Troubled Debt Restructurings A Closer Look

Troubled Debt RestructuringsWhen a debtor experiences financial difficulties before the debt is repaid, a creditor may need to recognize an impairment of the debt. An impairment of the debt is recognized when the present value of the expected future cash flows discounted at the debt’s original effective interest rate is less than the recorded investment in the debt. If for economic or legal reasons related to the debtor’s financial difficulties, the creditor grants the debtor concessions that would not otherwise have been granted. In the accounting world this situation referred to as TROUBLED DEBT RESTRUCTURING, in this case the debtor must determine how to recognize the effects of the troubled debt restructuring.

Therefore, Troubled debt restructurings are defined as situations in which the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants the debtor a concession that would not otherwise be granted.

On my post “How Troubled Debt Structuring Accounted?” I have briefly discussed troubled debt structuring. This post discusses this topic in much greater details with more case examples. Enjoy! 

 

How Troubled Debt Structuring Determined

No single characteristic or factor taken alone, it is determinative of whether a modification of terms or an exchange of a debt instrument is a troubled debt restructuring. Thus, making this determination requires the exercise of judgment.

To determine whether the troubled debt structuring applies in a particular instance, two questions need to be possessed:

  • Is the debtor experiencing financial difficulty?
  • Has the creditor granted a concession?

 

Both of these questions must be answered in the affirmative that we are going to discuss on the next paragraphs. Read on…

 

Question#1. Is The Debtor Experiencing Financial Difficulty?

If the debtor’s creditworthiness has deteriorated since the debt was originally issued, the debtor should evaluate whether it is experiencing financial difficulties. The following factors are indicators that this may be the case:

  • The debtor is in default on some of its debt
  • The debtor has declared, or is in the process of declaring, bankruptcy
  • There is doubt as to whether the debtor is a going concern
  • The debtor’s securities have been or are likely to be delisted
  • The debtor forecasts that its entity-specific cash flows are insufficient to service the debt through its maturity in accordance with its terms
  • The debtor cannot obtain resources at the current market rates for nontroubled debtors except through existing creditors

 

If both of the following factors are present, it would be concluded that the debtor is not experiencing financial difficulty:

  • The creditors agree to restructure the old debt solely to reflect either (1) a decrease in the current interest rates for the debtor, or (2) an increase in the debtor’s creditworthiness
  • The debtor is currently servicing the old debt and can obtain funds to repay the old debt at the current market rate for a nontroubled debtor

 
Question#2. Has The Creditor Granted A Concession?

The creditor has granted a concession if the debtor’s effective borrowing rate on the restructured debt is less than the effective borrowing rate immediately prior to the restructuring. The effective borrowing rate should give effect to all the terms of the restructured debt, including options, warrants, guarantees, and so forth.

If the debtor is restructuring the debt for a second time, the effective borrowing rate of the new debt should be compared to the effective borrowing rate of the original debt.

However, in any of the following four situations, a concession granted by the creditor does not automatically qualify as a restructuring:

  • The fair value of the assets or equity interest accepted by a creditor from a debtor in full satisfaction of its receivable is at least equal to the creditor’s recorded investment in the receivable.
  • The fair value of the assets or equity interest transferred by a debtor to a creditor in full settlement of its payable is at least equal to the carrying value of the payable.
  • The creditor reduces the effective interest rate to reflect a decrease in current interest rates or a decrease in the risk, in order to maintain the relationship.
  • The debtor, in exchange for old debt, issues new debt with an interest rate that reflects current market rates.

 

Accounting Standard Codification [ASC] No 470-60-55-1 notes that, the definition does not apply to debtors in bankruptcy unless the restructuring does not result from a general restatement of the debtor’s liabilities in bankruptcy proceedings. That is, the definition applies only if the debt restructuring is isolated to the creditor.

 

How “Troubled Debt Structuring” Can Occur

A troubled debt restructuring can occur one of two ways:

  • The first is a settlement of the debt at less than the carrying amount.
  • The second is a continuation of the debt with a modification of terms (i.e., a reduction in the interest rate, face amount, accrued interest owed, or an extension of the payment date for interest or face amount).

Accounting for such restructurings is prescribed for both debtors and creditors, which will be discussed with case examples on the next sections. Read on…

 

 
Troubled Debt Restructuring On Debtors Side

If the debt is settled by the exchange of assets, a gain is recognized in the period of transfer for the difference between the carrying amount of the debt (defined as the face amount of the debt increased or decreased by applicable accrued interest and applicable unamortized premium, discount, or issue costs) and the consideration given to extinguish the debt. A two-step process is used:

  • Step-1. Any non-cash assets used to settle the debt are revalued at fair market value and the associated ordinary gain or loss is recognized; and
  • Step-2. The debt restructuring gain is determined and recognized.

 
The gain or loss is evaluated under the “unusual and infrequent” criteria of Accounting Standard Codification [ASC] No 225-20. If stock is issued to settle the liability, the stock is recorded at its fair market value.

 

Case Example-1: Settlement Of Debt By Exchange Of Assets

Assume the debtor company transfers land having a book value of $70,000 and a fair market value of $80,000 in full settlement of its note payable. The note has a remaining life of five years, a principal balance of $90,000, and related accrued interest of $10,000 is recorded.

The following entries are required to record the settlement:

On Debtor’s Book

[Debit]. Land = $10,000
[Credit]. Gain on transfer of assets = $10,000

[Debit]. Note payable = $90,000
[Debit]. Interest payable = $10,000
[Credit]. Land = $80,000
[Credit]. Gain on settlement of debt = $20,000

 

If the debt is continued with a modification of terms, it is necessary to compare the total future cash flows of the restructured debt (both principal and stated interest) with the carrying value of the original debt. If the total amount of future cash payments is greater than the carrying value, no adjustment is made to the carrying value of the debt.

However, a new lower “effective interest rate” must be computed. This rate makes the present value of the total future cash payments equal to the present carrying value of debt and is used to determine interest expense in future periods. The effective interest method must be used to compute the expense. If the total future cash payments of the restructured debt are less than the present carrying value, the current debt should be reduced to the amount of the future cash flows and a gain should be recognized. No interest expense would be recognized in subsequent periods, since only the principal is being repaid.

A troubled debt restructuring that involves only a modification of terms is accounted for prospectively. Thus, there is no change in the carrying value of the liability unless the carrying amount of the original debt exceeds the total future cash payments specified by the new agreement.

If the restructuring consists of part settlement and part modification of payments, the part settlement is accounted for first and then the modification of payments.

 

Case Example 2: Restructuring With Gain/Loss Recognized
(Note: Payments are less than carrying value)

Assume that the note has a principal balance of $90,000, accrued interest of $10,000, an interest rate of 5%, and a remaining life of five years. The interest rate is reduced to 4%, the principal is reduced to $72,500, and the accrued interest at date of restructure is forgiven.

Future cash flows (after restructuring):

Principal                                           $ 72,500
Interest (5 years × $72,500 × 4%)    $ 14,500
Total cash to be paid                       $ 87,000
Amount prior to restructure
($90,000 principal + $10,000
accrued interest)                             ($100,000)
Debtor’s gain                                   $ 13,000

The following entries need to be recorded by the debtor to reflect the terms of the agreement:

 

Beginning of Year 1 [On Debtors Book]:

[Debit]. Interest payable = $10,000
[Debit]. Note payable = $3,000
[Credit]. Gain on restructure of debt = $13,000

End of Years 1-5 [On Debtors Book]:

[Debit]. Note payable = $2,900
[Credit]. Cash = $2,900

Note: $14,500 / 5 yrs. = $2,900; No interest expense is recorded in this case.

End of Year 5 [On Debtors Book]:

[Debit]. Note payable = $72,500
[Credit]. Cash = $72,500

 

Example 3: Restructuring With No Gain/Loss Recognized
(Note: Payments exceed carrying value)

ModifyCase Example-2above with the followings:

Assume the $100,000 owed is reduced to a principal balance of $95,000. The interest rate of 5% is reduced to 4%.

Future cash flows (after restructuring):

Principal                                          $  95,000
Interest (5 years × $95,000 × 4%)   $  19,000
Total cash to be received                $ 114,000
Amount prior to restructure
($90,000 principal + $10,000
accrued interest)                            ($100,000)
Interest expense/revenue-
over 5 years                                      $ 14,000

 

In this example, a new effective interest rate must be computed such that the present value of the future payments equals $100,000.

A trial and error” approach is used to calculate the effective interest rate that discounts the $95,000 principal and the $3,800 annual interest payments to $100,000, the amount owed prior to restructuring.

 

Trial and Error Calculation

                                           (n = 5, i = 2.5%)      (n = 5, i = 3%)
PV of ordinary annuity         4.64583                       4.57971
PV of 1                                 0.88385                       0.86261

2.5%: (0.88385 x $95,000) + (4.64583 x $3,800) = $101,620
   3%: (0.86261 x $95,000) + (4.57971 x $3,800) = $  99,351

 

Interpolation:

[(101,620 – 100,000) / (101,620 – 99,351)] x (3% – 2.5%) = 0.357%

New effective rate = 2.5% + .357% = 2.857%

 

Interest amortization schedule:

Year   Cash           Interest at          Reduction in         Carrying
                            effective rate     carrying value       amount
                                                                                  $100,000
1         $ 3,800(a)   $2,857(b)            $ 943(c)                99,057
2            3,800         2,830                  970                    98,087
3            3,800         2,802                  998                    97,089
4            3,800         2,774                 1,026                  96,063
5            3,800         2,745                 1,055                  95,000*)
          $19,000

Note:

*) Rounded
(a) $3,800 = $95,000 × 0.04
(b) $2,857 = $100,000 × 2.857%
(c) $943 = $3,800 – $2,857

The following entries are made by the debtor to recognize the cash payments in the subsequent periods:

End of Year 1 [On Debtors Book]:

[Debit]. Note payable ($3,800 – $2,857 = $943
[Debit]. Interest expense ($100,000 × 0.02857) = $2,857
[Credit]. Cash = $3,800

End of Year 5 [On Debtors Book]:

[Debit]. Note payable = $95,000
[Credit]. Cash = $95,000

 

When the total future cash payments may exceed the carrying amount of the liability, no gain or loss is recognized on the books of the debtor unless the maximum future cash payments are less than the carrying amount of the debt. For example, if the debtor is required to make interest payments at a higher rate if its financial condition improves before the maturity of the debt, the debtor should assume that the larger payments would have to be made.  The contingent payments would be included in the total future cash payments for comparison with the carrying amount of the debt.

If the future cash payments exceed the carrying amount, a new effective interest rate should be determined. The new rate should be the rate that equates the present value of the future cash payments with the carrying amount of the liability. Interest expense and principal reduction are then recognized as the future cash payments are made.

 

Example 4: Contingent Payments

Again, modify “Case Example 2” with the followings:

The new agreement states that if financial condition at maturity improves as specified, an additional principal payment of $15,000 is required and additional 1% of interest must be paid in arrears for years 4 and 5.

Future cash payments:

Required principal per agreement   $ 72,500
Required interest per agreement 
(5 years × $72,500 × 4%)                $ 14,500
Contingent principal payment         $ 15,000
Contingent interest payments
(2 years × 72,500 × 1%)                  $   1,450
                                                      $103,450
Amount prior to restructure
($90,000 + $10,000)                    ($100,000)
                                                        $ 3,450

 

When computing the new effective interest rate, only as many contingent payments as are needed to make the future cash payments exceed the carrying value are included in the calculation. Thus, the contingent principal payment would be included, but the contingent interest would not. The contingent interest payments would be recognized using the same criteria as are used in ASC 450; that is, the payments are recognized when they are both probable and reasonably estimable.

 

Troubled Debt Structuring On Creditors Side

Accounting Standard Codification [ASC] No 310-10-35 applies to all creditors, to all troubled debt restructurings involving a modification of terms, and to all loans.

Exception:

  • Groups of similar small balance loans that are collectively evaluated
  • Loans measured at fair value or lower of cost or fair value
  • Leases
  • Accounting Standard Codification [ASC] No 320, “debt securities”

 

If it is probable that a creditor will not collect all amounts (principal and interest) owed to the degree specified in the loan agreement, a loan is considered impaired. A delay does not impair the loan if the creditor collects all amounts due (including accrued interest during the delay at the contractual rate).

An impaired loan can be measured on a loan-by-loan basis in any of the following ways:

  • Present value of expected future cash flows using the loan’s original effective interest rate (the contractual interest rate adjusted for premium or discount and net deferred loan costs or fees at acquisition or origination)
  • Loan’s observable market price
  • Fair value of the collateral if the loan is collateral dependent (repayment expected to be provided by the collateral). If foreclosure is probable, this measurement must be used.

 

Other measurement considerations include:

  • Costs to sell, on a discounted basis, if they will reduce cash flows to satisfy the loan
  • Creation of or adjustment to a valuation allowance account with the offset to baddebt expense if the recorded investment is greater than the impaired loan measurement
  • If the contractual interest rate varies based on changes in an independent factor, the creditor can choose between: (a) Calculating the effective interest on the factor as it changes over the loan’s life; or (b) Calculating the effective interest as fixed at the rate in effect at the date of impairment. The choice must be consistently applied. Projections of factor changes should not be made.
  • Cash flow estimates should be the creditors’ best estimate based on reasonable and supportable assumptions
  • Significant changes occurring in measurement values require recalculation and adjustment of the valuation allowance. Net carrying amount of the loan should not exceed the recorded investment.

 

After impairment, creditors use existing methods to record, measure, and display interest income. If the existing policy results in a recorded investment less than fair value, no additional impairment is recognized.

The creditor would account for the earlier examples as follows:

 

Case Example-1 [on Creditors Book]:

[Debit]. Land = $80,000
[Debit]. Bad debt expense = $20,000
[Credit]. Note receivable = $90,000
[Credit]. Interest receivable = $10,000
Case Example-2 [On Creditors Book]

Future cash flows (after restructuring) at the agreement’s original effective interest rate

                                                            5% 5 yrs
                                                           PV Factor
Principal                      $ 56,806     ($72,500 x 0.78353)
Interest                           12,555     ($ 2,900 x 4.32948)
Total present value      $ 69,361
Amount prior to-
restructure  ($90,000
principal + $10,000
accrued interest)        ($100,000)
Creditor’s loss            ($30,639)

 

Beginning of Year 1 [On Creditors Book]:

[Debit]. Bad debt expense = $30,639
[Debit]. Interest receivable = $10,000
[Credit]. Valuation allowance = $20,639
End of Year 1[On Creditors Book]:

[Debit]. Cash = $2,900
[Debit]. Valuation allowance = $568
[Credit]. Bad debt expense (or interest income) = 3,468
               [=69,361 × 0.05]

End of Year 2 [On Creditors Book]:

[Debit]. Cash = $2,900
[Debit]. Valuation allowance 596
[Credit]. Bad debt expense (or interest income) = 3,496
               [(69,361 + 568) = 69,929 × 0.05]

End of Year 3 [On Creditors Book]:

[Debit]. Cash = $2,900
[Debit]. Valuation allowance = $626
[Credit]. Bad debt expense (or interest income) = $3,526
               [(69,929 + 596) = 70,525 × 0.05]

End of Year 4 [On Creditors Book]:

[Debit]. Cash = $2,900
[Debit]. Valuation allowance = $658
[Credit]. Bad debt expense (or interest income) = $3,558
               [(70,525 + 626) = 71,151 × .05]

End of Year 5 [On Creditors Book]:

[Debit]. Cash = $2,900
[Debit]. Valuation allowance = $691
[Credit]. Bad debt expense (or interest income) = $3,591
[(71,151 + 658) = 71,809 × 0.05]

[Debit]. Cash = $72,500
[Debit]. Valuation allowance = $17,500
[Credit]. Note receivable = $90,000

 

Case Example-3 [On Creditors Side]

Future cash flows (after restructuring) at the agreement’s original effective interest rate:

                                                             5% 5 yrs
                                                             PV Factor

Principal                      $ 74,435    ($95,000 x 0.78353)
Interest                        $ 16,452    ($ 3,800 x 4.32948)
Total present value      $ 90,887
Amount prior to-
restructure ($90,000
principal + $10,000
accrued interest)        ($100,000)
Creditor’s loss           ($    9,113)

 

Beginning of Year 1 [On Creditors Book]:

[Debit]. Bad debt expense = $9,113
[Debit]. Note receivable—new = $95,000
[Credit]. Note receivable—old = $90,000
[Credit]. Interest receivable = $10,000
[Credit]. Valuation allowance = $4,113

End of Year 1 [On Creditors Book]:

[Debit]. Cash = $3,800
[Debit]. Valuation allowance = $744
[Credit]. Bad debt expense (or interest income) = $4,544
[=90,887 × 0.05]

End of Year 2 [On Creditors Book]:

[Debit]. Cash = $3,800
[Debit]. Valuation allowance = $781
[Credit]. Bad debt expense (or interest income) = $4,581
[(90,887 + 744) = 91,631 × 0.05]

End of Year 3 [On Creditors Book]:

[Debit]. Cash = $3,800
[Debit]. Valuation allowance = $821
[Credit]. Bad debt expense (or interest income) = $4,621
[(91,631 + 781) = 92,412 × 0.05]

End of Year 4 [On Creditors Book]:

[Debit]. Cash = $3,800
[Debit]. Valuation allowance = $862
[Credit]. Bad debt expense (or interest income) = $4,662
[(92,412 + 821) = 93,233 × 0.05]

End of Year 5 [On Creditors Book]:

[Debit]. Cash = $3,800
[Debit]. Valuation allowance = $905
Bad debt expense (or interest income) = $4,705
[(93,233 + 862) = 94,095 × 0.05]

[Debit]. Cash = $95,000
[Credit]. Note receivable = $95,000