXAMPLE-1: The debtor owes the creditor $80,000. The creditor relieves the debtor of $10,000. The balance of the debt will be paid at a later time.

The journal entry for “the debtor“ is:

[Debit]. Accounts Payable = $10,000
[Credit]. Extraordinary gain = $10,000

The journal entry for “the creditor“ is:

[Debit]. Ordinary loss = $10,000
[Credit]. Accounts receivable = $10,000

EXAMPLE-2: The debtor owes the creditor $90,000. The creditor agrees to accept $70,000 in full satisfaction of the obligation.

The journal entry for the debtor is:

[Debit]. Accounts Payable = $90,000
[Credit]. Extraordinary gain = $20,000
[Credit]. Cash = $70,000

The journal entry for the creditor is:

[Debit]. Cash = $70,000
[Debit]. Ordinary loss = $20,000
[Credit]. Accounts receivable = $90,000

The debtor should disclose in the footnotes:

1. Terms of the restructuring agreement
2. The aggregate and per share amounts of the gain on restructuring
3. Amounts that are contingently payable, including the contingency terms

Creditor’s Side

The creditor’s loss is the difference between the “fair value of assets received“ and the“book value of the investment“.

When terms are modified, the creditor recognizes “interest income“ to the degree that total future payments are greater than the carrying value of the investment. Interest income is recognized using the “effective interest method“.

Assets received are reflected at “fair market value“. When the book value of the receivable is in excess of the aggregate payments, an ordinary loss is recognized for the difference. All cash received in the future is accounted for as a recovery of the investment. Direct costs of the creditor are expensed.

The creditor does not recognize contingent interest until the contingency is removed and interest has been earned. Furthermore, future changes in the interest rate are accounted for as a change in estimate.

The creditor discloses in the footnotes:

1. Loan commitments of additional funds to financially troubled companies
2. Loans and/or receivables by major type
3. Debt agreements in which the interest rate has been downwardly adjusted, including an explanation of the circumstances
4. Description of the restructuring provisions

Source:

http://accounting-financial-tax.com/2008/12/how-troubled-debt-restructuring-accounted/