Overview of the Accounting for a Troubled Debt Restructuring
A debtor may have financial difficulties, and so arranges with its lender to restructure any existing borrowing arrangements. If so, the accounting for the resulting modified arrangements is based on the effect on cash flows, rather than how those cash flows are described in the revised borrowing arrangements. The adjustments most likely to affect cash flows are changes in the timing of payments, and the amounts designated as face amounts or interest.
A troubled debt restructuring is considered to have occurred when the creditor grants concessions that it would not normally consider, due to the financial difficulties of the debtor. A troubled debt restructuring is generally not considered to have occurred if the debtor can obtain funds from other sources than its existing creditor. The accounting for troubled debt restructuring spans a number of payment instruments, including accounts payable, notes, and bonds.
A troubled debt restructuring transaction can involve an array of possible settlement solutions, including the transfer of tangible or intangible assets, the granting of an equity interest in the debtor, an interest rate reduction, an extended maturity date at a below-market interest rate, a reduction in the face amount of the debt, and/or a reduction in the amount of accrued but unpaid interest. The accounting for these restructurings varies, depending upon the nature of the transaction, as noted below:
- Full settlement with assets or equity. If the debtor transfers receivables from third parties or other assets or equity to the creditor to fully settle a debt, it should recognize a gain on the transaction in the amount by which the carrying amount of the payable exceeds the fair value of the assets transferred. The fair value of the payable settled can be used instead of the fair value of the assets transferred, if this is more clearly evident.
- Partial settlement with assets or equity. If the debtor transfers receivables from third parties or other assets or equity to the creditor to partially settle a debt, it should only measure the transaction with the fair value of the assets transferred (not the fair value of the payable).
- Change in terms. If there is only a change in the terms of a debt instrument, then only account for the change on a go-forward basis from the date of the restructuring. This means you do not change the carrying amount of the payable unless that amount exceeds the total amount of all remaining cash payments (including accrued interest) required under the new arrangement. This may result in the use of a new effective interest rate that equates the present value of the cash payments specified in the new arrangement with the current carrying amount of the liability. If the total future cash payments are less than the current carrying amount of the liability, reduce the carrying amount to equal the total of all future cash payments, and recognize a gain on the difference; this means that no interest expense can be recognized in association with any remaining periods.
- Partial settlement and change in terms. If a portion of a debt is settled and the terms of the remaining amount are altered, first reduce the carrying amount of the payable by the total fair value of the assets transferred. Record a gain or loss on any difference between the fair value and carrying amount of the transferred assets. However, GAAP does not allow the recognition of a gain on the restructuring of payables unless the total future cash payments remaining are less than the remaining carrying amount of the liability.
- Interest on contingent payments. If there are contingent payments included in the restructuring arrangement, recognize interest expense for these payments only when the amount of the liability can be reasonably estimated and it is probable that the debtor has incurred the liability. However, only do so after deducting a sufficient amount of these payments from the carrying amount of the liability to eliminate any restructuring gain that would otherwise be recognized. If the interest rate on these payments is variable, estimate the amount of future payments based on the current interest rate on the date of the restructuring. Ongoing accounting for these contingent payments can be adjusted to reflect subsequent changes in interest rates.
- Legal and other fees. If there are legal or other fees associated with the granting of an equity interest in the debtor, offset them against the recorded amount of the equity interest. Any other such fees not related to granting an equity interest shall be used to reduce any gain recognized on the restructuring transaction; if there is no gain to offset, charge the fees to expense as incurred.
Example of the Accounting for a Troubled Debt Restructuring
The Near Miss Company has a loan payable with Currency Bank that has an outstanding balance of $240,000 and accrued interest payable of $15,000. Near Miss finds itself nearing bankruptcy and negotiates with Currency Bank to restructure its debt. Currency agrees to accept from Near Miss a storage building having a book value of $200,000 and a fair value of $210,000, which will fully settle the debt. Near Miss records the following entry to record the settlement:
|Fixed assets - building||10,000|
|Fixed assets - building||200,000|
|Gain on asset transfer||10,000|
|Gain on debt settlement||55,000|