Question

CASE 11‐2 Debt Restructuring

Whiley Company issued a $100,000, five‐year, 10 percent note to Security Company on January 2, 2016. Interest was to be paid annually each December 31. The stated rate of interest reflected the market rate of interest on similar notes.

Whiley made the first interest payment on December 31, 2016. Owing to financial difficulties, the firm was unable to pay any interest on December 31, 2017.

Security Co. agreed to the following terms:

The $100,000 principal would be payable in five equal installments, beginning December 31, 2017.

The accrued interest at December 31, 2017, would be forgiven.

Whiley would be required to make no other payments.

Because of the risk associated with the note, it has no determinable fair value. The note is secured by equipment having a fair value of $80,000 at December 31, 2017. The present value of the five equal installments discounted at 10 percent is $75,815.

Required:

Under current U.S. GAAP, at which amount would Whiley report the restructured liability at December 31, 2017? Explain. How much gain would Whiley recognize in its income statement for 2017? Explain. How much interest expense would Whiley recognize in 2016? Explain.

Under current U.S. GAAP, what alternatives does Security have for reporting the restructured receivable? Explain. How would each alternative affect the 2017 income statement and future interest revenue? Explain.

Discuss the pros and cons of the alternatives in (b) and compare them to the prior U.S. GAAP treatment (treatment that was reciprocal to the debtor).

If debtors were allowed to record the restructuring agreement in a manner similar to creditors, what would be the incremental effect (difference between what would be reported in this case and current U.S. GAAP for debtors) on Whiley’s financial statements, debt‐to‐equity ratio, and EPS for 2016 and 2017? Explain.

Answer 1

a.According to ASC 470 (FASB) (IAS 37), a gain will be recognized if the excess carrying amount of the payable surpasses the fair value of the assets transferred to the creditor. In 2017, Whiley should report $100,000 for restructured liability. Since the accrued interest is forgiven in 2017, Whiley will report the $10,000 as a gain on the income statement for 2017 and for 2018, the interest expense will not be reported since the restructured liability is $100,000 and will be paid in five equal installments to the Security Company.

b.Under GAAP, the Security Company has different alternatives. The first alternative is the restructured receivable will be reported as present value at $75,815 which is discounted at 10%. The second alternative would be that the Security Company reports at fair value of $80,000.

Both of these alternatives would affect the 2018 income statement and future interest revenue because changes in the present value of expected future cash flows are reported as bad debt expense and all changes in the present value of expected future cash flows are treated as adjustments to bad debt expense

c.According to ASC 310 (FASB), the con of these methods are if the present value of expected future cash flows or the fair value of the collateral is less than the recorded investment in the loan including accrued interest, a creditor shall recognize an impairment by creating a valuation allowance with a corresponding charge to bad-debt expense or by adjusting an existing valuation allowance for the impaired loan with a corresponding charge or credit to bad-debt expense.

d.Whiley's financial statements would state an increase in earnings per share and it would decrease the debt-to-equity ratio.