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Page 1: Intermediate accounting
Page 2: Intermediate accounting

Intermediate AccountingCasePresentation

Troubled Debt Restructuring

Zheng Yuchuan

Lu Huiping

SalmanKamani

Qu Xin

Page 3: Intermediate accounting

Presentation FlowPresentation FlowPart IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Q&A

Page 4: Intermediate accounting

Part I

BackgroundIntroduction

Page 5: Intermediate accounting

$50 Millionof 8% bonds, issued years ago

Behindin interest payments and contributions to its bonds retirement fund

60%of par: $30 million

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 6: Intermediate accounting

Bondsto

Preference Shares

$30 million$30 million

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 7: Intermediate accounting

Here’s the Problem…

Bonds liability 50m Preference share capital 50m

Bonds liability 50mPreference share capital 30mExtraordinary gain on debt restructuring 20m

We really have

NO choice!You had use of the

money, and you won’t have to pay it back.

Auditor:Here we are, almost bankrupt, and you tell us we must report $20 m as a gain.

Are you

kiddingme?

Company:

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 8: Intermediate accounting

What should we do?

??

?

?

?

?

? ?

Page 9: Intermediate accounting

Part II

DebtRestructuring

Page 10: Intermediate accounting

Debt Restructuring

• Outstanding debt

• Alter debt agreements

• Achieve advantages.

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 11: Intermediate accounting

ModificationSettlementDebt

Impairments

• Creditor’s perspective

•Unable to collect all amounts due• Loss contingency

• Extraordinary loss

• Creditors: Grant a concession

•Asset/Equity Swap

• Less than CV

• Creditors: Grant a concession

•More favorable terms

• Extinguishment & Establishment

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 12: Intermediate accounting

Then…

When shall we recognize gains?

Page 13: Intermediate accounting

Debt Impairment

No Gain!!!

CV

Only Loss!!!

PV of expected future CF

using historical rates

Loss on Impairment

Bad Debt XXAllowance for Doubtful A/C XX

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 14: Intermediate accounting

Modification

Restructured gain = CV of debt – PV of expected CFs using

historical rates

Interest Payable XXBonds Payable XX Restructured Debt XX Gain on Restructuring of Debt XX

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 15: Intermediate accounting

Settlement - Equity/Asset Swap

Debt Equity/Asset

CV of Debt FMV of Asset/Equity

Not a troubled debt Restructuring

Restructured gain = CV of debt – Asset/Equity FMV

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 16: Intermediate accounting

Note Payable XXProperty Investment XXOrdinary Gain on Asset Disposition XXExtraordinary Gain on Debt Restructuring XX

Creditor

Asset Swap

Note Payable XXShare Capital XXShare Premium XXExtraordinary Gain on Debt Restructuring XX

Equity Swap

Allowance for doubtful A/C XXShare/Property Investment XXBonds Receivable XX

Debtor

Asset/Equity Swap

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 17: Intermediate accounting

Part III

RationalesBehind

Page 18: Intermediate accounting

Company’s Way (No Gain)

•Ridiculous financial statements situation •Bankrupt <-> $20 M gain?

•Misinterpretation of the company’s financial condition •Accounting gain <-> Economic loss

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 19: Intermediate accounting

Auditor’s Way (With Gain)•Accounting standard requirement•Equity swap -> fair market value of the debt or equity

•Creditor’s consideration•Exchange of one asset (Bond receivable) to another (Capital investment)

•Boost stock price•Higher reported net income

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 20: Intermediate accounting

Part IV

Influence onFinancial Statements

Page 21: Intermediate accounting

Company’s WayBonds liability 50m Preference share capital 50m

Bonds liability 50mPreference share capital 30mExtraordinary gain on debt restructuring 20m

Auditor’s Way

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 22: Intermediate accounting

Income Statement

Company’s Way

Auditor’s Way

No gainNo interestexpense

$20MExtraordinary Gain

No interest expense

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 23: Intermediate accounting

Balance Sheet

Company’s Way

ReducedBond Liability

IncreasedPreference Share Capital

$50M$50M

Auditor’s Way

$50MReducedBond Liability

$30M

$20MIncreased

Preference Share Capital

IncreasedRetainedProfits

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 24: Intermediate accounting

Cash Flow Statement

Company’s Way

Reduced cash outflow of annual interest expense

$4M

Auditor’s Way

Reduced cash outflow of annual interest expense

$4M

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 25: Intermediate accounting

Statement of Shareholders’ Equity

Company’s Way

IncreasedPreference Share Capital

$50M

Auditor’s Way

$30MIncreasedPreference Share Capital

$20MIncreasedRetained Profits

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 26: Intermediate accounting

Part V

Influence onStakeholders

Page 27: Intermediate accounting

Stakeholders

Shareholders

Creditors

InvestorsExternalAuditors

Government

CustomersEmployeesCommunities

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 28: Intermediate accounting

Needs:

• More dividends

• Accurate financial statements

Impact:

Company’s way• Increased

preference share capital ($50m)

• No retained profits allocated

Auditor’s Way• Potential raising

stock price•More accurate

financial information

Needs:

• Principal & interest repayment (high liquidity)

• Accurate financial statement for business decisions - lending

Auditor’s Way• Increased

preference share capital ($30m)

Company’s way•More attractive •Higher shareholder’s equity on book

Principal Bondholders

Auditor’s Way• Favorable debt-to-

equity ratio•More attractive to

creditors•More accurate

financial information

Company’s way• Favorable debt-to-

equity ratio

Potential Bondholders Needs:• Accurate financial statements

e.g.Government – tax obligationExternal auditor – follow accounting standardsEmployee – salary payment

Auditor’s Way•More accurate

financial information

Company’s way•Misinterpret

reported income

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 29: Intermediate accounting

Part VI

Economics of Transaction

Page 30: Intermediate accounting

Bonds liability 50m Preference share capital 50m

Company’s Way

$20m GainNot Realized

Overstatementof

Preference Share Capital

Favorabledebt-to-equity

ratio

Failto capture

adverse effect

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 31: Intermediate accounting

Bonds liability 50mPreference share capital 30mExtraordinary gain on debt restructuring 20m

Auditor’s Way

$20m GainRealized

Favorabledebt-to-equity

ratio

ReflectsEssence of transaction

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 32: Intermediate accounting

Aftermath Credibility Difficult Financing

•Damaged reputation and lower credibility.

•Investors: reluctant to invest

•Investors demand higher premium.

•Higher cost of debt/equity financing

Part IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Page 33: Intermediate accounting

Company’s Way Auditor’s WayNo Recognition of Gain Recognition of GainNo adverse effect on Financial Statements

No adverse effect on Financial Statements

Overstatement of Preference Share Capital

Preference Share Capital at Fair Value

• Both fail to faithfully represent the economics of the transaction.

• Auditor’s is fair and gives better information to stakeholders.