Case #1

Carter Manufacturing:
Do We Really Have Income?

Carter Manufacturing has $50 million of 8% bonds outstanding which were issued at par many
years ago. Because of cash flow problems, the company is behind in contributions to its bonds
retirement fund. The market value of the bonds was declined until it is currently only 60% of the
face value of the bonds. After lengthy negotiations, the principal bondholders have agreed to
exchange their bonds for preference share that has a current market value of $30 million. The
accountant for Carter recorded the transaction by charging Bond Liability for the entire $50
million and crediting Preference Share Capital for the same amount. This entry thus transfers the
amount received by the company from debt to equity.

The CPA firm performing the annual audit, however, does not agree with this treatment. The
auditors argue that this transfer represents a troubled debt restructuring due to the significant
concessions made by the bondholders, and under these conditions, accounting standards require
Carter to use the market value of the preference share as its recorded value. The difference
between $50 million book value of the bonds and the $30 million market value of the preference
share is a reportable gain.

The financial controller of Carter, Jackson Brown, is flabbergasted. “Here we are, almost
bankrupt, and you tell us we must report the $20 million as a gain. I don’t care what the
accounting standards require, that’s a ridiculous situation. You can’t be serious.”

The auditor in charge of the engagement is adamant. “We really have no choice. You have had a
forgiveness of debt for $20 million. You had use of the money, and based on current conditions,
you won’t have to pay it back. That situation looks like a gain to me.”

Discussion Questions
1. Under what circumstances a gain on troubled debt restructuring should be recorded?
2. Evaluate the various positions for recording the exchange of bonds for preference shares on
Carter’s books. What are the rationales and financial statement implications for the different
treatments suggested by the company’s accountant and its auditor? In your discussion, focus
on conceptual issues regarding the appropriate accounting treatment and consider the
external users of the financial statements and their needs. Also, focus your deliberations on
whether the accounting treatment would faithfully represent the economics of the transaction.