Debt Restructuring

LECTURE NOTES
Debt restructuring - The creditor grants the debtor concession that would not otherwise be granted in a normal business
relationship.

Common forms of debt restructuring

a. Asset swap – extinguishment of obligation through transfer of any asset such as real estate, inventory or
investment by the debtor. The difference between the carrying amount of the financial liability and the
consideration given shall be recognized in profit or loss.

b. Equity swap – Issuance of share capital by the debtor to the creditor in full or partial payment of an obligation.
 Measurement of equity instrument under PFRS 9 (in order of priority):
a. Fair value of equity instrument
b. Fair value of liability extinguished
c. Carrying amount of liability extinguished

c. Modification of terms
 Substantial modification – gain or loss on modification is at least 10% of the old financial liability. There
is extinguishment of old liability and recognition of a new liability.
 No substantial modification – gain or loss on modification is less than 10% of the old financial liability.
Note: Application Guidance of PFRS 9 clarified that any gain or loss on the modification shall be
recognized in profit or loss even if there is no substantial modification of terms.

APPLICATION
Problem 1: Youth Company is in financial trouble and could not meet maturing installments and interest on its bank
loan of P5,000,000. The accrued interest on the loan to date is P1,000,000.

The entity and the bank agreed on a "dacion en pago" arrangement. Thus, the mortgaged land and building were given
by the entity as full payment for the loan including accrued interest.

The cost of the land is P1,500,000 and the building, P6,000,000 with accumulated depreciation of P1,800,000. The fair
value of the land and building is about P5,900,000.

Required:
1. Compute the gain or loss on extinguishment of debt.
2. Prepare journal entry to record the "dacion en pago".

Guide:
1st: Compute for the liability extinguished
2nd: Compute for the asset given
3rd: Compare the 1st and 2nd for the G/L on extinguishment of liability

Solution:
Computation of gain on extinguishment of debt:
Bank loan payable 5,000,000
Accrued interest 1,000,000
Total liability 6,000,000 1st
Less: CA of asset:
Land 1,500,000
Building (Cost less Accum. Dep'n) 4,200,000 5,700,000 2nd
Gain on extinguishment of debt 300,000 3rd

JE:
Bank loan payable 5,000,000
Accrued interest 1,000,000
Accumulated dep'n - building 1,800,000
Building 6,000,000
Land 1,500,000
Gain on extinguishment of debt 300,000

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Problem 2: Gerald Company showed the following balances on December 31, 2020:
Note payable - due December 31, 2020 1,000,000
Accrued interest payable 200,000
The entity is in financial distress and negotiates with the creditor for the settlement of the note payable. Consequently,
the entity transferred a patent to the creditor in full satisfaction of the note payable. The patent has a carrying amount
of P600,000 and a fair value of P1,100,000.

Required: Prepare the journal entry to record the asset swap on the books of Gerald Company.
1. Under IFRS
2. Under US GAAP

Guide (IFRS):
1st: Compute for the liability extinguished
2nd: Compute for the asset given
3rd: Compare the 1st and 2nd for the G/L on extinguishment of liability

Solution:
Under IFRS
Computation of gain on extinguishment of debt:
Note payable 1,000,000
Accrued interest 200,000
Total liability 1,200,000 1st
Less: CA of asset (Patent) 600,000 2nd
Gain on extinguishment of debt 600,000 3rd

JE:
Note payable 1,000,000
Accrued interest 200,000
Patent 600,000
Gain on extinguishment of debt 600,000

Guide (US GAAP):

1st: Compute for the liability extinguished
2nd: Compute for the asset given (FV)
3rd: Compare the 1st and 2nd for the G/L on extinguishment of liability
4th: Compare the FV and CA of asset given for the gain on exchange

Under US GAAP
Computation of gain on restructuring of debt:
Note payable 1,000,000
Accrued interest 200,000
Total liability 1,200,000 CA of asset Gain on exchange
Less: FV of asset: 1,100,000 vs 600,000 500,000
Gain on restructuring of debt 100,000

JE:
Note payable 1,000,000
Accrued interest 200,000
Patent 600,000
Gain on restructuring of debt 100,000
Gain on exchange of asset 500,000

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Problem 3: Grab Company is threatened with bankruptcy due to the inability to meet interest payments and fund
requirements to retire P5,000,000 note payable with accrued interest payable of P400,000. The entity has entered into
an agreement with the creditor to exchange equity instruments for the financial liability.

The terms of the exchange are 300,000 ordinary shares with P5 par value and P10 market value, and 25,000 preference
shares with P10 par value and P60 market value. The fair value of the liability is P4,800,000.

Required: Prepare journal entry on the books of Grab Company to record the settlement of the note payable:
1. If the fair value of the equity instruments is used.
2. If the fair value of the liability is used.
3. If the carrying amount of the financial liability is used.

Guide:
1st: Compute for the liability extinguished
2nd: Compute for the shares given (FV)
3rd: Compare the 1st and 2nd for the G/L on extinguishment of liability
4th: Compare the FV and PAR VALUE of shares given for the share premium

1st: FV of EQUITY
Computation of gain on extinguishment of debt:
Note payable 5,000,000
Accrued interest 400,000
Total liability 5,400,000 1st
Less: FV of equity:
Ordinary 3,000,000
Preference 1,500,000 4,500,000 2nd
Gain on extinguishment of debt 900,000 3rd

4th
Computation of share premium: FV of Shares Par Value Share Premium
Ordinary 3,000,000 1,500,000 1,500,000
Preference 1,500,000 250,000 1,250,000
Total 4,500,000 1,750,000 2,750,000

JE:
Note payable 5,000,000
Accrued interest 400,000
Gain on extinguishment of debt 900,000
Ordinary share capital 1,500,000
Share premium - OSC 1,500,000
Preference share capital 250,000
Share premium - PSC 1,250,000

Guide:
1st: Compute for the liability extinguished
2nd: Compute for the FV of the liability
3rd: Compare the 1st and 2nd for the G/L on extinguishment of liability
4th: Compare the FV of the liability and PAR VALUE of shares given for the share premium

2nd: FV of LIABILITY
Computation of gain on extinguishment of debt:
Note payable 5,000,000
Accrued interest 400,000
Total liability 5,400,000 1st
Less: FV of liability 4,800,000 2nd
Gain on extinguishment of debt 600,000 3rd

**4th: Since there are two types of shares, allocate the FV of liability using the FV of shares.
Allocation of FV of Liability: FV of Shares Fraction FV of liability** Par Value Share Premium
Ordinary 3,000,000 3/4.5 3,200,000 1,500,000 1,700,000
Preference 1,500,000 1.5/4.5 1,600,000 250,000 1,350,000
4,500,000 4,800,000 1,750,000 3,050,000

JE:
Note payable 5,000,000
Accrued interest 400,000
Gain on extinguishment of debt 600,000
Ordinary share capital 1,500,000
Share premium - OSC 1,700,000
Preference share capital 250,000
Share premium - PSC 1,350,000

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Guide:
1st: Compute for the liability extinguished
2nd: Compute for the liability extinguished
3rd: No more G/L on extinguishment
4th: Compare the CA of the liability and PAR VALUE of shares given for the share premium

3rd: CA of LIABILITY
Computation of gain on extinguishment of debt:
Note payable 5,000,000
Accrued interest 400,000
Total liability 5,400,000 1st
Less: CA of liability attributable to: 5,400,000 2nd
Gain on extinguishment of debt - 3rd

4th: Since there are two types of shares, allocate the CA of liability using the FV of shares.
Allocation of CA of Liability: FV of Shares Fraction CA of liability Par Value Share Premium
Ordinary 3,000,000 3/4.5 3,600,000 1,500,000 2,100,000
Preference 1,500,000 1.5/4.5 1,800,000 250,000 1,550,000
4,500,000 5,400,000 1,750,000 3,650,000
JE:
Note payable 5,000,000
Accrued interest 400,000
Gain on extinguishment of debt -
Ordinary share capital 1,500,000
Share premium - OSC 2,100,000
Preference share capital 250,000
Share premium - PSC 1,550,000

Problem 4: Grey Company had an overdue 8% note payable to City Bank at P8,000,000 with accrued interest of
P640,000.

As a result of a settlement on January 1, 2020, City Bank agreed to the following restructuring arrangement:
a. Reduced the principal obligation to P7,000,000.
b. Forgave the P640,000 accrued interest.
c. Extended the maturity date to December 31, 2021.
d. Annual interest of 10% is to be paid on December 31, 2020 and 2021.

The present value of 1 at 8% for two periods is 0.8573, and the present value of an ordinary annuity of 1 at 8% for two
periods is 1.7833.

Required: Prepare journal entries for 2020 and 2021 to record the modification of terms.

Guide:
1st: Compute for the old.
2nd: Compute for the PV of the new liability. (Use Old ER for the PVF)
3rd: Compare the 1st and 2nd for the G/L on extinguishment of liability.
- If the G/L is at least 10% of the old liability, then there is extinguishment of debt.
- If the G/L is less than 10% of the old liability, then there is no extinguishment of debt, only modification of debt.
4th: Prepare an amortization table, if necessary.

Solution:
Computation of gain on extinguishment of debt:
Note payable 8,000,000
Accrued interest 640,000
Total liability (OLD) 8,640,000 1st
Less: FV of liability (NEW)**: 7,249,410 2nd (1,390,590 / 8.64M)
Gain on extinguishment of debt 1,390,590 3rd 16% There is extinguishment of debt.

Use old ER
**Computation of FV of liability (NEW): FCF PVF PV Premium
Principal 7,000,000 0.8573 6,001,100
Interest 700,000 1.7833 1,248,310
PV, Jan. 1, 2020 7,249,410 249,410

4th: The initial CA will be the PV of the NEW liability.

Amortization table: Use old ER
Date NI EI Prem. Amort. CA
1/1/2020 7,249,410
12/31/2020 700,000 579,953 120,047 7,129,363
12/31/2021 700,000 570,637 129,363 7,000,000

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JE:
Jan. 1, 2020
Note payable - old 8,000,000
Accrued interest 640,000
Note payable - new 7,000,000
Premium on note payable - new 249,410
Gain on extinguishment of debt 1,390,590

Dec. 31, 2020

Interest expense 579,953
Premium on note payable 120,047
Cash 700,000

Dec. 31, 2021

Interest expense 570,637
Premium on note payable 129,363
Cash 700,000

Note payable 7,000,000

Cash 7,000,000

Problem 5: On January 1, 2020, Sunrise Company is experiencing extreme financial pressure and is in default in
meeting interest payment on a long term note of P6,000,000 due on December 31, 2021.

The interest rate is 12% payable every December 31. The accrued interest payable on January 1, 2020 is P720,000. In
an agreement with the creditor, the entity obtained the following changes in the terms of note:
a. The accrued interest on January 1, 2020 is forgiven.
b. The principal is reduced by P500,000.
c. The new interest rate is 8% payable every December 31.
d. The new date of maturity is December 31, 2023.

The present value of 1 at 12% for four periods is 0.6355, and the present value of an ordinary annuity of 1 at 12% for
four periods is 3.0373.

Required: Prepare journal entries for 2020.

Guide:
1st: Compute for the old.
2nd: Compute for the PV of the new liability. (Use Old ER for the PVF)
3rd: Compare the 1st and 2nd for the G/L on extinguishment of liability.
- If the G/L is at least 10% of the old liability, then there is extinguishment of debt.
- If the G/L is less than 10% of the old liability, then there is no extinguishment of debt, only modification of debt.
4th: Prepare an amortization table, if necessary.

Solution:
Computation of gain on extinguishment of debt:
Note payable 6,000,000
Accrued interest 720,000
Total liability (OLD) 6,720,000 1st
Less: FV of liability (NEW)**: 4,831,662 2nd (1,888,338 / 6.72M)
Gain on extinguishment of debt 1,888,338 3rd 28.10% There is extinguishment of old debt.

Use old ER
**Computation of FV of liability (NEW): FCF PVF PV Discount
Principal 5,500,000 0.6355 3,495,250
Interest 440,000 3.0373 1,336,412
PV, Jan. 1, 2020 4,831,662 668,338

4th: The initial CA will be the PV of the NEW liability.

Amortization table: Use old ER
Date NI EI Prem. Amort. CA
1/1/2020 4,831,662
12/31/2020 440,000 579,799 139,799 4,971,461

JE:
Jan. 1, 2020
Note payable - old 6,000,000
Accrued interest 720,000
Discount on note payable 668,338
Note payable - new 5,500,000
Gain on extinguishment of debt 1,888,338

Dec. 31, 2020

Interest expense 579,799
Discount on note 139,799
Cash 440,000

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Problem 6: Due to adverse economic circumstances and poor management, Bontoc Company has negotiated a
restructuring of P8,500,000 note payable to Second Bank.

The bank has agreed to reduce the face amount of the note from P8,500,000 to P8,000,000, reduce the interest rate
from 14% to 10%, and extend the due date one year from date of restructuring.

The restructuring was done on January 1, 2020. There is no unpaid interest on the restructured note at this time.

The present value of 1 at 14% for one period is 0.8772, and the present value of an ordinary annuity of 1 at 14% for
two periods is 1.6467.

Required: Prepare journal entries for 2020.

Guide:
1st: Compute for the old.
2nd: Compute for the PV of the new liability. (Use Old ER for the PVF)
3rd: Compare the 1st and 2nd for the G/L on extinguishment of liability.
- If the G/L is at least 10% of the old liability, then there is extinguishment of debt.
- If the G/L is less than 10% of the old liability, then there is no extinguishment of debt, only modification of debt.
4th: Prepare an amortization table, if necessary.

Solution:
Computation of gain on modification of debt:
Total liability (OLD) 8,500,000 1st
Less: FV of liability (NEW)**: 7,719,360 2nd (780,640 / 8.5M)
Gain on modification of debt 780,640 3rd 9.18% There is no extinguishment of old debt.
There is only modification.

Use old ER
**Computation of FV of liability (NEW): FCF PVF PV Discount
Principal 8,000,000 0.8772 7,017,600
Interest 800,000 0.8772 701,760
PV, Jan. 1, 2020 7,719,360 280,640

4th: The initial CA will be the PV of the NEW liability.

Amortization table: Use old ER
Date NI EI Disc. Amort. CA
1/1/2020 7,719,360
12/31/2020 800,000 1,080,640 280,640 8,000,000

JE:
Jan. 1, 2020
Note payable 500,000
Discount on note payable 280,640
Gain on modification of debt 780,640

Dec. 31, 2020

Interest expense 1,080,640
Discount on note 280,640
Cash 800,000

Note payable 8,000,000

Cash 8,000,000

END

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