Troubled debt restructuring in accounting
November 26, 2014
Debt is a common financing tool for most corporations. In this article, we’ll discuss what happens when a company has trouble paying its legal bond obligations.
Under standard bond contract terms, a debtor must make periodic interest payments throughout the life of the bond, and must then repay the face value at maturity. Two potential issues arise when a company faces cash flow shortages. What if the company misses an interest payment? What if the company doesn’t have enough cash to pay the face value next month?
Creditors face a potential conundrum – if no concessions are made and the creditor demands payment according to the original terms, the debtor might default and the creditor could receive nothing. On the other hand, a restructuring will generally result in a guaranteed loss for the creditor.
There are three ways a creditor and debtor can change the terms of a loan agreement. First, the creditor could accept some kind of property from the debtor in exchange for writing off the remaining debt. This could be merchandise inventory, equipment, a building, or even land. These transactions result in two separate gain/loss situations. First, the debtor recognizes a gain or loss for the difference between the asset’s fair value and its book value as if the company had sold the asset at fair value. Next, the debtor compares the new fair value to the face value of the debt and all future required interest payments. That difference is a separate gain or loss on restructuring.
As a quick example of this situation, if a company gives its creditor a tract of land with a book value of $100,000 that is actually worth $150,000 in exchange for writing off a $150,000 note and a future $15,000 interest payment, the company would recognize a disposal gain of $50,000 and a restructuring gain of $15,000 on the transaction.
Second, the creditor could accept shares of stock in exchange for canceling the debt. In this case, the debtor would recognize a gain for the difference between the fair value of the stock and the sum of the debt’s face value and any future interest payments.
Finally, the creditor could modify the terms of the debt contract in a way that relieves some of the financial pressure on the debtor. For example, the creditor could forgive a missed interest payment and lower the future interest rate for the loan. The creditor could even reduce the face value or extend the repayment period. Recognition of a gain in this situation is not as cut-and-dry as with the other two methods. A gain is possible if the carrying amount of the debt is higher than the future cash payments required under the restructured terms, but the treatment of interest rates, premiums, and discounts for this final restructuring method is beyond the scope of this article.
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