Big Picture in Focus: ULOc.

Demonstrate the procedures

in accounting for debt restructure.

Metalanguage
In this section, the most essential terms relevant to the study of curriculum and to
demonstrate ULOc will be operationally defined to establish a common frame of
refence as to how the texts work in your chosen field or career. You will encounter
these terms as we go through the intermediate accounting. Please refer to these
definitions in case you will encounter difficulty in the understanding educational
concepts.
Please proceed immediately to the “Essential Knowledge” part since this is the first
time you will encounter the nature of this lesson.

Essential Knowledge

Debt restructuring is a situation where the creditor, for economic or legal reasons
related to the debtor's financial difficulties, grants to the debtor concession that would
not otherwise be granted in a normal business relationship. The concession either
stems from an agreement between the creditor and debtor or is imposed by law or a
court. The objective of the creditor in a debt restructuring is to make the best of a
bad situation or maximize recovery of investment. Thus, the creditor usually sustains
an accounting loss on debt restructuring and the debtor-usually realizes an
accounting gain.

Types of debt restructuring

There are three types of debt restructuring, namely:

1. Asset swap
2. Equity swap
3. Modification of terms

Asset swap

An asset swap 1s the transfer by the debtor to the creditor of any asset, such as real
estate, inventory, receivables and investment, in full payment of an obligation. Under
PFRS 9, paragraph 3.3.1, asset swap is treated as a derecognition of a financial
liability or extinguishment of an obligation. Paragraph 3.3.3 provides that the
difference between the carrying amount of the financial liability and the consideration
given shall be recognized in profit or loss.

Illustration

An entity provided the following balances at year-end:

Note payable 2,000,000

Accrued interest payable 400,000
At year-end, the entity transferred to the creditor land with carrying amount of
P1,500,000 and fair value of P2,200,000.

Computation

Note payable 2,000,000

Accrued interest payable 400,000
Total liability 2,400,000
Less: Carrying amount of land 1,500,000
Gain on extinguishment of debt 900,000

Journal entry

Note payable 2,000,000

Accrued interest payable 400,000
Land 1,500,000
Gain on extinguishment of debt 900,000

USA GAAP

Under USA GAAP, asset swap is recorded as if two transactions have taken place,
namely, the sale of the asset and the extinguishment of the liability. Accordingly, two
gains or losses are recognized. The difference between the fair value of the asset
and the carrying amount is the gain or loss on exchange. The difference between the
carrying amount of the liability and the fair value of the asset is gain or loss from
restructuring.

Fair value of land 2,000,000

Carrying amount of land 1,500,000
Gain on exchange 700,000

Note payable 2,000,000

Accrued interest payable 400,000
Total liability 2,400,000
Fair value of land 2,200,000
Gain on debt restructuring 200,000

Journal entry

Note payable 2,000,000

Accrued interest payable 400,000
Land 1,500,000
Gain on exchange 700,000
Gain on debt restructuring 200,000

Note that the gain on extinguishment under PFRS 9 includes both the gain on
exchange and gain on debt restructuring under USA GAAP.
PFRS 9 shall be followed as this is in conformity with international accounting
standard.

Dacion en pago accounting

Dacion en pago arises when a mortgaged property is offered by the debtor in full
settlement of the debt. The transaction shall be accounted for as an "asset swap"
form of debt restructuring. This requires recognition of gain or loss based on the
balance of the obligation including accrued interest and other charges.

If the balance of the obligation including accrued interest and other charges is more
than the carrying amount of the property mortgaged, there is a gain on
extinguishment of debt. Otherwise, if the balance of the obligation is less than the
carrying amount of property mortgaged, there is a loss on extinguishment.

Illustration

Land costing P500,000 and building costing P4,000,000 with accumulated

depreciation of P800,000, were mortgaged to secure a bank loan of P3,000,000.
Face amount of the loan 3,000,000
Accrued interest payable 200,000
Legal fee and bank service charges 50,000
Subsequently, the land and building were given to the bank in full payment of the
liability.

Journal entry

Mortgage payable 3,000,000

Accrued interest payable 200,000
Bank service charges 50,000
Loss on extinguishment of debt 450,000
Accumulated depreciation 800,000
Land 500,000
Building 4,000,000

Total liability 3,250,000

Less: Carrying amount of land and building (500,000+3,200,000) 3,700,000
Loss on extinguishment of debt (450,000)

Equity swap

Equity swap is a transaction where by a debtor and to may renegotiate the terms of a
financial liability with the result that the liability is fully or partially extinguished by the
debtor issuing equity instruments to the creditor. Simply stated, an equity swap is the
issuance of share capital by the debtor to the creditor in full or partial payment or an
obligation

Accounting issue
How should an entity initially measure the equity instruments issued to extinguish a
financial liability. The accounting issue of "extinguishment of a financial liability by
issuing equity instruments" is now well-settled under FRIC 19.

IFRIC 19 provides that when equity instruments issued to extinguish all or part of a
financial liability are recognized initially, an entity shall measure the equity
instruments at the fair value of the equity instruments issued, unless that fair value
cannot be reliably measured.
If the fair value of the equity instruments issued cannot be reliably measured, the
equity instruments shall be measured to reflect the fair value of the financial liability
extinguished.

Simply stated, the equity instruments issued to extinguish a financial liability shall be
measured at the following amounts in the order of priority:

a. Fair value of equity instruments issued

b. Fair value of liability extinguished
c. Carrying amount of liability extinguished

The difference between the carrying amount of the financial 1iability and the initial
measurement of the equity instruments issued shall be rec0gnized n profit or loss.
The gain or loss on extinguishment shall be reported as a separate line item in the
income statement.

Illustration

An entity showed the following data at year-end:

Bonds payable 5,000,000

Accrued interest payable 500,000

The entity issued share capital with a total par value of P2,000,000 and fair value of
P4,500,000 in full settlement of the bonds payable and accrued interest.

On the other hand, the fair value of the bonds payable is P4,700,000.

Fair value of shares issued is used

Bonds payable 5,000,000

Accrued interest payable 500,000
Share capital 2,000,000
Share premium 2,500,000
Gain on extinguishment of debt 1,000,000

Fair value of shares issued 4,500,000

Par value of shares issued 2,000,000
Share premium 2,500,000
Bonds payable 5,000,000
Accrued interest payable 500,000
Carrying amount of bonds payable 5,500,000
Fair value of shares issued 4,500,000
Gain on extinguishment of debt 1,000,000

Fair value of bonds payable is used

Bonds payable 5,000,000

Accrued interest payable 500,000
Share capital 2,000,000
Share premium 2,700,000
Gain on extinguishment of debt 800,000

Fair value of bonds payable 4,700,000

Par value of shares issued 2,000,000
Share premium 2,700,000
Carrying amount of bonds payable 5,500,000
Fair value of bonds payable 4,700,000
Gain on extinguishment of debt 800,000

Carrying amount of bonds payable is used

Bonds payable 5,000,000

Accrued interest payable 500,000
Share capital 2,000,000
Share premium 3,500,000

Carrying amount of bonds payable 5,500,000

Par value of shares issued 2,000,000
Share premium 3,500,000
* If the carrying amount of the liability is used, there is gain or loss on
extinguishment.

Modification of terms

Modification may involve either the interest, maturity value or both.

✓ Interest concession may involve a reduction of interest rate, forgiveness of
unpaid interest or a moratorium on interest.
✓ Maturity value concession may involve an extension of the maturity date or
a reduction of the principal amount.

PFRS 9, paragraph 3.3.2, provides that a substantial modification of terms of an

existing financial liability shall be accounted for as an extinguishment of the old
financial liability and the recognition of a new financial liability.

Under Application Guidance B3.3.6 of PFRS 9, there is substantial modification of

terms it the gain or loss on extinguishment is at least 10% of the old financial liability.
The difference between the carrying amount of the old liability and the present value
of new or restructured liability shall be accounted for as gain or loss on
extinguishment debt.
The old effective rate is used in computing the present value of the new liability. Any
costs or fees incurred as a result of the substantial modification of terms shall be
recognized as part of gain or loss on extinguishment.

Illustration- Modification of terms

On January 1, 2020, an entity showed the following:

Note payable - due January 1, 2020-14% 5,000,000
Accrued interest payable 1,000,000
The entity is granted by the creditor the following concessions on January 1, 2020:
a. The accrued interest of P1,000,000 is forgiven.
b. The principal obligation is reduced to P4,000,000.
C. The new interest rate is 10% payable every December 31.
d. The new date of maturity is December 31, 2023.

This requires computation of the present value of the new note payable using the old
rate of 14%. The present value of the new note payable is equal to the present value
of the new principal plus the present value of the interest payments on the new
principal liability.

Computation

The present value of 1 at 14% for 4 periods is 0.5921 and the present value of an
ordinary annuity of l at 14% for 4 periods is 2.9137.

PV of principal (4,000,000 x .5921) 2,368,400

PV of interest payments (400,000 x 2.9137) 1,165,480
Present value of new note payable 3,533,880
Face value of new note payable 4,000,000
Discount on note payable 466,120
Note payable – old 5,000,000
Accrued interest payable 1,000,000
Carrying amount of old liability 6,000,000
Present value of new note payable 3,533,880
Gain on extinguishment of debt 2,466,120

Journal entries

1. To record the extinguishment of the old note payable:

Note payable –old 5,000,000

Accrued interest payable 1,000,000
Discount on note payable 466,120
Note payable- new 4,000,000
Gain on extinguishment of debt 2,466,120

2. To record the interest payment on the new note payable

Interest expense (10% x 4,000,000) 400,000

 Cash 400,000

3. To amortize the discount on note payable for 2020:

Interest expense 94,743

Discount on note payable 94,743

Date Interest Interest Discount Carrying Amount

paid expense amortization
1/1/2020 3,533,880
12/31/2020 400,000 494,743 94,743 3,628,623
12/31/2021 400,000 508,007 108,007 3,736,630
12/31/2022 400,000 523,128 123,128 3,858,758
12/31/2023 400,000 540,242 140,242 4,000,000

December 31, 2020

Interest paid (10% x 4,000,000) 400,000

Interest expense (14% x 3,533,880) 494,743
Discount amortization 94,743
Carrying amount- January 1, 2020 3,533,880
Carrying amount-December 31, 2020 3,628,623

December 31, 2021

Interest paid 400,000

Interest expense (14% x 3,628,623) 508,007
Discount amortization 108,007
Carrying amount-December 31, 2020 3,628,623
Carrying amount--December 31, 2021 3,736,630

Books of creditor

Journal entries for 2020 on the books of creditor

Jan. 1 Note receivable-new 4,000,000

Loss on debt restructure 2,466,120
Note receivable –old 5,000,000
Accrued interest receivable 1,000,000
Unearned interest income 466,120

Dec. 31 Cash 400,000

Interest income 400,000

31 Unearned interest income 94,743

Interest income 94,743
No substantial modification

Note payable - due January 1, 2020-10% 5,000,000

Accrued interest payable 1,000,000

a. The accrued interest of P1,000,000 is forgiven

b. The interest rate is 14% payable every December 31
C. The date of maturity is December 31, 2022.

Note payable 5,000,000

Accrued interest payable 1,000,000
Carrying amount of old liability 6,000,000

This requires computation of the present value of the new note payable using the old
rate of 10%.

The present value of 1 at 10% for three periods is 0.7513 and the present value of
an ordinary of 1 at 10% for three period is 2.4869.

PV of principal (5,000,000 x .7513) 3,756,500

PV of interest payments (5,000,000 x 14% x 2.4869) 1,740,830
Total present value of new liability 5,497,330

Carrying amount of old liability 6,000,000

Present value of new note payable 5,497,330
Gain on modification 502,670

Present value of new note payable 5,497,330

Face amount of new note payable 5,000,000
Premium on the new note payable 497,330

The gain is less than 10% of the carrying amount of old liability of P6,000,000. Under
Application Guidance B3.3.6 of PFRS 9, there is no substantial modification of terms.

In accordance with PFRS 9, paragraph B5.4.6, the IASB recently clarified that any
gain or loss on modification should be recognized in profit or loss even if there is no
substantial modification of terms. The interest expense is computed based on the
original effective rate and any discount or premium on the new liability is amortized
using the effective interest method.

Journal entries

1. To record the modified liability on January 1, 2020:

Accrued interest payable 1,000,000

Premium on note payable 497,330
Gain on modification of terms 502,670

2. To record the annual interest payment for 2020:

Interest expense (5,000,000 x 14%) 700,000

Cash 700,000
3. To amortize the premium on note payable:

Premium on note payable 150,267

Interest expense 150,267

Date Interest Interest Premium Carrying

paid expense amortization amount
1/1/2020 5,497,330
12/31/2020 700,000 549,733 150,267 5,347,063
12/31/2021 700,000 534,706 165,294 5,181,769
12/31/2022 700,000 518,231* 181,769 5,000,000

Interest paid equals face value times modified stated rate. Thus, for 2020,
P5,000,000x 14% equals P700,000.

Interest expense equals carrying amount times original effective rate. Thus, for
2020, P5,497,330 x 10% equals P549,733 and so on.

Premium amortization equals interest paid minus interest expense. Thus, for 2020,
P700,000 minus P549,733 equals P150,267, and so on.

Self Help: You can also refer to the sources below to help
you further understand the lesson.

Cabrera, M. E. B. &Ocampo, R. R. (2015) Financial accounting & reporting Standards

& Applications (VOL 3, 2014-2015 ed). Manila: GIC Enterprises & Co., Inc.

Valix, C.T., Peralta, J.F. &Valix, C.M. (2019). Intermediate Accounting. (2019 ed., Vol.
2). Manila: GIC Enterprises & Co., Inc.

Valix, C. &Valix, C. (2018). Theory Financial Accounting (CPA Examination). Manila:

GIC Enterprises & Co., Inc.

Valix, C., &Valix, C. A. M. (2016). Practical financial accounting. (Vol.1). Manila,

Philippines: GIC enterprises & Co., Inc.

Let’s Check
Activity 1. Determine each question’s correct answer among the given choices.
1. In a debt restructuring that is considered an asset swap, the gain on
extinguishment is equal to
a. Excess of the fair value of the asset over its carrying amount
b. Excess of the carrying amount of the debt over the fair value of the asset
c. Excess of the fair value of the asset over the carrying amount of the debt
 d. Excess of the carrying amount of the debt over the carrying amount of the
asset
2. For a debt restructuring involving substantial modification of terms, it is
appropriate for a debtor to recognize a gain when the carrying amount of the
debt
a. Exceeds the total future cash payments specified by the new terms.
b. Is less than the total future cash payments specified by the new terms.
c. Exceeds the present value of the future cash payments specified by the
new terms.
d. Is less than the present value of the future cash payments specified by the
new terms.
3. For a debt restructuring 1nvolving a substantial modification of terms, which of
the following specified by the new terms would be compared to the carrying
amount of the debt to determine if the debtor should report a gain on
extinguishment?
a. The total future cash payments
b. The present value of the new debt at the original interest rate
c. The present value of the new debt at the modified interest rate
d. The amount of future cash payments
4. Under a debt restructuring involving substantial modification of terms, the
future cash flows under the new terms shall be discounted using
a. Original effective interest rate
b. Interest rate under the new terms
c. Market rate of interest
d. Prime interest rate
5. An entity shall initially measure equity instruments issued to extinguish a
financial liability at
a. Fair value of the equity instruments issued
b. fair value of the liability extinguished
c. par value of the equity instruments issued
d. carrying amount of the liability extinguished
6. If the fair value of the equity instruments issued cannot be reliably measured,
the equity instruments issued to extinguish a financial liability shall be
measured at
a. fair value of the liability extinguished
b. par value of the equity instruments issued
c. carrying amount of the liability extinguished
d. book value of the equity instruments issued
7. If both the fair value of the equity instruments issued and the fair value of the
financial liability extinguished cannot be measured reliably, the equity
instruments issued shall measured at
a. carrying amount of the liability extinguished
b. par value of the equity instruments issued
c. carrying amount of the equity issued
d. value assigned by the Board of directors
8. the difference between the carrying amount of the financial liability
extinguished and the fair value of equity instruments issued shall be
recognized in
a. profit and loss
b. other comprehensive income
 c. retained earnings
d. general reserve
9. the gain or loss from extinguishment of a financial liability by issuing equity
instruments is presented as
a. other income or other expense
b. separate line item in the income statement
c. component of other comprehensive income
d. component of finance cost

Let’s Analyze
Activity 1. MCQ Problem solving
1. Hull Company is indebted to Apex Company under a P5,000,000, 12%6,
three-year note dated December 31, 2018. Because of financial difficulties
developing in 2020, Hull Company owed accrued interest of P600,000 on the
note on December 31, 2020. Under a debt restructuring on December 31,
2020, Apex Company agreed to settle the note and accrued interest for a tract
of land having a fair value of P4,500,000. The acquisition cost of the land is
P3,600,000. What amount of pretax gain on extinguishment should Hull
Company report as component of income from continuing operations in 2020?
a. 2,000,000
b. 1,400,000
c. 1,100,000
d. 900,000
2. During 2020, Mann Company experienced financial difficulties and is likely to
default on a P5,000,000, 15% three year note dated January 1, 2018 payable
to Summit bank. On December 31, 2020, the bank agreed to settle the note
and unpaid interest of P750,000 for P4,100,000 cash payable on January 31,
2021. What amount should be reported as gain from extinguishment of debt in
the 2020 income statement?
a. 1,650,000
b. 900,000
c. 750,000
d. 0
3. The following information pertains to the transfer of real estate pursuant to a
debt restructuring by Knob Company to Mene Company in full liquidation of
Knob Company's liability to Mene Company:
Carrying amount of liability liquidated 1,500,000
Carrying amount of real estate transferred 1,000,000
Fair value of real estate transferred 1,200,000
What amount of pretax gain on extinguishment should Knob Company report
as component of income from continuing operations?
a. 300,000
b. 500,000
c. 200,000
d. 0
Due to extreme financial difficulties, Armada Company had negotiated a
restructuring of a 10% P5,000,000 note payable due on December 31, 2020. The
unpaid interest on the note on such date was P500,000. The creditor agreed to
reduce the face amount to P4,000,000, forgive the unpaid interest, reduce the
interest rate to 8% and extend the due date three years from December 31, 2020.
The present value of 1 at 10% for three periods is 0.75 and the present value of an
ordinary annuity of l at 10% for three periods is 2.49.
4. What is the gain on extinguishment for 2020?
a. 1,703,200
b. 1,203,200
c. 2,000,000
d. 540,000
5. What is the interest expense for 2021?
a. 320,000
b. 379,680
c. 500,000
d. 400,000
Due t0 adverse economic circumstances and poor management, Tagaytay
Highlands Company had negotiated a restructuring of a 9% P6,000,000 note
payable to Second Bank due on January 1, 2020. There was no accrued interest on
the note on January 1, 2020. The bank reduced the principal obligation from
P6,000,000 to P5,000,000 and extended the maturity to three years on December
31, 2022. However, the new interest rate is 13% payable annually every December
31.The present value of 1 at 9% for three periods is .77 and the present value of an
ordinary annuity of 1 at 9% for three periods is 2.53.
6. What is the present value of the new note payable on January 1, 2020?
a. 6,000,000
b. 5,000,000
c. 5,494,500
d. 3,850,000
7. What is the gain on modification of debt to be recognized for 2020?
a. 500,000
b. 350,000
c. 505,500
d. 0
8. What is the interest expense for 2020 as a result of the modification?
a. 650,000
b. 450,000
c. 494,505
d. 540,000
On January 1, 2020, Granada Company had an overdue 10% note payable to First
Bank at P8,000,00 and accrued interest of P800,000. As a result of a restructuring
agreement on January , 2040, First Bank agreed to the following provisions. The
principal obligation is reduced to P6,000,000. The accrued interest of P800,000 is
forgiven. The date of maturity is extended to December 31, 2023. Annual interest of
12% is to be paid for 4 years every December 31. The present value of 1 at 10% for
4 periods is 0.683 and the present value of an ordinary annuity of 1 at 10% for 4
periods is 3.17.
9. What is the present value of the new note payable on January 1, 2020?
a. 6,380, 400
b. 6,000,000
c. 4,098,000
d. 5,464,000
10. What is the gain on extinguishment of debt to be recognized for 2020?
a. 2,000,000
 b. 2,800,000
c. 2,419,600
d. 1,619,600

In a Nutshell

I. 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 all indicated entries for 2020.

II. White Company is indebted to Black Company for P5,000,000 on January 1,

2020. The principal and accrued interest of P1,000,000 are long overdue. The
interest on the note is 10%.The entity negotiated with Black Company for the
restructuring of the obligation.
a. The principal obligation is reduced by P500,000.
b. The accrued interest of P1,000,000 is waived.
c. The obligation will mature on December 31, 2021
d. The entity shall pay an annual interest of 12% every December 31.
The present value of 1 at 10% Ior two periods is 0.8264 and the present value of an
ordinary annuity of I at 10% for two periods 18 1.7855.

Required:

Prepare journal entries for 2020.

Q and A

In this section you are going to list what boggles you in this unit. You may indicate
your questions but noting you have to indicate the answers after your questions is
being raised and clarified. You can write your questions below:

Questions/ Issues Answers

1.
2.
3.
4.
5.