2. 1 Troubled Debt Restructuring n When the borrower is in severe financial difficulty, the creditor(s) may change the terms of debt agreement (i.e.,reduce the amount of principal or reduce the amount of interest payments or both.) rather than force the borrower to liquidate.

3. 2 Troubled Debt Restructuring (Contd.) n This new agreement is referred to as a trouble debt restructuring. n A trouble debt restructuring can be one of the following: 1.The debt is settled at the time of restructuring ; or 2.The debt is continued but with modified terms.

4. 3 Troubled Debt Restructuring (Contd.) A. Debt is Settled: n The debtor’s gain = the carry amount of the debt - the value of the asset(s) transferred to settle the debt. n This gain is reported as an “extraordinary item”as in the case of “early extinguishment of debt.”

5. 4 n Example 1: A bank holding a $50 million note agrees to accept a land valued at $40 million from R.J. company, which is in severe financial difficulty, as a settlement of the $50 million debt. Troubled Debt Restructuring (Contd.) A. Debt is Settled:

6. 5 n Assumed that the carrying amount of the land is $32 million. The following journal entries are recorded for this troubled debt restructuring: ($ in million) 1)Land (40million-32million)8 Gain on disposition of assets 8 (ordinary gain) 2)Note Payable50 Land(at fair value) 40 Gain on troubled debt restructuring 10 (extraordinary gain) Troubled Debt Restructuring (Contd.) A. Debt is Settled:

7. 6 n In this case of troubled debt restructuring, the bank allows the debt to continue but modifies the terms of debt agreement (i.e., reduce or delay the interest payments; reduce or delay the maturing amount or a combination of these concessions.) Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

8. 7 n Example 2: Assuming a 10% stated interest on the $50 million note in question and interests($50 million x 10% = 5 million) are payable in December of the two remaining years. In addition, R.J. failed to pay $5 million of interest for the year just ended. Therefore, the carrying amount of the debt is $55 million. Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

9. 8 n The accounting treatment for this type of trouble debt restructuring depends on the total amount of future cash payments. n Case I : Total future cash payments < The carrying amount of the debt Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

10. 9 n Accounting Treatment: a)Recognize a gain (extraordinary) equals the difference between the carrying amount of the debt and the total future cash payments and reduce the carrying amount of the debt to the total future cash payments. b)Assume that all interests have been eliminated; and c)All subsequent cash payments are payments for the debt itself. Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

11. 10 n Continued with Example 2, assuming that the bank agrees to the following terms: a)Eliminate the accrued interest of last year; b)Reduce the remaining two interest payments from $ 5 million each to $3 million each; and c)Reduce the maturity value from $50 million to $40 million. Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

12. 11 n Extraordinary Gain: Carrying Amount$55 million Future Cash Payments*$46 million Gain (extraordinary)$ 9 million * $3 million x 2+ 40 million = $46 million Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

13. 12 n J.E.($ in million) Interest Payable5 Note Payable**4 Gain on debt restructuring9 ** Balance of this debt = $50-4 = $46 million= Total future cash payments on this debt Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

14. 13 n J.E.At each of the two interest payment dates n 12/X+1 ($ in million) Note Payable3 Cash3 n 12/X+2 Note Payable3 Cash3 n At maturity: Note Payable40 Cash40 (revised principal amount) Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

15. 14 n Case II: Total cash payments exceed the carrying amount of the debt n Continued with example 2, assuming that the bank agrees to delay the due date for all cash payments until maturity date and accept $57,222,000 at maturity date.Since $57,222,000 exceeds the carrying amount of the debt ($55 million), the new agreement still require an interest payment. Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

16. 15 n A new effective interest rate needs to be calculated as follows: $55,000,000 / $57,221,927=0.96117 The present value table (6A-2) indicates that the new effective interest rate is 2%. Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

17. 16 n J.E. 1)At the debt restructuring date:no entry is required. 2)At the end of the first year following the restructuring: Interest Exp.(2%x$55 million) 1,100,000 Interest Payable1,100,000 Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms:

18. 17 3)At the end of the second year Interest Exp.*1,122,000 Interest Payable1,122,000 * 2% x ($55million + 1,100,000) 4)At maturity Date: Note Payable50,000,000 Interest Payable 7,222,000 Cash57,222,000 Troubled Debt Restructuring (Contd.) B. Debt is Continued but with Modified Terms: