Appendix
G-1
Warfield
Wyegandt
Kieso
APPENDIX F
ACCOUNTING FOR TROUBLED
DEBT
INTERMEDIATE ACCOUNTING
Principles and Analysis
2nd Edition
Appendix
G-2
Troubled Debt
Two situations result with troubled debt:
1. Impairments.
2. Restructurings:
a. Settlements.
b. Modification of terms
Appendix
G-3
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).
Appendix
G-4
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.
Appendix
G-5
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
Appendix
G-6
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
Appendix
G-7
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
Appendix
G-8
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
Appendix
G-9
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
Appendix
G-10
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:
1. Settlement of debt at less than its carrying amount.
2. Continuation of debt with a modification of terms.
Appendix
G-11
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.
Appendix
G-12
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.
Appendix
G-13
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
Machine
221,000
390,000
Gain on Disposition of Machine
Gain on Debt Restructuring
21,000 a
28,000 b
a $190,000 – ($390,000 – $221,000) = $21,000.
b ($200,000 + $18,000) – $190,000 = $28,000.
Appendix
G-14
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
Notes Receivable
Interest Receivable
Appendix
G-15
28,000
200,000
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
Appendix
G-16
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)
Allowance for Doubtful Accounts
Notes Receivable
Interest Receivable
Appendix
G-17
190,000
28,000
200,000
18,000
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Modification of Terms
1. Reduction of the interest rate.
2. Extension of maturity date of the face amount of debt.
3. Reduction of the face amount of the debt.
4. Reduction or deferral of any accrued interest.
Two examples demonstrate troubled-debt restructuring by
debtors and creditors:
1. No gain for debtor.
2. Gain for debtor.
Appendix
G-18
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Debtor
No Gain
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.
1. Reduce principal obligation from $2,000,000 to $1,600,000.
2. Extend the maturity date from December 31, 2008, to
December 31, 2011.
3. 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.
Appendix
G-19
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Debtor
No Gain
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):
Appendix
G-20
$2,000,000
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Debtor
No Gain
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.
Appendix
G-21
a. $1,600,000 x 10% = $160,000.
c. $160,000–$28,552 = $131,448.
b. $2,000,000 x 1.4276% = $28,552.
d. Adjusts $1 due to rounding.
Troubled-Debt Restructuring
Debtor
No Gain
EG-2 Prepare the interest payment entry for Bradtke
Company on December 31, 2010.
Note Payable
Interest Expense
133,325
26,675
Cash
EG-2
What entry should Bradtke make on January 1, 2012?
Note Payable
Cash
Appendix
G-22
160,000
1,600,000
1,600,000
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Creditor
No Gain
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.
1. Reduce principal obligation from $2,000,000 to $1,600,000.
2. Extend the maturity date from December 31, 2008, to
December 31, 2011.
3. 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.
Appendix
G-23
O 2 Describe the accounting for 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
a$1,600,000 X .71178 = $1,138,848.
Appendix
G-24
476,859
b$160,000 X 2.40183 = $384,293.
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Creditor
No Gain
EG-3 Prepare the interest receipt schedule for Firstar
Bank after the debt restructuring.
Appendix
G-25
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Creditor
No Gain
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
EG-3
185,510
What entry should Firstar make on Jan. 1, 2012?
Cash
1,600,000
Allowance for Doubtful Accounts 400,000
Note Receivable
Appendix
G-26
2,000,000
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Debtor
Gain
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.
1. Reduce principal obligation from $2,000,000 to $1,300,000.
2. Extend the maturity date from December 31, 2008, to
December 31, 2011.
3. 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.
Appendix
G-27
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Debtor
Gain
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
Interest ($1,300,000 X 10% X 3)
Total pre-restructuring carrying amount
of note (principal):
$1,300,000
390,000
$1,690,000
$2,000,000
Gain = $2,000,000 – $1,690,000 =
Journal December 31, 2008:
Note Payable
Gain on Debt Restructuring
Appendix
G-28
$310,000
310,000
310,000
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Debtor
Gain
EG-2 - Modified Prepare the interest payment schedule
of the note for Bradtke after the debt restructuring.
Appendix
G-29
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Debtor
Gain
EG-2 - Modified Prepare the interest payment entry for
Bradtke Company on December 31, 2009, 2010, and 2011.
Note Payable
130,000
Cash
EG-2
What entry should Bradtke make on January 1, 2012?
Note Payable
Cash
Appendix
G-30
130,000
1,300,000
1,300,000
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Creditor
Gain
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.
1. Reduce principal obligation from $2,000,000 to $1,300,000.
2. Extend the maturity date from December 31, 2008, to
December 31, 2011.
3. 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.
Appendix
G-31
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Creditor
Gain
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
Allowance for Doubtful Accounts
a$1,300,000 X .71178 = $925,314
Appendix
G-32
762,448
762,448
b$130,000 X 2.40183 = $312,238
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Creditor
Gain
EG-3 - Modified Prepare the interest receipt schedule
for Firstar Bank after the debt restructuring.
Appendix
G-33
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
Creditor
Gain
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
2010
Cash
148,506
130,000
Allowance for Doubtful Accounts
20,727
Interest Revenue
2011
Cash
130,000
Allowance for Doubtful Accounts
Appendix
G-34
150,727
Interest Revenue
23,215
153,215
O 2 Describe the accounting for debt restructuring.
Troubled-Debt Restructuring
EG-3 - Modified
1, 2012?
Creditor
Gain
What entry should Firstar make on Jan.
Cash
1,300,000
Allowance for Doubtful Accounts 700,000
Notes Receivable
Appendix
G-35
2,000,000
O 2 Describe the accounting for debt restructuring.
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Appendix
G-36