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

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

4. 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.

5. 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.

6. 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 ) on December 31, 2008.
Illustration G-2
O 1 Describe the accounting for a loan impairment.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

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

22. 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.

23. 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.

24. 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 = $1,138, b$160,000 X = $384,293.
O 2 Describe the accounting for debt restructuring.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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 = $925,314 b$130,000 X = $312,238
O 2 Describe the accounting for debt restructuring.

33. 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.

34. 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.

35. 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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