Appendix G-1. Appendix G-2 APPENDIX F ACCOUNTING FOR TROUBLED DEBT INTERMEDIATE ACCOUNTING Principles and Analysis 2nd Edition Warfield Wyegandt Kieso

Appendix G-1

Appendix G-2

APPENDIX F

ACCOUNTING FOR TROUBLED DEBT

INTERMEDIATE ACCOUNTING

Principles and Analysis

2nd Edition

Warfield Wyegandt

Kieso

Appendix G-3

Troubled DebtTroubled DebtTroubled DebtTroubled Debt

Two situations result with troubled debt:

1. Impairments.

2. Restructurings:

a. Settlements.

b. Modification of termsIllustration G-1Usual Progression

Appendix G-4

Impairments


O 1 Describe the accounting for a loan impairment.O 1 Describe the accounting for a loan impairment.

A loan is impaired when it is probable the creditor will not collect all amounts due (both principal and interest).

Appendix G-5

Impairments



If considering a loan impaired, the creditor should If considering a loan impaired, the creditor should measure the loss due to the impairment as the measure the loss due to the impairment as the difference between the investment in the loan difference between the investment in the loan (generally the principal plus accrued interest) and the (generally the principal plus accrued interest) and the expected future cash flows discounted at the loan’s expected future cash flows discounted at the loan’s historical effective interest rate.historical effective interest rate.

Appendix G-6

Example of Loss on Impairment


On December 31, 2008, Prospect Inc. issued a $500,000, five-year, zero-interest-bearing note to Community Bank. Prospect issued the note to yield 10% annual interest. As a result, Prospect received, and Community Bank paid, $310,460 ($500,000 x .62092) on December 31, 2008. Illustration G-2

Troubled Debt - ImpairmentsTroubled Debt - ImpairmentsTroubled Debt - ImpairmentsTroubled Debt - Impairments

Appendix G-7 O 1 Describe the accounting for a loan impairment.O 1 Describe the accounting for a loan impairment.

Show how Community Bank (creditor) and Prospect (debtor) record these transactions on December 31, 2008

Illustration G-3



Schedule of Interest and Discount Amortization (Before Impairment)

Illustration G-3

Illustration G-4



Assume Community Bank determines that Prospect will probably pay back only $300,000 of the principal at maturity. Community Bank declares the loan impaired.

Determine the loss due to impairment.Illustration G-5



The loss due to impairment is the difference between the present value of the expected future cash flows and the recorded carrying amount of the investment in the loan. Illustration G-6

Illustration G-7


Appendix G-11

Restructurings


O 2 Describe the accounting for debt restructuring.O 2 Describe the accounting for debt restructuring.

A troubled-debt restructuring occurs when a creditor “for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it wouldnot otherwise consider.”Two basic types of transactions:

1. Settlement of debt at less than its carrying amount.

2. Continuation of debt with a modification of terms.

Appendix G-12

Settlement of Debt

Troubled-Debt RestructuringTroubled-Debt RestructuringTroubled-Debt RestructuringTroubled-Debt Restructuring


Involve either a:

Transfer of noncash assets (real estate, receivables, or other assets) or

Issuance of the debtor’s stock.

Creditor should account for noncash assets or equity interest received at their fair value.

Appendix G-13



EG-1 (Settlement of Debt) Larisa Nieland Company owes $200,000 plus $18,000 of accrued interest to First State Bank. The debt is a 10-year, 10% note. During 2008, Larisa Nieland’s business deteriorated due to a faltering regional economy. On December 31, 2008, First State Bank agrees to accept an old machine and cancel the entire debt. The machine has a cost of $390,000, accumulated depreciation of $221,000, and a fair market value of $190,000.

Appendix G-14



EG-1 Prepare journal entries for Larisa Nieland Company and First State Bank to record this debt settlement.

Larisa Nieland Company (Debtor):

Notes Payable 200,000

Interest Payable 18,000

Accumulated Depreciation 221,000

Machine 390,000

Gain on Disposition of Machine 21,000

Gain on Debt Restructuring 28,000

a $190,000 – ($390,000 – $221,000) = $21,000. b ($200,000 + $18,000) – $190,000 = $28,000.

a

b

Appendix G-15



EG-1 Prepare journal entries for Larisa Nieland Company and First State Bank to record this debt settlement.

First State Bank (Creditor):

Machine 190,000

Allowance for Doubtful Accounts 28,000

Notes Receivable 200,000

Interest Receivable 18,000

Appendix G-16



EG-1 Assume instead that Larisa Nieland decides to grant 15,000 shares of its common stock ($10 par) which has a fair value of $190,000 in full settlement of the loan obligation. If First State Bank treats Larisa Nieland’s stock as a trading investment, prepare the entries to record the transaction for both parties.

Larisa Nieland Company (Debtor):

Notes Payable 200,000

Interest Payable 18,000

Common Stock 150,000

Additional Paid-in Capital 40,000


Appendix G-17



EG-1 Assume instead that Larisa Nieland decides to grant 15,000 shares of its common stock ($10 par) which has a fair value of $190,000 in full settlement of the loan obligation. If First State Bank treats Larisa Nieland’s stock as a trading investment, prepare the entries to record the transaction for both parties.

First State Bank (Creditor):

Investment (Trading) 190,000


Notes Receivable 200,000

Interest Receivable 18,000

Appendix G-18

Modification of Terms



1. Reduction of the interest rate.

2. Extension of maturity date of the face amount of debt.

3. Reduction of the face amount of the debt.

4. Reduction or deferral of any accrued interest.Two examples demonstrate troubled-debt restructuring by debtors and creditors:

1. No gain for debtor.

2. Gain for debtor.

Appendix G-19



EG-2 (Term Modification without Gain — Debtor’s Entries) On December 31, 2008, Firstar Bank enters into a debt restructuring agreement with Nicole Bradtke Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications.

1. Reduce principal obligation from $2,000,000 to $1,600,000.

2. Extend the maturity date from December 31, 2008, to December 31, 2011.

3. Reduce the interest rate from 12% to 10%.

Bradtke pays interest at the end of each year. On January 1, 2012, Bradtke Company pays $1,600,000 in cash to Firstar.

DebtorNo Gain

Appendix G-20



EG-2 Can Bradtke Company record a gain under the term modification mentioned above? Explain.

No. Total future cash flows after restructuring exceed total pre-restructuring carrying amount of the note (principal):

Total future cash flows after restructuring:Principal $1,600,000Interest ($1,600,000 X 10% X 3) 480,000

$2,080,000

Total pre-restructuring carrying amount of note (principal): $2,000,000

DebtorNo Gain

Appendix G-21


EG-2 Assuming the interest rate Bradtke should use to compute interest expense is 1.4276%, prepare the interest payment schedule of the note after the debt restructuring.

a. $1,600,000 x 10% = $160,000. b. $2,000,000 x 1.4276% = $28,552. c. $160,000–$28,552 = $131,448. d. Adjusts $1 due to rounding.

DebtorNo Gain

Appendix G-22


EG-2 Prepare the interest payment entry for Bradtke Company on December 31, 2010.

Note Payable 133,325

Interest Expense 26,675

Cash 160,000

EG-2 What entry should Bradtke make on January 1, 2012?

Note Payable 1,600,000

Cash 1,600,000

DebtorNo Gain


Appendix G-23



EG-3 (Term Modification without Gain — Creditor’s Entries) On December 31, 2008, Firstar Bank enters into a debt restructuring agreement with Nicole Bradtke Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications.





Creditor No Gain

Appendix G-24



EG-3 Compute the loss that Firstar Bank will suffer from the debt restructuring. Prepare the journal entry to recordthe loss.

a$1,600,000 X .71178 = $1,138,848. b$160,000 X 2.40183 = $384,293.

Bad Debt Expense 476,859


Creditor No Gain

Appendix G-25



EG-3 Prepare the interest receipt schedule for Firstar Bank after the debt restructuring.

Creditor No Gain

Appendix G-26


EG-3 Prepare the interest receipt entry for Firstar Bank on December 31, 2010.

Cash 160,000


Interest Revenue 185,510

EG-3 What entry should Firstar make on Jan. 1, 2012?

Cash 1,600,000

Allowance for Doubtful Accounts400,000

Note Receivable 2,000,000

Creditor No Gain


Appendix G-27



EG-2 - Modified (Term Modification with Gain — Debtor’s Entries) On December 31, 2008, Firstar Bank enters into a debt restructuring agreement with Nicole Bradtke Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications.





DebtorGain

Appendix G-28



EG-2 – Modified Can Bradtke Company record a gain under the term modification mentioned above? If yes, record the gain.

Total future cash flows after restructuring:Principal $1,300,000Interest ($1,300,000 X 10% X 3) 390,000

$1,690,000

Total pre-restructuring carrying amount of note (principal): $2,000,000

Gain = $2,000,000 – $1,690,000 = $310,000

Journal December 31, 2008:



DebtorGain

Appendix G-29


EG-2 - Modified Prepare the interest payment schedule of the note for Bradtke after the debt restructuring.

DebtorGain


Appendix G-30


EG-2 - Modified Prepare the interest payment entry for Bradtke Company on December 31, 2009, 2010, and 2011.


Cash 130,000

EG-2 What entry should Bradtke make on January 1, 2012?

Note Payable 1,300,000

Cash 1,300,000

DebtorGain


Appendix G-31



EG-3 - Modified (Term Modification with Gain — Creditor’s Entries) On December 31, 2008, Firstar Bank enters into a debt restructuring agreement with Nicole Bradtke Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications.





Creditor Gain

Appendix G-32



EG-3 - Modified Compute the loss that Firstar Bank will suffer from the debt restructuring. Prepare the journal entry to record the loss on Firstar’s books.

a$1,300,000 X .71178 = $925,314 b$130,000 X 2.40183 = $312,238

Creditor Gain

Bad Debt Expense 762,448


Appendix G-33



EG-3 - Modified Prepare the interest receipt schedule for Firstar Bank after the debt restructuring.

Creditor Gain

Appendix G-34


EG-3 - Modified Prepare the interest receipt entry for Firstar Bank on December 31, 2009, 2010, and 2011.

Cash 130,000



Creditor Gain

Cash 130,000



Cash 130,000



20092009

20102010

20112011


Appendix G-35


EG-3 - Modified What entry should Firstar make on Jan. 1, 2012?

Cash 1,300,000

Allowance for Doubtful Accounts700,000

Notes Receivable 2,000,000

Creditor Gain


Appendix G-36

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Appendix G-1. Appendix G-2 APPENDIX F ACCOUNTING FOR TROUBLED DEBT INTERMEDIATE ACCOUNTING Principles and Analysis 2nd Edition Warfield Wyegandt Kieso