ACCOUNTING FOR TROUBLED DEBT Warfield Wyegandt Kieso APPENDIX F ACCOUNTING FOR TROUBLED DEBT INTERMEDIATE ACCOUNTING Principles and Analysis 2nd Edition

Troubled Debt Two situations result with troubled debt: Impairments. Restructurings: Settlements. Modification of terms Illustration G-1 Usual Progression

Troubled Debt Impairments A loan is impaired when it is probable the creditor will not collect all amounts due (both principal and interest). O 1 Describe the accounting for a loan impairment.

Troubled Debt Impairments If considering a loan impaired, the creditor should measure the loss due to the impairment as the difference between the investment in the loan (generally the principal plus accrued interest) and the expected future cash flows discounted at the loan’s historical effective interest rate. O 1 Describe the accounting for a loan impairment.

Troubled Debt - Impairments Example of Loss on Impairment On December 31, 2008, Prospect Inc. issued a $500,000, five-year, zero-interest-bearing note to Community Bank. Prospect issued the note to yield 10% annual interest. As a result, Prospect received, and Community Bank paid, $310,460 ($500,000 x .62092) on December 31, 2008. Illustration G-2 O 1 Describe the accounting for a loan impairment.

Troubled Debt - Impairments Show how Community Bank (creditor) and Prospect (debtor) record these transactions on December 31, 2008 Illustration G-3 O 1 Describe the accounting for a loan impairment.

Troubled Debt - Impairments Schedule of Interest and Discount Amortization (Before Impairment) Illustration G-4 Illustration G-3 O 1 Describe the accounting for a loan impairment.

Troubled Debt - Impairments Assume Community Bank determines that Prospect will probably pay back only $300,000 of the principal at maturity. Community Bank declares the loan impaired. Determine the loss due to impairment. Illustration G-5 O 1 Describe the accounting for a loan impairment.

Troubled Debt - Impairments The loss due to impairment is the difference between the present value of the expected future cash flows and the recorded carrying amount of the investment in the loan. Illustration G-6 Illustration G-7 O 1 Describe the accounting for a loan impairment.

Troubled Debt Restructurings A troubled-debt restructuring occurs when a creditor “for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.” Two basic types of transactions: Settlement of debt at less than its carrying amount. Continuation of debt with a modification of terms. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Settlement of Debt Involve either a: Transfer of noncash assets (real estate, receivables, or other assets) or Issuance of the debtor’s stock. Creditor should account for noncash assets or equity interest received at their fair value. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring EG-1 (Settlement of Debt) Larisa Nieland Company owes $200,000 plus $18,000 of accrued interest to First State Bank. The debt is a 10-year, 10% note. During 2008, Larisa Nieland’s business deteriorated due to a faltering regional economy. On December 31, 2008, First State Bank agrees to accept an old machine and cancel the entire debt. The machine has a cost of $390,000, accumulated depreciation of $221,000, and a fair market value of $190,000. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring EG-1 Prepare journal entries for Larisa Nieland Company and First State Bank to record this debt settlement. Larisa Nieland Company (Debtor): Notes Payable 200,000 Interest Payable 18,000 Accumulated Depreciation 221,000 Machine 390,000 Gain on Disposition of Machine 21,000 Gain on Debt Restructuring 28,000 a b a $190,000 – ($390,000 – $221,000) = $21,000. b ($200,000 + $18,000) – $190,000 = $28,000. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring EG-1 Prepare journal entries for Larisa Nieland Company and First State Bank to record this debt settlement. First State Bank (Creditor): Machine 190,000 Allowance for Doubtful Accounts 28,000 Notes Receivable 200,000 Interest Receivable 18,000 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring EG-1 Assume instead that Larisa Nieland decides to grant 15,000 shares of its common stock ($10 par) which has a fair value of $190,000 in full settlement of the loan obligation. If First State Bank treats Larisa Nieland’s stock as a trading investment, prepare the entries to record the transaction for both parties. Larisa Nieland Company (Debtor): Notes Payable 200,000 Interest Payable 18,000 Common Stock 150,000 Additional Paid-in Capital 40,000 Gain on Debt Restructuring 28,000 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring EG-1 Assume instead that Larisa Nieland decides to grant 15,000 shares of its common stock ($10 par) which has a fair value of $190,000 in full settlement of the loan obligation. If First State Bank treats Larisa Nieland’s stock as a trading investment, prepare the entries to record the transaction for both parties. First State Bank (Creditor): Investment (Trading) 190,000 Allowance for Doubtful Accounts 28,000 Notes Receivable 200,000 Interest Receivable 18,000 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Modification of Terms Reduction of the interest rate. Extension of maturity date of the face amount of debt. Reduction of the face amount of the debt. Reduction or deferral of any accrued interest. Two examples demonstrate troubled-debt restructuring by debtors and creditors: No gain for debtor. Gain for debtor. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Debtor No Gain Troubled-Debt Restructuring EG-2 (Term Modification without Gain — Debtor’s Entries) On December 31, 2008, Firstar Bank enters into a debt restructuring agreement with Nicole Bradtke Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications. Reduce principal obligation from $2,000,000 to $1,600,000. Extend the maturity date from December 31, 2008, to December 31, 2011. Reduce the interest rate from 12% to 10%. Bradtke pays interest at the end of each year. On January 1, 2012, Bradtke Company pays $1,600,000 in cash to Firstar. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Debtor No Gain Troubled-Debt Restructuring EG-2 Can Bradtke Company record a gain under the term modification mentioned above? Explain. No. Total future cash flows after restructuring exceed total pre-restructuring carrying amount of the note (principal): Total future cash flows after restructuring: Principal $1,600,000 Interest ($1,600,000 X 10% X 3) 480,000 $2,080,000 Total pre-restructuring carrying amount of note (principal): $2,000,000 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Debtor No Gain Troubled-Debt Restructuring EG-2 Assuming the interest rate Bradtke should use to compute interest expense is 1.4276%, prepare the interest payment schedule of the note after the debt restructuring. a. $1,600,000 x 10% = $160,000. b. $2,000,000 x 1.4276% = $28,552. c. $160,000–$28,552 = $131,448. d. Adjusts $1 due to rounding.

Troubled-Debt Restructuring Debtor No Gain Troubled-Debt Restructuring EG-2 Prepare the interest payment entry for Bradtke Company on December 31, 2010. Note Payable 133,325 Interest Expense 26,675 Cash 160,000 EG-2 What entry should Bradtke make on January 1, 2012? Note Payable 1,600,000 Cash 1,600,000 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Creditor No Gain Troubled-Debt Restructuring EG-3 (Term Modification without Gain — Creditor’s Entries) On December 31, 2008, Firstar Bank enters into a debt restructuring agreement with Nicole Bradtke Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications. Reduce principal obligation from $2,000,000 to $1,600,000. Extend the maturity date from December 31, 2008, to December 31, 2011. Reduce the interest rate from 12% to 10%. Bradtke pays interest at the end of each year. On January 1, 2012, Bradtke Company pays $1,600,000 in cash to Firstar. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Creditor No Gain Troubled-Debt Restructuring EG-3 Compute the loss that Firstar Bank will suffer from the debt restructuring. Prepare the journal entry to record the loss. Bad Debt Expense 476,859 Allowance for Doubtful Accounts 476,859 a$1,600,000 X .71178 = $1,138,848. b$160,000 X 2.40183 = $384,293. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Creditor No Gain Troubled-Debt Restructuring EG-3 Prepare the interest receipt schedule for Firstar Bank after the debt restructuring. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Creditor No Gain Troubled-Debt Restructuring EG-3 Prepare the interest receipt entry for Firstar Bank on December 31, 2010. Cash 160,000 Allowance for Doubtful Accounts 25,510 Interest Revenue 185,510 EG-3 What entry should Firstar make on Jan. 1, 2012? Cash 1,600,000 Allowance for Doubtful Accounts 400,000 Note Receivable 2,000,000 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Debtor Gain Troubled-Debt Restructuring EG-2 - Modified (Term Modification with Gain — Debtor’s Entries) On December 31, 2008, Firstar Bank enters into a debt restructuring agreement with Nicole Bradtke Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications. Reduce principal obligation from $2,000,000 to $1,300,000. Extend the maturity date from December 31, 2008, to December 31, 2011. Reduce the interest rate from 12% to 10%. Bradtke pays interest at the end of each year. On January 1, 2012, Bradtke Company pays $1,300,000 in cash to Firstar. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Debtor Gain Troubled-Debt Restructuring EG-2 – Modified Can Bradtke Company record a gain under the term modification mentioned above? If yes, record the gain. Total future cash flows after restructuring: Principal $1,300,000 Interest ($1,300,000 X 10% X 3) 390,000 $1,690,000 Total pre-restructuring carrying amount of note (principal): $2,000,000 Gain = $2,000,000 – $1,690,000 = $310,000 Journal December 31, 2008: Note Payable 310,000 Gain on Debt Restructuring 310,000 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Debtor Gain Troubled-Debt Restructuring EG-2 - Modified Prepare the interest payment schedule of the note for Bradtke after the debt restructuring. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Debtor Gain Troubled-Debt Restructuring EG-2 - Modified Prepare the interest payment entry for Bradtke Company on December 31, 2009, 2010, and 2011. Note Payable 130,000 Cash 130,000 EG-2 What entry should Bradtke make on January 1, 2012? Note Payable 1,300,000 Cash 1,300,000 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Creditor Gain Troubled-Debt Restructuring EG-3 - Modified (Term Modification with Gain — Creditor’s Entries) On December 31, 2008, Firstar Bank enters into a debt restructuring agreement with Nicole Bradtke Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications. Reduce principal obligation from $2,000,000 to $1,300,000. Extend the maturity date from December 31, 2008, to December 31, 2011. Reduce the interest rate from 12% to 10%. Bradtke pays interest at the end of each year. On January 1, 2012, Bradtke Company pays $1,300,000 in cash to Firstar. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Creditor Gain Troubled-Debt Restructuring EG-3 - Modified Compute the loss that Firstar Bank will suffer from the debt restructuring. Prepare the journal entry to record the loss on Firstar’s books. Bad Debt Expense 762,448 Allowance for Doubtful Accounts 762,448 a$1,300,000 X .71178 = $925,314 b$130,000 X 2.40183 = $312,238 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Creditor Gain Troubled-Debt Restructuring EG-3 - Modified Prepare the interest receipt schedule for Firstar Bank after the debt restructuring. O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Creditor Gain Troubled-Debt Restructuring EG-3 - Modified Prepare the interest receipt entry for Firstar Bank on December 31, 2009, 2010, and 2011. 2009 Cash 130,000 Allowance for Doubtful Accounts 18,506 Interest Revenue 148,506 2010 Cash 130,000 Allowance for Doubtful Accounts 20,727 Interest Revenue 150,727 2011 Cash 130,000 Allowance for Doubtful Accounts 23,215 Interest Revenue 153,215 O 2 Describe the accounting for debt restructuring.

Troubled-Debt Restructuring Creditor Gain Troubled-Debt Restructuring EG-3 - Modified What entry should Firstar make on Jan. 1, 2012? Cash 1,300,000 Allowance for Doubtful Accounts 700,000 Notes Receivable 2,000,000 O 2 Describe the accounting for debt restructuring.

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