Intermediate Accounting,17E
Debt Financing (Part Two)
ACC 202 A/B
OBJECTIVE 5
Understand the effective interest
method in calculation of the
amortized cost for bonds
12-2
Effective-Interest Method
Interest accrues on an outstanding debt at a
constant percentage of the debt each period.
Interest each period is recorded as the effective
market rate of interest multiplied by the outstanding
balance of the debt (during the interest period).
12-3
Effective-Interest Method
Consider once again the $100,000, 8%, 10year bonds sold for $87,539, based on an
effective interest rate of 10%.
Bond balance (carrying value) at beginning of year
Effective rate per semiannual period
Stated rate per semiannual period
Interest amount based on carrying value and effective
rate ($87,538 × 0.05)
Interest payment based on face value and stated
rate ($100,00 × 0.040)
Discount amortization
$87,538
5%
4%
$ 4,377
4,000
$ 377
12-4
Effective-Interest Method
Issuer’s Books
July 1 Interest Expense
Discount on Bonds Payable
Cash
4,377
377
4,000
Investor’s Books
July 1 Cash
Bond Investment
Interest Revenue
4,000
377
4,377
12-5
12-6
Effective-Interest Method
Assume the $100,000, 8%, 10-year bonds is
sold for $107,106, based on an effective
interest rate of 7%.
Bond balance (carrying value) at beginning of first period $107,106
Effective rate per semiannual period
3.5%
Stated rate per semiannual period
4%
Interest payment based on face value and stated
rate ($100,00 × 0.040)
4,000
Interest amount based on carrying value and effective
rate ($107,106 × .035)
3,749
Premium amortization
$
251
12-7
Effective-Interest Method
Interest is recorded as expense to the issuer and revenue to the investor. For
the first six-month interest period the amount is calculated as follows:
$107,106
Outstanding Balance
×
(7% ÷ 2)
Effective Rate
=
$3,749
Effective Interest
12-8
Effective-Interest Method
First Interest payment
Issuer’s Books
July
1 Interest Expense
Premium on Bonds Payable
Cash
3,749
251
4,000
Investor’s Books
July
1 Cash
Bond Investment
Interest Revenue
4,000
251
3,749
12-9
Effective-Interest Method
The bond indenture calls for semiannual interest
payments of only $4,000 – the stated rate (4%)
times the face value of $100,000.
The
difference (e.g. $251 for interest payment 1)
decreases the liability for the Issuer and the
investment balance for the Investor.
12-10
When Financial Statements Are Prepared
Between Interest Dates
On 1/1/09, Masterwear Industries issues $700,000 face value
bonds to United Intergroup. The market interest rate is 14%.
The bonds have the following terms:
Face Value of Each Bond = $1,000
Maturity Date = 12/31/11 (3 years)
Stated Interest Rate = 12%
Interest Dates = 6/30 & 12/31
Bond Date = 1/1/09
Present value (price) of the bond = 666,633 (Part One Slide 12-22)
Assume Masterwear and United both have September
30th year-ends and effective interest method is used.
12-11
When Financial Statements Are Prepared
Between Interest Dates
Masterwear - Issuer
Date Description
Jun. 30 Interest expense
Discount on bonds payable
Cash
Debit
46,664
Credit
4,664
42,000
7% × $666,633
6% × $700,000
United - Investor
Date Description
Jun. 30 Cash
Discount on bond investment
Interest revenue
Debit
42,000
4,664
Left click on the button to go to Slide 12-22 (Part One).
Credit
46,664
12-12
When Financial Statements Are Prepared
Between Interest Dates
The bond indenture calls for semiannual interest payments of
only $42,000 – the stated rate (6%) times the face value of
$700,000. The difference ($4,664) increases the liability and is
reflected as a reduction in the discount (a valuation account).
12-13
Amortization Schedule - Discount
Date
01/01/09
06/30/09
12/31/09
06/30/10
12/31/10
06/30/11
12/31/11
Cash
Interest
(6% × Face
Amount)
Effective
Interest
(7% × Outstanding
Balance)
42,000 .07 × 666,633 = 46,664
42,000
42,000
7% × $666,633
42,000
42,000
42,000
6% × $700,000
252,000
Increase in
Balance
(Discount
Reduction)
4,664
Outstanding
Balance
666,633
671,297
$46,664 – 42,000
$666,633 + 4,664
12-14
Amortization Schedule - Discount
Date
01/01/09
06/30/09
12/31/09
06/30/10
12/31/10
06/30/11
12/31/11
Cash
Interest
(6% × Face
Amount)
42,000
42,000
42,000
42,000
42,000
42,000
252,000
Effective
Interest
(7% × Outstanding
Balance)
.07 ×
.07 ×
.07 ×
.07 ×
.07 ×
.07 ×
666,633 =
671,633 =
676,288 =
681,628 =
687,342 =
693,456 =
Increase in
Balance
(Discount
Reduction)
46,664
46,991
47,340
47,714
48,114
48,544
4,664
4,991
5,340
5,714
6,114
6,544
285,367
33,367
Outstanding
Balance
666,633
671,297
676,288
681,628
687,342
693,456
700,000
$48,544 is rounded to cause outstanding
balance to be exactly $700,000 on 12/31/11.
12-15
When Financial Statements Are Prepared
Between Interest Dates
Year-end is on September 30, 2009, before the second interest
date of December 31, so we must accrue interest for 3 months
from June 30 to September 30.
Masterwear - Issuer
Date Description
Sep. 30 Interest expense ($46,991 × 1/2)
Discount on bonds payable
Interest payable ($42,000 × 1/2)
Debit
23,496
Credit
2,496
21,000
United - Investor
Date Description
Sep. 30 Interest receivable
Discount on bond investment
Interest revenue
Debit
21,000
2,496
Credit
23,496 12-16
OBJECTIVE 6
Understand the accounting
treatment for extinguishment of
debt
12-17
Extinguishment of Debt
Prior to Maturity
Debt retired at maturity results
in no gains or losses.
BUT
Debt retired before maturity may result in an
gain or loss on extinguishment.
Cash Proceeds – Book Value = Gain or Loss
12-18
Extinguishment of Debt
Prior to Maturity
•
Bonds may be redeemed by the issuer by
purchasing the bonds on the open market or by
exercising the call provision (if available).
A call provision gives the issuer the option of
retiring bonds prior to maturity.
The inclusion of call provisions in a bond
agreement is a feature favoring the issuer. The
company is in a position to terminate the bond
agreement and eliminate future interest charges
whenever its financial position make such action
feasible.
12-19
Extinguishment of Debt
Prior to Maturity
•
Bonds may be converted,
exchanged for other securities.
that
is,
•
Bonds may be refinanced by using the
proceeds from the sale of a new bond
issue to retire outstanding bonds.
12-20
Redemption by Purchase of
Bonds in the Market
Trident, Inc.’s $100,000, 8% bonds are not held
to maturity. They are redeemed on February 1,
2011, at 97,000. The carrying value of the
bonds is $97,700 as of this date. Interest
payment
datesvalue
are ofJanuary
31 and July $97,700
31.
Carrying
bonds, 2/1/11
Redemption price
Books
Gain on bondIssuer’s
redemption
Feb. 1 Bonds Payable
100,000
Discount on Bonds Payable
Cash
Gain on Bond Redemption
(continues)
97,000
$ 700
2,300
97,000
700
12-21
Redemption by Purchase of
Bonds in the Market
Investor’s Books
Feb. 1 Cash
Loss on Sale of Bonds
Bond Investment—
Trident Inc.
97,000
700
97,700
12-22
Redemption by Exercise
of Call Provision
On July 1, 2002, Ball Corporation issued for
US$900,000, 1,000 (Bond quantities) of its 9%,
US$1,000 callable bonds. The bonds are dated
July 1, 2002, and mature on July 1, 2012.
Interest is payable semiannually on January 1
and July 1. Bell uses the straight-line method
of amortizing bond discount. The bonds can be
called by the issuer at 102% at any time after
June 30, 2007. On July 1, 2009, Ball called in
all of the bonds and retired them.
12-23
Redemption by Exercise
of Call Provision
What is the amount of loss which Ball should report
on this early extinguishment of debt for the year
ended December 31, 2008?
• The bonds payable ($1,000 x 1,000 = $1,000,000)
were issued at a discount of $100,000 [($1,000 x
1,000) - $900,000] on 7/1/01.
• The bonds are called at 102%, 7 years later on
7/1/09. Since the bonds were due in 10 years,
7/10 of the discount (7/10 x $100,000 or $70,000)
would have been amortized by 7/1/08.
12-24
Redemption by Exercise
of Call Provision
• Therefore, the balance in the bond discount
account is $30,000 ($100,000 - $70,000), and the
carrying amount of the debt is $970,000
($1,000,000 - $30,000).
• The loss on the retirement is the difference
between the $1,020,000 x 1.02) and the $970,000
carrying amount, or $50,000.
12-25
Bond Refinancing
• Cash for the retirement of a bond issue is
frequently raised through the “sale of a
new issue” and is referred to as bond
refinancing.
• When refinancing before the maturity
date of the old issue, the Opinions of the
Accounting Principles Board (“APB”)
selected the immediate recognition of a
gain or loss for all early extinguishment
of debt.
12-26
OBJECTIVE 7
Understand the accounting
treatment for convertible bonds
12-27
Convertible Bonds
Some bonds may be converted into common
stock at the option of the holder. When bonds
are converted the issuer updates interest
expense and amortization of discount or
premium to the date of conversion. The
bonds are reduced and shares of common
stock are increased.
Bonds into Stock
12-28
Convertible Bonds
• Convertible debt securities usually
have the following features:
1. An interest rate lower than the issuer
could establish for nonconvertible debt
2. An initial conversion price higher than
the market value of the common stock
at time of issuance
3. A call option retained by the issuer
• Convertible debt gives both the issuer
and the holder advantages.
12-29
Convertible Bonds –
Advantages to an issuer
• An issuer is able to obtain financing at a lower
interest rate because of the value of the conversion
feature to the holder.
• Because of the call provision, an issuer is in a
position to exert influence on the holders to
exchange the debt for equity securities if stock
values increase.
• The issuer has had the use of relatively low
interest rate financing if stock values do not
increase.
12-30
Convertible Bonds –
Advantages to an issuer
• The holder has a debt instrument that, barring
default, ensures the return of investment plus a
fixed return and, at the same times, offers an
option to transfer his or her interest to equity
capital should such transfer become attractive.
12-31
Convertible Bonds – Induced
Conversion
Companies
sometimes
try to
induce
conversion of their bonds into stock. One way
to induce conversion is through a “call”
provision. When the specified call price is less
than the conversion value of the bonds (the
market value of the shares), calling the
convertible bonds provides bondholders with
incentive to convert. Bondholders will choose
the shares rather than the lower call price.
12-32
Accounting for convertible debt issuance
when the conversion feature is nondetachable
• Differences of opinion exist as to whether
convertible debt securities should be treated by an
issuer solely as debt or whether part of the
proceeds received from the issuance of debt should
be recognized as equity capital.
• One view holds that the debt and the conversion
privilege
are inseparately
connected,
and,
therefore, the debt and equity portions of a
security should not be separately valued. A holder
cannot sell part of the instrument and retain the
other.
12-33
Accounting for convertible debt issuance
when the conversion feature is nondetachable
• An alternative view holds that there are two
distinct elements in these securities and that each
should be recognized in the accounts:
• The portion of the issuance price attributable to
the conversion privilege should be recorded as a
credit to Paid-In Capital;
• The balance of the issuance price should be
assigned to the debt.
12-34
Accounting for convertible debt issuance
when the conversion feature is nondetachable
Assume that 500 ten-year bonds, face value $1,000, are
sold at 105, or a total issue price of $525,000 (500 x
$1,000 x 1.05). The bonds contain a conversion
privilege that provides for exchange of a $1,000 bond
for 20 shares of stock, par value $1.
The interest rate on the bonds is 8%. It is estimated
that without the conversion privilege, the bonds would
sell at 96%.
Assume that a separate value of the conversion feature
cannot be determined. The journal entries to record the
issuance on the issuer’s books under the two
approaches are as follows:
12-35
Convertible Bonds
Convertible Bonds
Issued with Conversion Feature Nondetachable
and Debt and Equity Not Separated
Cash
Bonds Payable
Premium on Bonds Payable
525,000
500,000
25,000
12-36
Convertible Bonds
Issued with Conversion Feature Nondetachable
and Debt and Equity Separated
Cash
Discount on Bonds Payable
Bonds Payable
Paid-In Capital Arising from Bond
Conversion Feature
525,000
20,000
500,000
45,000
Par value of bonds (500 × $1,000)
$500,000
Selling price of bonds without
conversion feature ($500,000 x 0.96) 480,000
Discount on bonds w/o conversion
$ 20,000
12-37
Convertible Bonds
Issued with Conversion Feature Nondetachable
and Debt and Equity Separated
Cash
Discount on Bonds Payable
Bonds Payable
Paid-In Capital Arising from Bond
Conversion Feature
525,000
20,000
500,000
45,000
Total cash received on sale of bonds $525,000
Selling price of bonds without
conversion feature ($500,000 × 0.96) 480,000
Amount applicable to conversion
$ 45,000
12-38
Accounting for Conversion
When conversion takes place, a special valuation
question must be answered: Should the market
value of the securities be used to compute a gain or
loss on the transaction?
Two approaches are possible to account for bond
conversions: valuing the transaction at cost (book
value of the bonds), or valuing at market (of the
stocks or bonds, whichever is more reliable).
12-39
Accounting for Conversion
(Book Value or Carrying Amount Method)
William, Inc. had outstanding 10%, $1,500,000 face
amount convertible bonds maturing on December 31,
2012, on which interest is paid December 31 and June
30. After amortization through June 30, 2008, the
unamortized balance in the bond premium account
was $45,000. On that date, bonds with a face amount
of $750,000 were converted into 30,000 shares of $20
par common stock.
William incurred expenses of
$15,000 in connection with the conversion.
Compute the additional paid-in capital (“APIC”) which
William should credit in it’s books (Record the conversion
by the book value method).
12-40
Accounting for Conversion
(Book Value or Carrying Amount Method)
Under the book value method, the common stock is
recorded at the carrying amount of the converted bonds
less any conversion expenses. No gain or loss recognized.
$750,000 of the $1,500,000 of bonds are converted.
The premium relating to these bonds is 750/1,500 of
$45,000, or $22,500.
Therefore, the carrying amount of the converted bonds
is $772,500 ($750,000 + $22,500).
The common stock must be recorded at this amount
less the conversion expenses ($15,000), or $757,500.
12-41
Accounting for Conversion
(Book Value or Carrying Amount Method)
Issuer’s Books
Since the par value of the stock issued is $600,000
(30,000 x $20), AIPC is credited for $157,500
($757,500 - $600,000). The journal entry is
Dr. Bond payable
$750,000
Dr. Premium on Bond Payable
$22,500
Cr. Common stock
$600,000
Cr. APIC
$157,500
Cr. Cash
$15,000
12-42
Accounting for Conversion
(Market Value Method)
On September 1, 2008, after interest and
amortization had been recorded, OK Co. converted
$1,100,000 of its 10% convertible bonds into 55,000
shares of $5.5 par common stock. The carrying
amount of the bonds on the date of conversion was
$1,320,000, and the market value of OK’s common
stock was $27.5 per share.
Under the market value method, what amount should
OK record as a credit to additional paid-in capital?
12-43
Accounting for Conversion
(Market Value Method)
Under the market value method, a conversion of bonds
to common stock is recorded at the market value of
either the stock or the bonds, whichever is more reliable.
In this case, the market value of OK’s stock is given.
The common stock account is credited for the par value
of the stock (55,000 x $5.5 = $302,500) and APIC is
increased by market value minus par [55,000 x
($27.5 – $5.5) = $1,210,000].
Bonds payable and any related accounts are removed
from the books.
12-44
Accounting for Conversion
(Market Value Method)
Issuer’s Books
OK sustained a loss on this redemption of $192,500, as
shown in the entry recording the conversion.
Dr. Loss on redemption
Dr. Bond Payable
$192,500
$1,100,000
Dr. Premium on Bond Payable
$220,000
Cr. Common stock
$302,500
Cr. APIC
$1,210,000
$1,320,000 - $1,100,000
12-45
Accounting for Conversion
(Market Value Method)
Investor’s Books
Dr. Investment in OK Co
Common stock
$1,512,500
Cr. Bond Investment
(55,000 x $27.5)
Cr. Gain on conversion
$1,320,000
$192,500
($1,100,000 + $220,000)
12-46
OBJECTIVE 8
Discuss the use of the fair value
option for financial assets and
liabilities.
12-47
Fair Value Option
In 2007, with SFAS No. 159 (“The Fair Value Option
for Financial Assets and Financial Liabilities”), the
FASB took a bold step toward increased use of fair
value by allowing companies a fair value option for
the reporting of financial assets and liabilities.
 Fair value is defined as the “the price that would be
received to sell an asset or paid to transfer a liability
in an orderly transaction between market
participants.
12-48
Fair Value Option
Orderly transaction
A sale or transfer by the reporting entity that holds an asset or
owes a liability that:
• Is not a forced liquidation or distress sale;
• Assumes exposure of the asset or liability to the market
for a period prior to the measurement date to facilitate
marketing activities that are usual and customary for
transactions involving such assets or liabilities.
12-49
Fair Value Option
• Under the provisions of SFAS No. 159, a company has
the option to report, at each balance sheet date, any or
all of its financial assets and liabilities at their fair
values on the balance sheet date.
• This is a very interesting accounting rule because a
company can choose to report some financial assets
and liabilities of a certain type at fair value while at the
same time continuing to use another basis, such as
historical cost, for other financial assets and liabilities
of exactly the same type.
12-50
Fair Value Option
If a company chooses the option to report at fair value,
then it reports changes in fair value in its income
statement.
A company must make the election when the item
originates and is not allowed to switch methods once a
method is chosen.
12-51
Fair Value Option - Example
On July 1, HSA, Inc. issued $200,000 face value, 8% bonds, priced
at $180,000 to yield an effective rate of 10% . HSA chose the fair
value option for the bonds. Six months later, on December 31, HSA
recorded the following interest entry:
Date Description
Dec. 31 Interest expense ($180,000 × 5% )
Discount on bonds payable
Cash ($200,000 × 4% )
Debit
9,000
Credit
1,000
8,000
The December 31 entry reduced the unamortized discount to $19,000
and increased the book value of the liability by $1,000 to $181,000.
Bonds payable
Less: Unamortized discount
Book value
$ 200,000
(19,000)
$ 181,000
12-52
Fair Value Option - Example
On December 31, the fair value of the bonds was $183,000.
Bonds payable
Less: Unamortized discount
Book value
Fair value of bonds
Fair value adjustment needed
$ 200,000
(19,000)
181,000
183,000
2,000
Rather than increasing the bonds payable account itself, we increase
it indirectly with a valuation allowance (or contra) account:
Date Description
Dec. 31 Unrealized holding loss
Fair value adjustment
Debit
2,000
Credit
2,000
The $2,000 credit to fair value adjustment will increase the bond credit
balance to $183,000. HSA must recognize the unrealized holding loss
in the income statement.
12-53
OBJECTIVE 9
Understand the conditions under
which troubled debt restructuring
occurs, and be able to account
for troubled debt restructuring.
12-54
Troubled Debt Restructuring
Debt restructuring is a process that allows a private or
public company – or a sovereign entity – facing cash
flow problems and financial distress, to reduce and
renegotiate its delinquent debts in order to improve or
restore liquidity and rehabilitate so that it can continue
its operations.
In Statement No. 15, the FASB defined troubled debt
restructuring as a situation in which “the 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.
12-55
Troubled Debt Restructuring
Troubled debt may be
restructured in one of two ways:
Settled at time
of restructuring.
Continued with
modified terms.
12-56
Accounting for Troubled
Debt Restructuring
12-57
Troubled Debt Restructuring Appendix
Settled at time of restructuring.
Book value of the debt
– Fair value of asset transferred
Gain on restructuring
Debtor reports ordinary gain or loss on
adjustment to fair value of the asset transferred. Thus, a twostep process is used: (1) revalue the noncash asset to fair
market value and (2) determine the restructuring gain.
12-58
Transfer of Assets in Full
Settlement (Asset Swap)
A debtor that transfers assets, such as
real estate or inventories, to a creditor to
fully settle a payable will recognize two
types of gains or losses:
1. A gain or loss on disposal of the asset
2. A gain or loss arising from the
concession granted in the restructuring
of the debt
(continues)
12-59
Transfer of Assets in Full
Settlement (Asset Swap)
The computation of these gains and/or
losses is made as follows:
Carrying value of assets
being transferred
Market value of asset
being transferred
Carrying value of debt
being liquidated
Difference represents
gain or loss on disposal
Difference represents
gain on restructuring
(continues)
12-60
Transfer of Assets in Full
Settlement (Asset Swap)
An investor always recognizes a loss on
the restructuring due to concessions
granted.
Carrying value of
investment liquidated
Market value of asset
being transferred
Difference represents loss
on restructuring
12-61
Transfer of Assets in Full
Settlement (Asset Swap)
Acer Corp. entered into a troubled debt
restructuring agreement with National Bank.
National agreed to accept land with a carrying
amount of $75,000 and a fair value of $100,000 in
exchange for a note with a carrying amount of
$150,000.
Disregarding income taxes, what amount should
Acer report as a gain on restructuring the debt?
12-62
Transfer of Assets in Full
Settlement (Asset Swap)
$150,000 (Carrying amount of the Note)
- ($100,000) (Fair market value of land)
$50,000 (Gain on restructuring the debt)
Dr. Note payable
$150,000
Cr. Land
Cr. Gain on restructuring the debt
$100,000
$50,000
12-63
Transfer of Assets in Full
Settlement (Asset Swap)
Assume that Stanley Industries is behind in its
interest payments on outstanding bonds of $500,000
and is threatened with bankruptcy proceedings.
The carrying value of the bonds on Stanley’s books is
$545,000 after deducting the unamortizd discount of
$5,000 and adding unpaid interest of $50,000.
To settle the debt, Stanley transfers long-term
investments it holds in Worth common stock with a
carrying value of $350,000 and a current market
value of $400,000 to all investors on a pro rata basis.
12-64
Asset Swap Example
Assume Realty, Inc. holds $40,000 face
value of Stanley’s bonds. Because of the
troubled financial condition of Stanley
Industries, Realty Inc. has previously
recognized as a loss a $5,000 decline in the
value of the debt and is carrying the
investment of $35,000 on its books plus
interest receivable of $4,000. The entries for
Stanley and Realty are on Slides 12-66 and
12-67.
(continues)
12-65
Asset Swap Example
Stanley Industries (Issuer)
Interest Payable
50,000
Bonds Payable
500,000
Discount on Bonds Payable
5,000
Long-Term Investment—Worth Common
Stock
350,000
Gain on Disposal of Worth Common
Stock
50,000
Gain on Restructuring of Debt
145,000
Carrying value of Worth common
$350,000
Market value of Worth common
$400,000
Carrying value of debt liquidated
$545,000
(continues)
$50,000 gain on disposal
$145,000 gain from
restructuring
12-66
Asset Swap Example
Realty Inc. (Investor)
Long-Term Investments—Worth
Common Stock
32,000
Loss on Restructuring of Debt
7,000
Bond Investments—Stanley Industries
Interest Receivable
35,000
4,000
Percentage of debt held by Realty Inc.: $40,000/$500,000 = 8%
Market value of long-term investment received in settlement of debt:
0.08 × $400,000 = $32,000
12-67
Grant of Equity Interest
(Equity Swap)
Stanley Industries transfers 20,000
shares of common stock to satisfy the
$500,000 face value of the bonds. The
par value of the common stock is $1,
and the market value at the date of
the restructuring is $20 per share.
Entries for both parties are shown on
Slides 12-69 and 12-70.
(continues)
12-68
Grant of Equity Interest
(Equity Swap)
Stanley Industries (Issuer)
Interest Payable
20,000 x ($20 - $1)
Bonds Payable
Discount on Bonds Payable
Common Stock
Paid-In Capital in Excess of Par
Gain on Restructuring the Debt
Market value of Worth common
$400,000
Carrying value of debt liquidated
$545,000
50,000
500,000
5,000
20,000
380,000
145,000
$145,000 gain from
restructuring
(continues)
12-69
Grant of Equity Interest
(Equity Swap)
Realty Inc. (Investor)
Long-Term Investments—Stanley
Common Stock
32,000
Loss on Restructuring of Debt
7,000
Bond Investments—Stanley Industries
Interest Receivable
35,000
4,000
Percentage of debt held by Realty Inc.: $40,000/$500,000 = 8%
Market value of long-term investment received in settlement of debt:
0.08 × $400,000 = $32,000
12-70
Troubled Debt Restructuring
Continued with modified terms.
Reduce or delay
interest payments.
Reduce or delay
maturity payment.
Accounting treatment depends on a comparison
of total cash payments after restructuring with
the book value of the original debt.
12-71
Troubled Debt Restructuring
Continued with modified terms.
The sum of the future payments
(undiscounted) less than
book value of debt.
Debtor reports difference as a gain.
All cash payments are reductions in
principal. (No interest expense in
subsequent periods)
New carrying value of the loan equals
the undiscounted future payments.
The sum of the future
payments (undiscounted)
exceeds
book value of debt.
No gain reported.
Compute new “implicit” interest rate.
Record annual interest at new
“implicit” interest rate.
12-72
Troubled Debt Restructuring
Future payments (undiscounted) excess the book value of debt
Assume the interest rate on the Stanley
Industries bonds is reduced from 10% to
7%, the maturity date is extended from
three to five years from the restructuring
date, and the past interest due of $50,000
is forgiven. The total future payments to be
made after this restructuring are as follows:
12-73
Troubled Debt Restructuring
Future payments (undiscounted) excess the book value of debt
Maturity value of bonds
Interest – 0.07 x $500,000 x 5 years
Total payments to be made after restructuring
$500,000
175,000
$675,000
Because the $675,000 exceeds the carrying
value of $545,000 [($500,000 - $5,000) +
$50,000], no gain is recognized on the books of
Stanley Industries at the time of restructuring.
12-74
Troubled Debt Restructuring
Future payments (undiscounted) excess the book value of debt
If the total future payments are greater than
the carrying amount of the debt (principal plus
unpaid interest), the excess is recognized as
future interest expense using a newly
computed implicit interest rate. The total
carrying value of the restructured debt is not
changed and no gain is recognized.
12-75
Troubled Debt Restructuring
Future payments (undiscounted) excess the book value of debt
To illustrate the computation of an implicit
interest rate, the initial restructuring of Stanley
Industries described above will be used. The
question to be answered is what rate of interest
will equate the total future payments of
$675,000 to the present carrying value of
$545,000. Interest is paid and compounded
semiannually.
12-76
Troubled Debt Restructuring
Future payments (undiscounted) excess the book value of debt
Business Calculator Keystrokes
PV = -$545,000 (this is the carrying value of the loan, enter as
a negative number)
PMT = $17,500 ($500,000 x 0.07 x 6/12)
FV = $500,000 (amount to be paid in a lump sum at the loan
maturity date)
N = 10 (the total loan term is 5 years; interest payments are
semiannual)
I = ???
The solution returned by the calculator is 2.47% for each 6month period.
12-77
Troubled Debt Restructuring
Future payments (undiscounted) excess the book value of debt
Using this rate, the recorded interest expense for the first
six months would be $13,462, or 2.47% of $545,000.
Because the actual cash payment for interest is $17,500,
the carrying value of the debt will decline by $4,038
($17,500 - $13,462).
The interest expense for the second semiannual period will
be less than for the first period because of the decrease in
the carrying value of the debt [($545,000 - $4,038) x 0.0247
= $13,362 interest expense].
These computations are the same as those required in
applying
the
effective-interest
method
amortization
described earlier.
12-78
Troubled Debt Restructuring
Future payments (undiscounted) excess the book value of debt
The entries to record the restructuring on Stanley’s books
and the first two interest payments would be as follows:
Bond Payable……………………………….$500,000
Interest Payable………………………………$50,000
Discount on Bonds Payable…………………………....$5,000
Restructuring Debt…………………………………….$545,000
12-79
Troubled Debt Restructuring
Future payments (undiscounted) excess the book value of debt
The entries to record the restructuring on Stanley’s books
and the first two interest payments would be as follows:
Interest Expense……………………………$13,462
Restructured Debt……………………………$4,038
Cash……………………………………………………$17,500
Interest Expense……………………………$13,362
Restructured Debt………………………..….$4,138
Cash……………………………………………………$17,500
12-80
Troubled Debt Restructuring
Future payments (undiscounted) is less than the book value of debt
However, if, in addition to the preceding
changes, $200,000 of maturity value is forgiven,
the future payments would be reduced as
follows:
Maturity value of bonds ($500,000 - $200,000)
Interest – 0.07 x $300,000 x 5 years
Total payments to be made after restructuring
$300,000
105,000
$405,000
12-81
Troubled Debt Restructuring
Future payments (undiscounted) is less than the book value of debt
Now the carrying value exceeds the future payments by
$140,000 ($545,000 – $405,000), and this gain would
be recognize by Stanley as follows:
Interest Payable………………………….$50,000
Bonds Payable………………….………$500,000
Discount on Bonds Payable………………………..$5,000
Restructured Debt………………………………..$405,000
Gain on Restructuring of Debt…………………..$140,000
12-82
Troubled Debt Restructuring
Future payments (undiscounted) is less than the book value of debt
In this case, the carrying value must be reduced
to the cash to be realized and a gain recognized
for the difference. All interest payments in the
future are offset directly to the debt account. No
interest expense will be recognized in the future
because of the extreme concessions made in the
restructuring.
12-83
Chapter 12
The End
12-84