A modification or restructuring in a troubled debt occurs if a debtor is facing financial issues or the creditor grants concession.
The debtor must evaluate the financial circumstances carefully. The creditor’s concession terms should also be evaluated to determine whether the restructuring of troubled debt falls under the accounting standards of ASC 470.
Let us discuss the accounting treatment for troubled debt restructuring with the help of a few examples.
Accounting for Troubled Debt Restructuring
Troubled debt restructuring scenarios may occur when a debtor faces financial problems. The creditor may modify the loan terms to allow the debtor relaxed conditions that otherwise wouldn’t be available.
The debtor must consider several factors to decide the proper accounting treatment of the new arrangements. For instance, if the new terms involve the transfer of shares, the debtor would analyze whether the transaction results in the transfer of ownership or not.
ASC 470-60 guides on the accounting treatment of restructured loans. However, the standard says the debtor needs to use professional judgment as there cannot be a single factor in deciding the accounting treatment of modified loan arrangements.
ASC 470-60 provides two key questions as a guideline to assess the circumstances:
- Is The Debtor Facing financial difficulties?
- Has the creditor granted a concession that would not be otherwise be available?
If both of these questions can be affirmatively satisfied, the new arrangement would be accounted for under ASC 470-60.
The Debtor Faces Financial Difficulty
A debtor may face financial difficulties when its creditworthiness is affected. ASC 470-60-55-7 guides on judging whether a debtor’s creditworthiness is affected.
Excerpt of ASC 470-55-60-7 reads:
“Changes in an investment-grade credit rating are not considered a deterioration in the debtor’s creditworthiness for purposes of this guidance. Conversely, a decline in credit rating from investment grade to non-investment grade is considered a deterioration in the debtor’s creditworthiness for purposes of this guidance.”
ASC 470-55-60-8 guides on determining the financial difficulties of a debtor with the following indicators:
- The debtor is on default on one or more loans.
- The debtor has applied for bankruptcy or is in the process.
- Currently, the debtor holds financial securities that are in the process of being delisted, have been, or are under threat of being delisted.
- There is a significant doubt that the debtor will be a going concern.
- The debtor estimates based on its cash flow forecasts and projections that it will unable to meet the debt obligations under the current terms and conditions.
- The debtor has no alternative funding sources other than the modification terms offered by the current creditors.
If the debtor fulfills these two conditions, it cannot be appraised as in the financial difficulty as per ASC 470-60.
- The debtor is currently servicing other debts. Also, the debtor can obtain financing sources other than the current creditors and the required modifications.
- The modification in the loan terms occurs only to reflect the increased creditworthiness of the debtor or due to changing interest rates in the market.
The Creditor Grants a Concession
A creditor has granted a concession when the modification results in a lower collection of loan repayment than the previous contract terms. However, both parties should determine the appropriateness of the restructuring conditions.
A creditor has granted a concession if the new effective interest rate for the debt is less than the effective interest rate of the debt previously.
ASC 470-60-55-11 to 14 provide guidelines to determine whether the creditor has granted a concession:
- The carrying amount to evaluate this standard would not include any hedging effects. However, it will include any unamortized premium, discounts, issuance costs, and other similar factors.
- The current fair value of the new or revised debt sweeteners should be included in the day-one cashflows.
- If an entity has previously restructured debt and is doing it again, it should evaluate the effective interest rate by projecting all cash flows under the new terms and solving for the interest rate that equates the PV of future cash flows to the carrying value of the debt immediately preceding earlier restructuring.
Example 1: Settlement of Debt by Exchange of Assets
Suppose a company ABC as a debtor transfers property with a book value of $ 80,000 in exchange for a remaining debt liability. The fair value of the property is $ 100,000.
The loan has a remaining liability of $ 95,000 and accrued interest of $15,000. ABC Company will record the following journal entries.
| Account | Debit | Credit |
| Property | $ 20,000 | |
| Gain on Transfer of Property | $ 20,000 | |
| Loan Payable | $ 95,000 | |
| Interest Accumulated | $ 15,000 | |
| Property | $ 100,000 | |
| Gain on Settlement | $ 10,000 |
The debtor must analyze the future cash flows of a restructured loan and the carrying value of the debt (the principal amount and interest) if the loan continues with the modified conditions.
If the total value of future cash flows is greater than the carrying value of the loan, there should be no adjustment to the carrying value of the debt. However, the debtor must adjust for the interest rate by lowering it.
If the total value of future cash flows is less than the carrying value of the loan, the debtor would adjust the difference. The debtor will record the reduced loan value and a gain would be recorded.
If the modification of debt is partly modified and partly settled then the debtor should first record the partial settlement and then the modification part.
Example 2: Loan Restructuring with Gain/Loss
Suppose a company ABC has an outstanding loan with a remaining life of 5 years and a balance of $ 80,000. The loan has an interest rate of 7% and an accrued interest of $15,000.
The loan is modified and the new remaining principal balance is $ 60,000. It has a reduced interest rate of 5%. The accrued interest is forgiven.
ABC Company will record the following entries with new calculations.
Modified Future cash flows:
| Principal | $ 60,000 |
| Interest (60,000 ×5% ×5) | $ 15,000 |
| Total Cash Payable | $ 75,000 |
Amount Payable Before Restructuring:
Principal + Accrued Interest = $ 95,000
Debtor’s Gain = $ 20,000
ABC Company will record the following journal entries to reflect the modified loan terms.
| Account | Debit | Credit |
| Interest Payable | $ 15,000 | |
| Loan Payable | $ 5,000 | |
| Gain on Loan Restructuring | $ 20,000 | |
| From Year 1 to Year5 | ||
| Loan Payable | $ 5,000 | |
| Cash | $ 5,000 | |
| End of Year 5 | ||
| Loan Payable | $ 72,500 | |
| Cash | $ 72,500 |
Similarly, ABC company will record a loss on the modification if the interest rate increases.
Example 3: Restructuring with No Gain/Loss Recognized on Modification
Now let us assume ABC company’s 5-year term loan of $ 100,000 has been reduced to $ 95,000. It has an accumulated interest amount of $ 10,000. The interest rate of the loan decreases from 5% to 4%.
ABC Company will record the following entries with new calculations.
Modified Future cash flows:
| Principal | $ 95,000 |
| Interest (95,000 ×4% ×5) | $ 19,000 |
| Total Cash Payable | $ 114,000 |
Amount Payable Before Restructuring:
Principal + Accrued Interest = $ 100,000
Debtor’s interest expense/revenue = $ 14,000
If there is no gain or loss on the debt modification, the interest rate must be lowered from 4% so that the PV of future cash flows equals $ 100,000 (previous total).
The interest amount per year is $ 3,800 and the principal amount is $ 95,000. We’ll need to use a trial-and-error method that equates the PV of these two future cash flows to $ 100,000.
Through iteration, we can find that 2.857% is the effective interest rate for our example.
The new loan amortization table will look like this:
| Year | Cash Flow At 4% | New Effective Interest (2.857%) | Reduction in the Carrying Value | Loan Carrying Value |
| 0 | $ 100,000 | |||
| 1 | $ 3,800 | $ 2,857 | $ 943 | $ 99,057 |
| 2 | $ 3,800 | $ 2,830 | $ 970 | $ 98,087 |
| 3 | $ 3,800 | $ 2,802 | $ 998 | $ 97,089 |
| 4 | $ 3,800 | $ 2,774 | $ 1,026 | $ 96,063 |
| 5 | $ 3,800 | $ 2,745 | $ 1,055 | $ 95,000 |
The accounting entries to record the modified transactions will be:
| Account | Debit | Credit |
| Loan Payable | $ 943 | |
| Interest Expense (new) | $ 2,857 | |
| Cash | $ 3,800 | |
| At the end of Year 5 | ||
| Loan Payable | $ 95,000 | |
| Cash | $ 95,000 |
Example 4: Loan Restructuring with Contingent Payment
Suppose a company ABC has an outstanding loan amount of $ 90,000 and accumulated interest of $ 10,000. It has five years of remaining life. The interest rate is 5%. The creditor modifies the loan terms two years ago and the principal was lowered to $ 70,000 and the interest rate to 4%.
Assume that the creditor now requires ABC company to make an additional principal payment of $ 15,000 and an additional 1% in interest for years 4 and 5.
Cash Payments for ABC company with restructuring terms were:
| Principal | $ 70,000 |
| Interest (70,000 ×4% ×5) | $ 14,000 |
| New Contingent Payment | $ 15,000 |
| Additional Interest (70,000 ×4% ×2) | $ 5,600 |
| Total Cash Payable | $ 104,600 |
Amount Payable Before Restructuring:
Principal + Accrued Interest = $ 100,000
Debtor’s interest expense/revenue = $ 4,600
ABC company will only record the contingent principal payment of $ 15,000 in its calculations. The contingent interest portion of the modified terms will not be included in its calculations. A company is only required to include only those contingent payments that make the new future cash flows exceed the carrying value of the loan.
