 Hello, and welcome to the session in which we will discuss troubled debt restructuring. So what is the big idea with the troubled debt restructuring? It's a mouthful, and it sounds very intimidating. Well, the basically what we're looking at is when the creditor, when a lender, when the bank grant concessions to debtor, to the borrower, not made under normal circumstances. What does that mean? It means at some point the bank says, you know what, I should cut my losses and accept whatever I can get from the borrower because I may not get anything. And this happened during the real estate crash of 2007, 2008. I was still in practice, and we had many construction in real estate companies as clients, and they went through this troubled debt restructuring. So I still remember those days where I had to deal with this topic right front and center. Simply what happened is this, we have two options. The person in trouble and the creditor, they'll have to agree and they will agree on two things. Either they will settle the debt that's called settlement of the debt at less than the carrying amount. So if you owe a million dollar, they would say, if you can give us 600,000 and we call it even and it's done. We settle the debt at less than the carrying value. If that happens, the debtor would record the gain. It's an unfortunate that they would record the gain. Think about it. You're going out of business or you're in trouble, but somehow you happen to record a gain. That's fine. You record a gain on the settlement of the debt. Now also you might record either a gain or a loss on the asset that you are exchanging will hold on that. The creditor usually would record the loss. Usually it's a part of allowance. So if the creditor estimated enough allowance, it will be an allowance. If they don't have enough allowance, they'll have to debit a loss or some sort of a write off expense. The other option is rather than settle the debt. And once you settle the debt, basically the case is closed. You settle the debt, the debtor go their way. The creditor goes the other way and it's over. The other option, if there is some issues with the debt is modification. What is modification? You modify the terms of the debt. So the debt don't go away. What does that mean? It's either extended that lower the interest rate, accept the lower payment, but the process keeps on going. Now, from an accounting perspective, we have to look at two treatments when it comes to debt modification. It's called basically the technical term is loan impairment. And what we look at is we will look to see if the future cash flow from this new deal is less than the carrying value of the debt. Or if the future cash flow, again, un-discounted is greater than the carrying value of the debt. We would look at these two options in the next session. For this session, we would look at how to deal with troubled debt restructuring when it comes to settlement of the debt. Now, how do we settle the debt? Think about it. How do you settle a debt? You just have to give something to the creditor. What would you give them? Obviously, if you have the cash, you wouldn't be in trouble. You're going to have to give the creditor non-cash assets, and those could be construction vehicle, building, land that you own, some sort of a value, or some might accept stocks of your company. They might say, okay, I want 50% of your company, 40% of your stocks. If they think there's a value into it. And guess what? If banks or creditors did accept those and accepted stocks in construction company two years later, they would have been made whole and even make a profit because two years later, the economy picked up in construction company. Since then, they've been very busy because the government lowered the interest rate. So this is what you will do. The creditor should account for any non-cash asset or equity interest received at fair value. So whatever you receive in stocks of the company that you are dealing with, or if they gave you assets, you have to value them at fair value. And this is important. Why? Also, the debtor will have to value them at fair value. What does that mean? That means when they give you something, they either have to record or again. Now the best way to illustrate this concept is to actually look at an example to show you the process and the journal entries. Before we look at the example, whether you are a student or a CPA candidate, I strongly encourage you to take a look at my website, farhatlectures.com. I don't replace your CPA review course. My motto is saving CPA exam candidate and accounting student one at a time. I'm a useful addition. I can provide you with additional resources, which can help you with your accounting courses with your CPA exam preparation. I supplement your CPA review course. 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If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendations. Like this recording, share it with other connect with me on Instagram, Facebook, Twitter and Reddit. Local Bank loaned $10 million to Adam Construction Company, ACC. Due to the real estate crisis, Adam Construction Company can no longer make the payments. Let's see what happened. Local Bank agrees to accept a land from Adam's company with a fair value of $8 million in full settlement of the $10 million obligation. So simply put, the bank says, okay, you owe me $10 million, give me that land that's worth $8 million and we'll call it even. The land has a book value of $12 million on the books of Adam's company. So we're going to do the journal entries for both the bank as well as Adam's company to see how it works. Let's start with the bank. Local Bank will credit the notes receivable for Adam. That's it. They're going to have to credit this $10 million because they no longer have it. They have to remove it. They will debit the land. Instead they got the land for $8 million. Remember they have to record it at fair value, at fair value. Now the difference is allowance for doubtful accounts. And here we are assuming the bank estimated enough losses that this goes against their allowance. If they don't have enough losses estimated, if they don't have enough allowance estimated, it will be a loss. Now what would Adam's company do? Well Adam will be happy to remove the $10 million notes payable from the local bank. They will debit the notes payable and also they will need to get rid of the land. They will get rid of the land because it's on the books for $12 million. They credit the land for $12 million. Now here's what happened. Adam had a gain and Adam had a loss at the same time. How? When it comes to the land itself, when it comes to the land itself, okay, the land has a book value of $12 million and fair value of $8. It's as if Adam sold the land for $8 million, had a loss of $4 million and gave the $8 million to the bank. It's the same thing because look, the bank got $8 million. But that's all what happened. It's if they sold it. So if they sold it, they would have a loss of $4 million. So Adam will book a loss on the land of $4 million. That's the bad news. The good news is Adam had a loan of $10 million. He got rid of a loan for $10 million for something that's worth $8 million. So what happened is this. The land, again, we had a liability for $10 million. We purchased it back. We settled it, a liability of $10 million and we paid for it only $8 million. What's that $8 million in the land? Well, we have a gain. We have a gain. So notice what happened. We have a gain and a loss at the same time, a loss on the land itself. Because think about it. Adam could have just sold that land, get the $8 million, write a check to the bank and gave them the $8 million and book the loss of $4 million on the land sale. But they didn't do this. Just basically, it's if they sold it to the bank. On the loan, Adam owns $10 million. The bank says, give me $8 million and I will settle your loan. Well, I have a gain on the loan. So notice you have a gain and a loss and this is what I was trying to say earlier. You could have a gain or a loss. Well, what else could happen? Well, instead, assume local bank agrees to accept from Adam Construction Company, $400,000 share of its $1 common stock that has a fair value of $9 million, I would have taken this deal, right? In full settlement of the $10 million loan. What happens here? Let's go through the journal entries again. From the bank's perspective, they will remove the notes payable for Adam's company. They will debit equity investment in Adam's Construction Company and they will debit allowance again or a loss depending on their balance. This is local bank. What would Adam's company do? Adam will be happy to remove the loan of $10 million. They're going to have to issue stocks of $400,000. Remember, number of shares times the power value, number of shares is $400,000 times the power value happens to be $1. Then what we do is we determine whether Adam has a gain or a loss. Well, let's think about it. Adam settles a debt for $9 million. That's the fair value that they gave out and the debt was for $10 million. Simply put, Adam would have a gain of a million dollar. The entry will need to balance since we're issuing stocks. Anything left, we're going to credit paid in capital and excess of power for the difference and that's the $8.6 million. This is the entry that Adam would make under books. Obviously, if I was the bank, I will own an Adam's stocks, assuming I know what happened post 0708 or it could be that I invested in the Adam construction company. The economy kept going south and Adam went out of business, so your equity investment is worth zero versus the land. You can sell the land. Basically, the bank will take a risk. Usually, the bank don't accept stocks. They usually prefer land or some asset that they can sell or they can value. It doesn't fluctuate as much as stocks. What should you do now? The best way to learn this concept is go to my website, farhatlectures.com, work additional multiple choice questions and look at additional resources. In the next session, I would look at the second option. Remember, we can settle the debt. That's one way to do it or we can have a modification of the debt. That's the other option that we have. In the next session, that's what we do. We would look at the modification of the terms and see what would happen if we have a modification of the term. Again, I'm going to invite you, farhatlectures.com. Invest in yourself. Invest in your career. The CPA exam is worth it. Don't shortchange yourself. Good luck.