 Hello and welcome to this session. This is Professor Farhad and this session we're going to be looking at that restructuring. This topic is covered in advanced accounting and it's also covered on the CPA, specifically the FAR section. As always, I would like to remind you to connect with me only then if you are, if we are not connected already and make sure to subscribe to my YouTube. I have over 1500 plus accounting, auditing and tax lectures. Please, like my lectures if you like them, share them, put them in the playlist, let the world know about them. If you're benefiting from my YouTube, it means other people might benefit as well. This is my Instagram account, this is my Facebook account, and this is my website. On my website, I often have CPA offer. Right now I have a limited time offer for the gold standard CPA preparation with Becker. Right now, Becker is offering $1,000 off of the best course out there with unlimited access. But you have to keep in mind when you want to buy something, make sure you buy something when it's on sale. Now, why do companies put things on sale when it's a slow season? So right now it's summertime, it's a slow season. If you need a CPA course, buy it now and get $1,000 off. You will not get this offer when the busy season is on, which is toward the end of the year or post-attack season. So take advantage of this offer. Whether you're studying for your exam or if you are still a college student, Becker can supplement your education, your accounting education. So today we're going to be talking about troubled debt restructuring. The first thing I want to tell you is this. This topic is close to my heart and the reason is this, because I was practicing during 2007, 2008, 2009, and to a degree 2010, because this was still going on, the financial crisis. And if you know anything about those years, those were the financial crisis, the great financial crisis. And what happened during this time, many companies, especially companies that deals with construction, real estate, went through that restructuring. They got into trouble. They borrowed money prior to the financial crisis. They borrowed the money in 2005, 2006 when the economy is doing well. When 2007, 2008 hits, they were having difficulty paying back their loans. So what happened is they work with the bank and their lenders work with them, some sort of a structuring of the debt. So this is why this topic is close to my heart. So what is troubled debt restructuring? It occurred when a creditor, think of it as a bank, it doesn't have to be a bank, for economic or legal reason related to the debtor's financial difficulty grant a concession. Because think of it, economic difficulties. We're not going to go into the legal reasons because of economic difficulties. The debtor cannot pay their loan. They're going through a financial difficulty and clearly in 2007, 2008, both the debtor and the creditor were going through financial difficulties. So they grant some sort of a concession that it would not otherwise would not be considered. What do we mean by otherwise it would not be considered? Here they are not refinancing. Because companies sometimes they refinance their loan. Well, if the interest rate goes down, they refinance their loan. Here we are not talking about refinancing the loan. Here we're talking about there are some difficulties. The debtor, the person, the company that borrowed the money is going through some difficulty and they cannot pay off their loan. Refinancing occurred when the company decided to refinance because of lower interest rate. That's not the case here. So what happened? Here's what happened. Maybe the loan was originated, let's assume in 2005. In 2007 or the end of 2007, they find out that the debtor is not really paying their loan. So they did what they did is they did the loan impairment. So they reduce the balance of the loan on their books. Then in 2008, what happened is the financial crisis still going on. So the bank said, let's work some sort of a deal. Let's work some sort of a deal and hopefully it will stop here. What do you mean work some sort of a deal? Let's do some debt restructuring. Let's restructure the debt. And hopefully if we restructure the debt, you'll be able to pay us something rather than us not getting anything. Well, if this doesn't work, we would go into a bankruptcy event. We'll force you into bankruptcy. So this is what we're going to be talking about today. Basically some sort of a debt restructuring modification of the terms. So it involves two basic transactions when we modify the term. Maybe we're going to settle the debt less than the carrying value. What does that mean? You owe us a million. We will accept 700,000. Give us the money and we'll call it even. Or we're going to keep the debt going, but we're going to change the terms. We may give you longer period to pay or we may lower your interest rate, not because you're refinancing because you're going through some financial difficulties. Now bear in mind what we're talking about here today, not bankruptcy. We are talking about a specific debt. We're looking at a specific debt. We are not restating all the liabilities. We're looking at a specific debt with a specific loan. So what would the settlement involve? So when we go through the settlement, it could involve the debtor may transfer assets in full settlement. So this could be a reason. Just get it done like this. The debtor may give an equity interest in a firm for full settlement. Guess what? We borrowed money from you. How about this? Why don't we switch the loan into equity? Simply put, we don't have money to pay you, but we'll give you stocks. Would you accept? If that's the case, you switch the debt into equity and you settle the loan or the creditor may modify the term of the payable. Modify means they may extend the, they may lower the payment, extend the payment, lower the interest rate or a combination of all of those. Okay. Now, anything that the creditor receive, anything that the creditor receive from the debtor, it's valued at fair market value. So if we gave the creditor a piece of land, some sort of an equity investment, it's always valued at fair value. Now the next thing we're going to do, we're going to look at all three transfer of assets, the debtor giving some equity or modification of the loan and work an example, explain them a little bit further and work an example starting with the transfer of asset, which is one of three, one of three options. The debtor transfer asset to a creditor is the total settlement of a payable recognizes a gain. So if the debtor transfers some sort of an asset, let's assume the asset is worth 100,000 and you owe a loan for 130, then you have a gain of 30,000. The gain is measured by the access of the carrying value of the payable over the fair value of the asset. So I'm giving you something that's worth only 100,000 and you are forgiving my $130,000 loan. The difference between the fair value and the carrying value of the asset transfer is a gain or a loss and is reported as a component of net income for the period transfer. Let's take a look at this example to illustrate this concept. The debtor transfer a land with a cost of 20,000, fair value of 15. So right there, stop right there. If we transfer a land that's worth 20,000 with a fair value of 15, immediately what we have to do is to book a loss and the loss is 5,000. The loss is on the land. Think about if you want to sell this land. If you sell this land, you only get 15,000 for it. Therefore, you have a loss of the land. Now you transfer this land that's worth 15,000, that's the fair value of the land, and you remove a payable that's worth 25. So you transfer the land and they say, guess what? Your payables are forgiving. Guess what? For this deal, you have a gain of 10,000. So notice you have a loss. You have to book a loss because the land is worth 15,000. If you sold it, it's worth 15, but it's on the books, it's worth 20. That's a loss on the land, but on the debt restructuring you have a gain. So the debt restructuring is you have a gain. Let's take a look at another example. Let's assume Barr Company, who's in financial difficulty in the process of voluntary reorganization, has agreed to transfer to a creditor to a copyright that owns for a full settlement of a $100,000 payable and 15,000 in accrued interest. Simple English, we owe the creditor $150,000 loan, and we are behind on our interest for 15,000. So simply put, we owe in total 165. 150 is the note and 15 is the interest. The copyright, which originally cost 100,000, this is the cost, has an accumulated amortization of 55. Well, now we can find the book value of it. So we have 100,000 minus 55. The book value of this copyright is 45,000. This is the book value and the current value of 95. So the fair market value, so the book value is 45. The fair value is 95. Well, the first thing we have to do, the first thing we have to do is we have to determine if we have a gain on the copyright itself. If we sell this copyright today, we can sell it for 95 and the book value is 45. Therefore, we have a gain of 50,000. We have a gain of 50,000 on the copyright itself. This is a gain of 50,000. Okay, this is a gain. Then we have to book the gain. Simply put, what we have to do is we have to increase the asset by 50,000 and book the gain of 50,000. And this is what it looked like. We have to increase the asset by 50,000 and credit the gain of 50,000. Now the copyright, remember now the copyright has a value. Now the copyright book, now the copyright on the books, this is the copyright. It was at 100,000. Now we wrote it up by 50. Now the book value or the, yeah, the book value, not the book value, the cost is 150. Or the asset is listed at 150, okay? So that's that. Now, so we have a gain on the revaluation of the asset. Now we have to do what? We have to do the following. First, we have to remove the loan because remember, we owe the loan of 150,000. So we have to remove the loan. So we have to debit notes, payable 150,000 because we have to remove the loan. We have to remove the accrued interest. Accrued interest is 15,000. Those are liabilities, therefore we debit them. Those are the debit. Now we remove the asset. The asset has 150 debit and 55 of accumulated depreciation. So we have to debit accumulated depreciation to remove the depreciation. And we have to credit the asset. We have to credit the asset. Then we have to determine if we had a gain or a loss on this deal. Well, let's think about it. We owe the company 165,000. That's how much we owe the company. Now for this 165,000, we gave them an asset that is worth. What's the worth of the asset? Let's find out 150. What's the book value of the asset? Minus 55. 150 minus 55. The book value of the asset is 95,000. The book value of the asset, by the time we get to the debt restructuring, is 95,000. 95,000. 95,000 book value. And they are removing a loan that's worth 65. We're giving them something that's worth 95. They said, well, your loan is forgiving. I'm going to forgive this loan. Notice I debited this loan for both loans for 165. They're gone. Well, guess what? You have a gain. That's 70,000 on the debt restructuring. Notice we have a gain on the debt restructuring and a gain on the transfer of the asset. So the asset, we have to revalue the asset first. And when we revalued the asset, we booked the gain. Then when we went through the debt restructuring, we had another gain. So we had two gains. We had two gains of a total of 120. Okay. Now, the question is how do we report those gains? Well, how do we report those gains? The gain on the transfer of the 50,000 should be reported as a separate item, assuming it's a material amount. If it's not a material amount, it will be reported with other gains. The gain on the 70,000 should be reported as a separate amount because now we want to show that this is a debt restructuring. Again, from debt restructuring is not really good in a sense that you should not be proud of it. Therefore, you need to disclose it separately if there's a gain on restructuring. So let's change the scenario a little bit. And let's assume the fair value of the asset rather than, how much was it earlier? Rather than 95, rather than 95, let's assume the fair value of the asset was 30. What happened if the value of the asset is 30? Well, the first thing we have to do is we let's assume we solve this asset. That's because we need to revalue the asset. Well, the fair value equal to 30. What's the book value? The book value of the asset was 100,000 cost minus 55 accumulated depreciation. The book value was 45. This is the book value. Well, guess what? We have a loss. We debit the loss of 15 and we credit the asset. We have to write down the asset. Now, the asset is only worth 15,000. So we have a loss. Why? Because the fair value is 30. The book value is 45. The next thing we're going to have to do, we're going to have to, we gave them the, now we're going to give them the copyright and we're going to start to remove the debt. So the first thing we do is we debit the note, debit the accrued interest. This is the 165, the R4 given 165. Now we have to debit accumulated amortization. Just to remove the asset, remove the asset copyright with the book value of 85, remove the asset as well. Okay. Remember, it's 100,000 minus 15. Okay. Which is 85 because we reduce the asset. Why did we reduce the asset? Because of the revaluation. Now, let's compute to see if we have a gain or we have a loss on this example. We gave them an asset that's only worth. That's only worth. Okay. That's only worth how much? Okay. We gave them an asset. I'm sorry. That's only worth the book value. We gave them an asset with the book value of let's see 85,000 minus 55,000. So the book value of the asset is 30,000. The book value of the asset is 30,000. We gave them something that's worth 30,000. And they said, guess what? We're going to forgive 165 of your debt restructuring. Guess what? That's a good deal. We have a gain. How much is the gain? The gain is 135,000, 135,000. Not bad at all. Not bad at all. So notice we work an example where we had the fair value of the asset was less than the book value and one example where the fair value is higher. The second option is to grant an equity interest. And what do you mean by grant equity interest? I'm not sure if you guys remember this company called Borders. Borders used to be like bonds and nobles, basically a bookstore. Maybe you remember it. Maybe not. Borders used to go there a lot. Borders also went through trouble. They faced financial difficulties and they could not pay their liabilities. So here's what Borders did. They offered their supplier, which is the book publisher, equity. They said, guess what? We have an accounts payable, let's assume $20 million for our suppliers. Would you be interested in switching that and will give you equity worth of $20 million? And the publisher said, no, we're not interested. So that was their last resort. Why? Because the publisher knew Borders was not doing well. They knew this because Borders were not paying their well. So this is what you do. You offer them equity. I will give you stocks in my company. You just remove my debt. That's the idea. So the debtor may issue equity interest in the firm to a creditor in full settlement of a payable. So the creditor will account for the stock at its fair value if they received equity stocks. The difference between the fair value of the equity issued and the carrying amount of the debt is reported as a gain. Let's assume you owe them $1 million. You gave them only $800,000 of equity you have a gain. The debtor determined the gain based on the indiscounted cash flow. So if there is no fair market value for the stock, you figure out what's the discounted cash flow. The best way to illustrate this is to work a quick example. Let's assume American Citibank agrees to accept from Union mortgage $320,000 shares of its common $10 power value. The fair value is $16 million. So the mortgage company told the bank, I will give you $320,000 shares of stocks that are worth today $16 million. But you have to remove my loan that I owe you, which is $20 million. Do I have a gain? Of course I have a gain. Why? Because I am removing a debt of $20 million with only $16 million of value. So what do I do? I debit the bank. This is the bank. So let's look at the bank's perspective. The bank will debit equity investment of $16 million. Now they have an investment, which is an asset. This is the bank entry. This is American Citibank. They will, they have a loss allowance for the outfall account because now they have basically a loss on the receivable and they credit a note. They will credit the note to remove the note because the mortgage company owe them $20 million. Now they no longer owe them $20 million. What they did, they removed the note and they replace it with $16 million. And in between they have a loss. Now let's take a look at the mortgage company. What would the mortgage company do? The mortgage company, they'd have to remove the note. The mortgage companies are very happy because they remove the note. They credit common stock by $3.2 million. Now why $3.2 million? Maybe you know this, maybe not. It's the number of shares times the par value. Par value is $10. That's giving them the problem. $3.2 million. Then they will, the remainder of the $16 million is paid in capital. Remember, those two has to equal to $16 million. Whatever we give to common stock, anything that's left goes into paid in capital. Now obviously, since the bank has a loss of $4 million, we have again a $4 million. The union mortgage company, why do we have a gain of $4 million? Because we settle alone, we owe them, initially we owe them $16 million. But we only, sorry, we owe them $20 million and we pay them $16 million. So for us, it's again, obviously the other side of the party, there is basically a loss of $4 million. They had to write down their asset. They had to write down their asset. The third option for a debt resettlement is modification of terms. What is modification of terms? Here what we're doing is we are changing the terms. Basically, we might extend the terms. We might change the interest rates, some sort of a modification. The debtor and trouble that restructuring involving only modification of terms of a payable account for the effect of the restructuring prospectively from the time of the restructuring. Simply put, we don't look back. We just say we modify the loan, then we look forward to computing the interest, the principal, basically, according to the new terms of the loan. So the carrying value of the payable has not changed at the time of the restructuring unless the carrying value exceed the total future cash flow. So the carrying value of the payable has not changed unless the carrying value is greater. The carrying value is greater than the future cash flow. What does that mean? Think about it for a moment. Think about it for a moment. The carrying value, the book value of the loan should be less than the future cash flow. Why? Because the loan, because in the future, when you pay the future cash flow, the future cash flow has to be more. Why? Because it involves interest. So we don't do any modification unless the carrying value is greater than the cash flow. Because the loan, remember, the loan, any loan is the present value of payments. Therefore, the loan, the present value of the loan. So the book value of the loan should be lower than the payments. If we happen to have a deal where the book value of the loan exceeds the future value of the payment, that's a little bit unusual than what we have to do. When I talk about this topic more in my intermediate accounting chapter 14, then we no longer charge interest. The loan, the payments will be all principle. Okay, we have to change the loan to equal to the future cash flow payment. Okay, but just FYI. Because one more time, any loan equal to the present value of payments. So the loan is recorded at the present value of the payments. Well, if you compute all the future cash flow, those should be higher. If they happen to be lower after the modification, then you have to adjust. Okay, just have to know this. Let's take a look at this example to see how this all work. Lake Company, a major creditor to the financially troubled Spain company, had agreed to modify the terms of a debt owed to Lake Company. The debt consists of 9 million, 12% no debts due currently along with the crude interest of 95,000. So the principle of the loan is 900,000 and there is 95,000 in interest that's unpaid. Lake Company agreed to extend the due date of the note in a crude interest for three years and to reduce the interest rate to 5%. They were charging them 12, now they're going to charge them 5. And they agreed to increase the payment into three years on both the maturity value and the crude interest and the interest to be paid annually. So that's the deal. So the first thing is we want to know should again be recognized by Spain company. Now let's think about it for a moment. Should again be recognized. Well, how much do we owe them today? How much do we owe them today? Well, do we owe them today? Today we owe them 995,000. Now what do you have to do? You have to compare this to the new, to the new, to the new, to the new future cash payment. Okay. Now the interest rate is 5% on the new loan and they extended the term by three years. Let's take a look at this. No gain should be recognized because the total future cash payment specified under the new terms, 1,144,250 which is 995,000. This is what we owe them now. What else do we have to do? We have to also pay plus three years interest of 49,000, 49,750 plus those plus the interest payment will give us 1,144,250. We have to pay this much and we owe them this much. So do we have a gain? No, we don't have a gain because the payments that we're going to be making will be greater than what we owe them today. So let's book the journal entry today for this deal. Well, if we book the journal entry, we have to remove the note. We debit the note because they said, you know, your note is forgiven. We debit the accrued interest because also the accrued interest is forgiven. We have basically a new loan and the new loan is 995,000. And on this loan, we're going to be making three payments basically extended for three years, making three payments which include interest. So basically this is a modification of the terms. Now, in advanced accounting, I don't go into modification of the terms much, much, much more in details because this topic is mostly covered in advanced accounting. So if you want to know more about modification of the terms including gains, losses, different scenarios, go to my website under intermediate accounting chapter 14. And I have plenty of, I have one whole lecture about modification of terms because it gets really, really involved. If you happen to visit my website, please consider donating if you are studying for your CPA exam. As always, study hard, it's worth it. And see you on the other side of success.