 Hello and welcome to the session in which we will discuss troubled debt restructuring. In the prior session we looked at a troubled debt restructuring and we explored the option of settling the debt. Another option when you have a troubled debt restructuring is modification of terms and this is what we will discuss in this session. When we modify the terms of the loan, how does it work? And we have two treatments when it comes to that. Sometimes the future cash flow, which is the undiscounted, is less than the carrying value and sometimes the future cash flow, which is undiscounted, is greater than the carrying value of the debt. But what is a troubled debt restructuring is when the creditor, which is the lender, the person that gave money, lent money, grant concessions to the debtor, to the person that borrowed money, not made under normal circumstances. And what I discussed in the prior session, this happened a lot to construction companies in the real estate crash of 2007, 2008. So this is what we are discussing. Now we discussed the settlement option and we said that what we can do is the creditor and the debtor, they can settle. They can close the deal by the debtor given something to the creditor. The creditor will accept and that's over. Or what we can do is the creditor can change, can modify the terms of the loan. Now how can they modify the terms of the loan? Well, there are many tools that you can do it. They can lower the interest rate on the loan. They can give the debtor more time to pay, basically extend the maturity. I'll give you, if you cannot pay this amount now, I would move it a little bit into the future. I can reduce your principal amount, forgive some of the principal amount. I can reduce or forgive any accrued interest that you have not paid. I can use any of the combination above. So when I'm modifying the loan, I have all these options including a combination of these options. Now the most difficult thing in my opinion for a student to understand when it comes to loan modification is how to compute the debtor and the creditor gain and losses. So I'm going to show you how to compute them side by side. Then we will work an example to illustrate this concept. For the debtor, for the borrower, the borrower will have a gain. How do we compute the gain for the debtor? Well, think about it. Why would, first, do you understand why the debtor could have a gain? Well, the debtor could have a gain because the borrower, it's going to forgive a certain amount of money. Well, as a result, if you tell me you don't have to pay this amount or you have to pay me 50% or 60% or 70% of this amount, then I basically have a gain because I'm settling my loan without paying it. How do I compute a gain? Here's what I'm going to do. I'm going to look at my loan. I'm going to look at my liability. What's my loan now? What's my liability now? And I'm going to compare it to my future undiscounted. So it's easy cash flow. I would look at my liability now. If my liability now is $1,000 and what I have to pay you in the future under the new terms is $800, guess what? I'm paying less than my liability. I have a gain. Otherwise, I have no gain. So you either have a gain or you don't have a gain. Those are the options. Gain or no gain. Now, for the creditor, the creditor will always have a loss. Why? Because the creditor is accepting less than the amount of their note receivable. The creditor is giving the concession. The creditor is telling the lender, pay me less. Why would they do that? Because the creditor, they want to walk away with some money. They want to cut down on their losses. Therefore, they're willing to work some sort of deal with a debtor. So they don't lose everything 100%. So they will have a loss. Otherwise, if they collect everything, they will have no gain and no loss. Well, if they're going to collect less, they will have a loss. How do we compute the loss on the lender? Please listen to me carefully. We're going to compare the expected new cash flows discounted at the old historical rate. Few things we have to be worried about. First of all, new cash flows discounted at old rate. Wow, it's a lot. So we have to see, what's the new cash flow? We have to discount the cash flow using the old percentage rate. And we're going to compare this to the current liability. What is the liability now? What's the liability now? What's the liability now? So the liability now is $1,000. And if the new discounted cash flow discounted at the old rate is 800, or let's make it 700. So guess what? I'm supposed to have basically a loan means for the creditor, that's a receivable. If I'm expecting to receive 1,000, now I'm only going to receive 700, I have a loss of 300. Don't worry, we will work an example to illustrate this concept. So let's take a look at this example. On December 31, X1, Local Bank and Adam Construction Company, which is experiencing financial difficulties due to the housing crisis, signed a debt restructuring agreement. The parties agreed to the following. One, Local Bank to forgive $600,000 of the principal balance by reducing the loan from 300,000 to 2.4 million. Two, Local Bank to extend the maturity date from December 31, X1 to December 31, X4. I'm going to give you three more years to pay. Three, Local Bank to lower the interest rate by 2% from 12, which is the old interest rate. So I'm going to charge you 10% the new interest rate. Now let's compute to see if the debtor has a gain, if so how much, and let's see how much is the creditor's loss. The debtor, the debtor will compare the old loan prior to the restructuring to the future undiscounted cash flow. So the old loan is 3 million. The future undiscounted cash flow is 2.4 million plus 10%, 240,000, and we're gonna be making four payments on this. So simply put, the debtor will be paying in the future 3,120,000. Well, the future cash flow is greater than 3 million. Therefore, we have no gain, no gain on the loan. Easy, remember this is an easy computation because we don't involve discounted cash flow. Let's compute the loss for the creditor. The creditor will look at their old receivable, which is 3 million, and they will compare it to their new discounted cash flow. Well, what is the creditor getting now? The creditor is getting one, two, three payments. The creditor is getting three payments and each payment is 240,000, 240,000, 240,000, plus they're gonna get the principal amount which is 2.4 million. Now, what would the creditor do? The creditor will discount those payments at 12% and equal to three. So this is what we're gonna do. We're gonna discount the 2.4 million at 0.7178, which is from the present value of a single amount. Discount the new payment based on the old rate, again, based on the old rate, 240,000, times 2.40183, which is the present value of an annuity table. And what we find out, the value of the new loan, basically value of the receivable of the note receivable for the creditor is 2,284,711. Notice, this is the value of the new loan, the value, the note receivable, which is the loan for the debtor. Well, the creditor had a receivable of 3 million, now they took a loss. The loss is 715,000. What they're gonna do, they're gonna book that expense for that amount and credit allowance for doubtful account for that amount. Notice they took the expense upfront, 715,289. So let's see what's gonna happen after we compute the gain or the loss. For the debtor, the debtor is gonna complete a new schedule to compute their payments and to compute how much of it is interest, how much of it is principal. So let's take a look at this. Remember, the creditor and under those circumstances, the creditor has no gain. Remember, the creditor has no gain and we computed this. I'm sorry, the debtor has no gain. So now what do we do now? Well, we're gonna start with the carrying amount of the note. Then we're gonna take the carrying amount of the note and first compute interest expense. How much is interest expense? How do we compute the interest expense? We're gonna be using an effective rate of 1.4276. Hold on a second. How did we come up with this 1.4276? It's not anywhere. Let me tell you how you come up with this number. You set up this formula and you would say, okay, 3 million, the old loan equal to one divided by one plus I raised to the third power times 2.4 million, which is the new loan plus one minus one over one plus I raised to the third power over I times the payment and you solve for I. Now, in an intermediate accounting course, most of the time, you will be given I. You will be given, this is called the new interest rate, the new interest rate, or you could use a financial calculator. For this exercise, I'm just gonna tell you, we're gonna be using an interest rate of 1.4276. However, I gave you the formula if you're interested in computing the formula or use a financial calculator for that matter. So 3 million times the interest rate, 1.4276%, it's gonna give us interest expense of 42,828. Now, we're gonna be making a payment of 240,000, right? Of that payment, 42,828 is interest expense and the remainder will be reduction of the principal note. So payment is split between interest expense and reduction of the note. Let's take a look at the journal entry. The interest payment would look something like this. I'm gonna reduce my note for the first payment for 197,172. I'm gonna record interest expense of 42,828 and I'm gonna credit my cash 240,000. This is the first payment. The second payment, the cash will stay the same. The second payment, my interest expense is $40,013 and I reduced the loan by 199,987. And the third payment will apply with these numbers. Then at the end, by the end of 1231, 20x4, the balance will be 2.4 million. We pay the last payment of 2.4 million and we pay off the loan. So these are the payments for the debtor. These are the payments for the debtor. Before we look at the creditor journal entries, I would like to remind you whether you are an accounting student or a CPA candidate to take a look at my website, farhatlectures.com. I don't replace your CPA review course nor replace your accounting course. I'm a useful addition. I'm gonna give you additional resources that's gonna help you succeed on your exam, succeed on the CPA exam. My motto is saving CPA exam candidate and accounting student one at a time. You have to take, give me a chance. Subscribe for one month, you like it. You feel it's helping you, you keep it. You don't, you cancel. If not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. This is a list of all my accounting courses that I have. Lectures, multiple choice through false exercises that's gonna help you prepare for your accounting career in the CPA exam. My supplementary CPA resources are aligned with your Becker, Roger, Wiley, and Glean. I also provide you access to 1,500 previously released AI CPA questions with detailed solution. Invest in yourself. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation like this recording, share it with other connect with me on Instagram, Facebook, Twitter, and Reddit. The creditor will start with a balance of 2,284,711. Now how did we come up with this carrying of notes, carrying of notes receivable? And this is by the way, this is the creditor so we're looking at note receivable here. So how did we come up with this one? Well remember, we had to compute the present value, the present value of the loan amount and the present value of the payment and this is the value of the note. At the beginning of this modification terms. Then what we're gonna do, we're gonna find out what's our interest revenue. Our interest revenue is the note times 12%. So it's gonna be the note times 12% and it's gonna give us 274,165. So the cash is based on the new loan. So the cash amount of 240,000, it's a loan of 2.4 million times 10%. This is how much the borrower is paying us now. And the payment is split between interest revenue and an increase in the notes receivable. So if we got paid 240,000, well, interest revenue is 274,165. The remainder, it's gonna be increase in the note, increase in the note. So we're gonna debit cash, 240,000, debit allowance, 34,165 and credit interest revenue, 274,165. Then for payment two, cash will be the same. The allowance will be 38,265 and the interest revenue will be 278,265. And obviously, this will be the entry for year three. By year three, we're gonna make the last payment and the last payment will be 2.4, the last payment that we will receive will be 2.4 million. We debit allowance 600,000 and we credit the old note of 3 million. This is the last payment. In case you are wondering, why are we debiting allowance for doubtful account? Well, by debiting the allowance, we are reducing the allowance because remember the allowance is a counter receivable. By reducing the allowance, we are increasing the notes receivable. So just in case you're wondering, why am I debiting the allowance? Now let's change the scenario a little bit for this example and change the following agreement between local bank and Adam construction. Now local banks gonna forgive 1.1 million rather than 600,000. It's gonna reduce the loan from 3 million to 1.9 million. Also, local banks gonna extend the note and it's gonna lower the interest rate by 2%. So all we did is rather than forgiving 600,000, local bank forgave 1 million, 1 million, 100,000. Again, we're gonna try to find out whether the debtor has a gain, yes or no, a gain or no gain when how much and the creditor, if they have a loss, of course the creditor will have a loss just how much is the loss. Let's look at the debtor first Adam. They have an old loan of 3 million and the new loan, what they're responsible for is 1.9 million, 1.9 million plus three interest payment of 190,000 because the loan now is 1.9 million, the new interest rate is 10. So they have to pay 2,470 in total. Do they have a gain? Yes, they do and the gain is 530,000. So Adam will happily debit notes payable 530,000. They would reduce the notes payable 530,000 and they will credit it again on troubled debt restructuring. So notice in this example we had a gain and the prior example we had no gain. Okay, now you have to be a little bit careful. You're gonna see what's gonna happen to the debtor when they journalize their entries next. Now they have a gain. The creditor, what's gonna happen to the creditor now? The creditor they have a prior, when I say loan is I mean notes receivable but since I just for simplicity I'm just comparing loan to loan but it's really a notes receivable prior to the debt restructuring. I should have changed it to notes receivable. At discount the new loan, the loan from the debtor, discount the new loan based on the old rate. So when we do the discount we'll use the old rate. Be careful. So 1.9 million times the factor 0.71178, 1,352 million. We're gonna discount the new payments based on again the old rate, 190,000 which is the new interest payment times 2.40183, 456,348. What we're gonna do, we're gonna add those two and we're gonna compare them to the three million. So let's go ahead, add them up, compare them to the three million and find out how much is our loss. So if we take 1,352,382 plus 456,348 and that's gonna give us a new notes receivable of 1,808,730. So if we take this number, the new notes receivable deducted from the three million old notes receivable we find out that we have a loss of 1 million. The loss is 1,191,270. We have a loss and this is how we did the discounting. The present value of a single amount, the present value of an annuity factor 2.401. Now what would the creditor do? The creditor will debit that expense for the amount 1,191,270 and they will credit allowance for 1,191,270. Remember the new balance now, be careful. The new carrying amount of the notes receivable is 1,808,730. We're gonna see this again once we prepare the schedule for the creditor. Now let's take a look at what the debtor will do and what the creditor will do subsequent to this. The debtor is gonna start with the carrying amount of a notes payable of 2,470. Then the debtor will start to make a payment of 190,000. How much of that payment is interest and how much of it is a reduction in the notes? None of it is interest. Zero of it is interest. Why? Why? Because the debtor now, they cannot even pay the principal, okay? Everything that they're paying, everything that they're gonna pay is 570,000. Everything that they pay in total and the creditor forgave 1.1 million. So none of their payment is interest. They cannot deduct any of it. So all the payments, it's gonna go toward reducing the carrying value. So when would that happen? Well, when the sum of the interest-counted cash flow is less than the carrying value of the old debt. Then guess what? We have no interest, okay? So we're gonna debit notes payable 190 for the 190, credit cash 190. And we're gonna reduce the note to 2,280,000. Payment two, same thing. So we're gonna be debiting cash, debiting notes payable, crediting cash. And payment three, debiting notes receivable, crediting cash. And the balance will become 1.9 million. Then we make the last payment, what we agreed on. They reduce the balance to 1.9 million, and we are done. So notice here, why did we do this? Why we did not account for any interest expense? Because we had a gain. We cannot even pay back the principal. So none of our payments should be considered interest expense. What would the creditor do? The creditor is starting with a balance of 1,800, 8,730, and it's based on the old balance was 3 million. Remember we computed the new discounted cash flow and we took a loss of 1,191,270. So the new receivable is 1,808,730. And we're gonna do the same thing. We're gonna compute the interest revenue based on the carrying amount times the old rate, which is 1,808,730 times 12%. That's gonna be the interest revenue. The cash received is based on the new loan. The debtor now is sending us 190,000 and we're gonna split it between the interest revenue and the increase in the carrying amount. And we're gonna debit cash, debit allowance. And again, when we debit allowance, when it means we are reducing allowance, it means we are increasing the note. We increase the note to 1,835,778. Now, we're gonna do this again for payment two, 190,000, compute the interest revenue, and the difference is an increase in the note. By the third payment, our note will be 1.9 million. We're receiving the last payment of cash 1.9 million, debit the allowance 1,100,000 and crediting the notes receivable of 3 million. So those are the entries. What should you do now? Well, the best way to do this is to go to my website, farhatlectures.com and work MCQs, multiple choice questions to learn more about this topic. At the end of this recording, I'm gonna remind you to take a look at my website. I provide you additional resources that's gonna help you, whether you are an accounting student or a CPA candidate. Don't shortchange yourself. Your CPA exam is worth it. Your accounting career is worth it. 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