A basic approach to resolving an inability to service debt is to seek some concessions or compromises from major creditors. A troubled debt restructuring is a process whereby creditors grant concessions to the debtor that they would not consider otherwise. However, both the debtor and creditor are faced with a difficult situation, and a restructuring offers the creditor the best opportunity to recover the debt, as compared to nonrestructuring alternatives. Although not all debt restructurings qualify as troubled debt restructurings, those that do generally take several forms. Troubled debt restructurings are discussed in FASB No. 15. The most common forms of restructuring, along with the appropriate debtor accounting, are summarized as follows:
Transfer of Assets in Full Settlement:
• Form: The debtor transfers assets, such as third-party receivables, real estate, and other assets, to the creditors in order to satisfy the debt either totally or partially.
• Accounting by Debtor: The debtor records a gain on restructuring measured by the excess of the carrying basis of the debt, including related accrued interest, premiums, etc., and the fair value of the transferred assets. The restructuring gain should be classified as an extraordinary item, if material. The difference between the book value of assets transferred to the debtor and their fair value results in a gain or loss, which is not part of the gain on restructuring.
• Example: Assets with a book value of $100,000 and a fair value of $120,000 are transferred to a creditor in full settlement of a loan of $130,000 plus accrued interest of $2,000.
Granting an Equity Interest:
• Form: Excluding existing terms for converting debt into equity (e.g., convertible debt), an equity interest in the company is granted to the creditor in order to satisfy the debt either totally or partially.
• Accounting by Debtor: The debtor records a gain on restructuring measured by the excess of the carrying basis of the debt and the fair value of the equity interest. The restructuring gain should be classified as an extraordinary item, if material.
• Example: Preferred stock with a par value of $20,000 and a fair value of $120,000 is granted to a creditor in full settlement of a loan of $130,000 plus accrued interest of $2,000.
• Form: Excluding existing terms for converting debt into equity (e.g., convertible debt), an equity interest in the company is granted to the creditor in order to satisfy the debt either totally or partially.
• Accounting by Debtor: The debtor records a gain on restructuring measured by the excess of the carrying basis of the debt and the fair value of the equity interest. The restructuring gain should be classified as an extraordinary item, if material.
• Example: Preferred stock with a par value of $20,000 and a fair value of $120,000 is granted to a creditor in full settlement of a loan of $130,000 plus accrued interest of $2,000.
Modification of Terms:
• Form: The terms of the debt are modified in several possible ways involving interest and/or principal. Interest rates may be reduced and/or accrued interest may be reduced. The principal amount of the debt may be reduced and/or the maturity date of the loan may be extended.
• Accounting by Debtor: If the total future cash payments (both principal and interest) specified by the restructuring are less than the carrying basis of the debt, a gain on restructuring is recognized. The restructuring gain should be classified as an extraordinary item, if material. After recognizing the gain, all subsequent cash payments made per the terms of the restructuring should be accounted for as a reduction of the debt payable. Therefore, no interest expense shall be recognized on the restructured debt. If the total future cash payments (both principal and interest) specified by the restructuring are more than the carrying basis of the debt, no gain on restructuring is recognized. However, interest expense is recognized between restructuring and maturity. The interest recognized should be based on an effective interest rate that equates
the present value of restructured future cash payments to the carrying value of the debt.
• Form: The terms of the debt are modified in several possible ways involving interest and/or principal. Interest rates may be reduced and/or accrued interest may be reduced. The principal amount of the debt may be reduced and/or the maturity date of the loan may be extended.
• Accounting by Debtor: If the total future cash payments (both principal and interest) specified by the restructuring are less than the carrying basis of the debt, a gain on restructuring is recognized. The restructuring gain should be classified as an extraordinary item, if material. After recognizing the gain, all subsequent cash payments made per the terms of the restructuring should be accounted for as a reduction of the debt payable. Therefore, no interest expense shall be recognized on the restructured debt. If the total future cash payments (both principal and interest) specified by the restructuring are more than the carrying basis of the debt, no gain on restructuring is recognized. However, interest expense is recognized between restructuring and maturity. The interest recognized should be based on an effective interest rate that equates
the present value of restructured future cash payments to the carrying value of the debt.
• Example A: The terms of an outstanding debt of $130,000 plus accrued interest of $2,000 have been modified as follows: payments of $60,000 per year will be made over the next two years in full satisfaction of the debt.
Combination Restructurings:
• Form: A restructuring may involve some combination of the above restructuring features.
• Form: A restructuring may involve some combination of the above restructuring features.
• Accounting by Debtor: The accounting for a combination restructuring is the same as discussed above except that first, the carrying basis of the debt should be reduced by the fair market value of assets transferred and/or equity interests granted. This step does not result in the recognition of a gain on restructuring. Second, the remaining carrying basis of the debt is compared against the “modification of terms” portion of the restructuring and accounted for accordingly.
• Example: Land with a fair value of $52,000 and a cost basis of $45,000 is transferred to a creditor in partial settlement of a debt of $130,000 plus accrued interest of $2,000. The balance of the debt is satisfied by the payment of $35,000 per year for each of the next two years.