The financial crisis of the late 2000s found many firms struggling to make debt payments. Many firms ended up declaring bankruptcy or renegotiating the terms of outstanding debt obligations. This section examines how the debtor accounts for the restructuring of troubled debt.From the debtor’s perspective, two situations exist for handling troubled debt: settlement and modification of terms.
The settlement of troubled debt results in an economic gain to the debtor because the creditor accepts less than the book value of the debt to settle the debt. If a non-cash asset is transferred to settle the debt (for example, a collateral asset), the non-cash asset must be adjusted to fair value prior to its transfer, with the resulting gain or loss reported in income. A gain on debt settlement is recognized as the difference between the book value of the debt settled (principal plus any accrued interest) and the fair value of the non-cash asset or cash transferred to retire the debt. Alternatively, debt could be settled by issuing capital stock. Inthis case, the stock issue is recorded at its fair value and the gain to the debtor is the excess of the book value of the debt relative to the fair value of the stock issued.
Instead of accepting an asset or common stock to retire the debt, a creditor might modify the terms of the debt (for example, reducing the payments or lengthening the amount of time to pay), hoping a debtor will be able to perform under less stringent debt service requirements. Under U.S. GAAP, if terms are modified, the debtor must compare the total (undiscounted) future cash flows of the restructured debt to the current book value of the debt. If the total restructured future cash flows remain greater than the book value of the debt, the debtor will make no adjustment to book value (that is, record no gain). Future recognition of interest expense will follow the effective interest method using a new interest rate that discounts the total restructured future cash flows to the current book value.
Alternatively, if the total undiscounted restructured future cash flows are less than the book value of the debt, the debtor will reduce the book value of the debt to equal the total of the new restructured future cash flows, recording a gain in the process
Future interest expense will not be recognized because all future cash flows represent the repayment of principal; that is, the discount rate is assumed to be zero. This accounting is conservative because future cash flows must fall significantly before the debtor actually recognizes a gain. The result of the conservative accounting is to minimize any gains recognized by debtors who experience difficulty and must restructure debt agreements. The existing conservative accounting rules for troubled debt are subject to frequent (and deserved) criticism because they ignore the present value of future restructured cash flows for determining book values of troubled debt and gains from debt restructuring, and they often result in subsequent recognition of interest expense based on an unrealistic interest rate assumption
We contrast U.S. GAAP and IFRS treatment of troubled debt from the debtor’s perspective with the following example. Assume that Tribune Co. owes Bank of America $2,000,000 on a 5-year, 8% note originally issued at par. After one year of making scheduled payments, Tribune faces financial difficulty. At the end of the second year, Tribune owes Bank of America $2,000,000 plus $160,000 of accrued but unpaid interest. Bank of America restructures the note by forgiving the $160,000 interest payable, reducing the note principal to $1,800,000, and reducing the interest rate to 7%. Under U.S. GAAP, Tribune compares the gross (that is, undiscounted) future cash outflows under the restructured debt to the current book value of the debt as follows
The settlement of troubled debt results in an economic gain to the debtor because the creditor accepts less than the book value of the debt to settle the debt. If a non-cash asset is transferred to settle the debt (for example, a collateral asset), the non-cash asset must be adjusted to fair value prior to its transfer, with the resulting gain or loss reported in income. A gain on debt settlement is recognized as the difference between the book value of the debt settled (principal plus any accrued interest) and the fair value of the non-cash asset or cash transferred to retire the debt. Alternatively, debt could be settled by issuing capital stock. Inthis case, the stock issue is recorded at its fair value and the gain to the debtor is the excess of the book value of the debt relative to the fair value of the stock issued.
Instead of accepting an asset or common stock to retire the debt, a creditor might modify the terms of the debt (for example, reducing the payments or lengthening the amount of time to pay), hoping a debtor will be able to perform under less stringent debt service requirements. Under U.S. GAAP, if terms are modified, the debtor must compare the total (undiscounted) future cash flows of the restructured debt to the current book value of the debt. If the total restructured future cash flows remain greater than the book value of the debt, the debtor will make no adjustment to book value (that is, record no gain). Future recognition of interest expense will follow the effective interest method using a new interest rate that discounts the total restructured future cash flows to the current book value.
Alternatively, if the total undiscounted restructured future cash flows are less than the book value of the debt, the debtor will reduce the book value of the debt to equal the total of the new restructured future cash flows, recording a gain in the process
Future interest expense will not be recognized because all future cash flows represent the repayment of principal; that is, the discount rate is assumed to be zero. This accounting is conservative because future cash flows must fall significantly before the debtor actually recognizes a gain. The result of the conservative accounting is to minimize any gains recognized by debtors who experience difficulty and must restructure debt agreements. The existing conservative accounting rules for troubled debt are subject to frequent (and deserved) criticism because they ignore the present value of future restructured cash flows for determining book values of troubled debt and gains from debt restructuring, and they often result in subsequent recognition of interest expense based on an unrealistic interest rate assumption
We contrast U.S. GAAP and IFRS treatment of troubled debt from the debtor’s perspective with the following example. Assume that Tribune Co. owes Bank of America $2,000,000 on a 5-year, 8% note originally issued at par. After one year of making scheduled payments, Tribune faces financial difficulty. At the end of the second year, Tribune owes Bank of America $2,000,000 plus $160,000 of accrued but unpaid interest. Bank of America restructures the note by forgiving the $160,000 interest payable, reducing the note principal to $1,800,000, and reducing the interest rate to 7%. Under U.S. GAAP, Tribune compares the gross (that is, undiscounted) future cash outflows under the restructured debt to the current book value of the debt as follows
Because undiscounted future cash flows exceed the current book value of the debt, Tribune does not record a gain. Future interest expense is accounted for using the effective interest method and an effective interest rate that equates the future cash flows with the present value (that is, current book value) of the debt.
Because undiscounted future cash flows are less than the current book value of debt, Tribune reduces the book value of the debt to $2,057,000 and records a gain of $103,000 ($2,160,000 – $2,057,000). Future interest expense does not exist (that is, the effective rate is set equal to zero) because the future cash flows are now equal to the = present value (that is, the reduced book value).
Under IFRS, Tribune would compare the present value of future cash flows under the restructured debt (instead of the undiscounted cash flows as under U.S. GAAP) to the book value of the debt. Return to the original example where Bank of America reduced the principal to $1,800,000. The present value calculation uses the historical effective interest rate of 8% as follows:
Under IFRS, Tribune would compare the present value of future cash flows under the restructured debt (instead of the undiscounted cash flows as under U.S. GAAP) to the book value of the debt. Return to the original example where Bank of America reduced the principal to $1,800,000. The present value calculation uses the historical effective interest rate of 8% as follows:
IFRS uses a ‘‘10 percent rule’’ to determine whether a gain is recognized. Because the present value of $1,753,612 is 23.2% below the book value of $2,160,000 (that is, greater than 10% below book value), Tribune recognizes a gain. The amount of the gain is equal to the amount by which the fair value of the debt is below the current book value. Computing fair value of the restructured debt’s cash flows requires the use of a current market rate of interest instead of the historical rate of 8%. For example, because of Tribune’s financial difficulties, assume that a more appropriate current rate of interest for Tribune is 12%. Discounting the same cash flows using a 12% rate yields a present value of $1,583,835. Therefore, Tribune would report the book value of this restructured debt at $1,583,835 and record a gain of $576,165 ($2,160,000 – $1,583,835) in net income. Under IFRS, Tribune will recognize future interest expense using the 12% effective interest rate so that the new book value is correctly amortized to the new maturity value by the maturity date.
If the present value of the restructured cash flows at the historical rate is within 10% of the book value of the debt, Tribune does not recognize a gain. Income effects are similar to the effects under U.S. GAAP when no gain is recognized. Because IFRS uses the economically sound present value approach to determine the magnitude of the settlement and U.S. GAAP uses the more conservative undiscounted future cash flows approach, the magnitude of the new book value of the restructured debt will be lower and the gain recognition will be larger under IFRS.
If the present value of the restructured cash flows at the historical rate is within 10% of the book value of the debt, Tribune does not recognize a gain. Income effects are similar to the effects under U.S. GAAP when no gain is recognized. Because IFRS uses the economically sound present value approach to determine the magnitude of the settlement and U.S. GAAP uses the more conservative undiscounted future cash flows approach, the magnitude of the new book value of the restructured debt will be lower and the gain recognition will be larger under IFRS.
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