CARTER MANUFACTURING

D O W E R E A L LY H A V E I N C O M E ?
PRESENTED BY:

REN WEI GUO DESIREE, MUHAMMAD ZARGAM ARSHAD HELENA LIANDE, CHEN HOI KEI EMILY KONG KA WANG KELVIN

AGENDA
Case Background

Knowledge Recap

Case Issues

How Accounting Method Impacts Decision Making

Recommendations

Lesson learned

CASE BACKGROUND
CARTER MANUFACTURING

$ 50 million, 8% bonds outstanding

CASE BACKGROUND
CARTER MANUFACTURING

60%

KNOWLEDGE RECAP

Definition of Troubled Debt Restructuring

To avoid bankruptcy proceedings, creditor grant a concession to the debtor, who is in financial difficulty and change the terms of the debt
Asset Swap
Cash settlement in less amounts

Equity Swap

KNOWLEDGE RECAP
Equity Swap Convertible Bonds
A hybrid security with a bond and equity option component linked by the conversion feature, giving the investor the option of converting the security into a specified number of shares of stock within a specified time.

A financial derivative contract where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future.

In troubled debt structure, FMV Equity < Debt

FMV Equity < / = / > Debt

KNOWLEDGE RECAP

When should a gain on troubled debt restructuring be recorded ?

1. Restructuring gain extraordinary 2. Debt = carrying value of the note 3. FMV Equity = Fair Market Value of the equity interests provided

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Cash flow problems

CASE ISSUES

Reasons for Debt Restructuring

Decline in value of the bonds

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Carter: Dr. Bond Payable

CASE ISSUES
CARTER VS CPA FIRM

Accounting Treatment
$million $million 50 50

Cr. Share Capital Preference

CPA firm:
Dr. Bond Payable Cr. Share Capital Preference Extraordinary Gain on Debt Restructuring

$million $million
50 30 20

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Carters Rationale

CASE ISSUES
CARTER VS CPA FIRM

Exchange of debt with equity Without reference to the market value Do not care what the accounting standard requires

CASE ISSUES
CARTER VS CPA FIRM

CPA Firm: Accounting Standard

Troubled debt restructuring

Record market value of preference shares exchanged

Forgiveness of debt recognized as a gain

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Carter
Balance Sheet

CASE ISSUES
CARTER VS CPA FIRM

Financial statement implications

Income statement: NO change

Equity $50m Debt $50m

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CPA firm
Income statement

CASE ISSUES
CARTER VS CPA FIRM

Net Income $20m

Balance Sheet

Equity $30m Debt $50m

ECONOMIC IMPACT OF THE TRANSACTION

Economic Impact Liquidity and Solvency CPA Firm Option Cash outflow : tax on extraordinary gain Debt to Equity ratio improves Income Statement Equity Total Liability Increase by $20 million Increases by $30 million Decreases by $50 million Carters Financial Controller Option No Effect

Debt to Equity ratio improves No Effect Increases by $50 million Decreases by $50 million

ECONOMIC IMPACT: LIQUIDITY AND SOLVENCY

ECONOMIC IMPACT: INCOME STATEMENT

Income Statement: Extraordinary gain

NO legal changes before the debt-equity swap.

oThe swap is basically a speculation of future events. oFrom the borrowers perspective, we are dealing with a gain contingency

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Financial Controller

IMPACT OF GAIN DISCLOSURE ON EXTERNAL USERS

Firm is almost bankrupt. Entire amount should be credited to Preference Share Capital account.

Reporting it as a gain might mislead external users that the firm is performing well.

IMPACT OF GAIN DISCLOSURE ON EXTERNAL USERS

In fact, the extraordinary gain is recorded separately from a firms usual operating income.
Hence, the gain will not be misleading to external users.

ECONOMIC IMPACT : EQUITY

Carrying Value

Market value only 60% of face value of bond

$50 million x 60% = $30 million

Computation

Answer

As market value of bonds is only $30 million, the bond holders are not entitled to the entire $50 million as Preference Share Capital.

ALTERNATIVE SOLUTIONS

A. Operational restructuring (Corporate restructuring)

Changing business mix
Disposal of non-core assets Closing underperforming businesses

B. Financial restructuring
Refinancing
Changing interest rates Deferring interests Rescheduling of debts

Convertible Bonds
White Knights

C. Merger

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Refinancing

ALTERNATIVE SOLUTIONS

A. Corporate restructuring
B. Financial restructuring
Convertible bonds Asset swap

C. Merger

A. CORPORATE RESTRUCTURING
Assets Operating Cash Flows Liabilities Debt Equity

Operational restructuring

Financial restructuring

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Operational Structuring

A. CORPORATE RESTRUCTURING

Purpose: Identify the cause of underlying performance and develop new corporate strategy

Financial restructuring
Purpose: Reorganize business assets and liabilities

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Streamlining operations

A. CORPORATE RESTRUCTURING

Disposal of non-core assets

Closing of underperforming businesses

B. DEBT RESTRUCTURING (DR): REFINANCING

Lower interest rates

Delay payment of debts

B. DEBT RESTRUCTURING (DR): REFINANCING

Medium-term debt leverage ratio

Deferred stocks

Reimburse existing debt

Improve debt ratio, assets unchanged

B. DEBT RESTRUCTURING (DR): ASSET SWAP

Debt settled at the time of restructuring

Creditor accept an asset with fair value less than the carrying amount of the liability as final settlement of the debt

E.g. cash, receivables, inventory, PPE, intangible assets

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For financial leveraging
Carter Manufacturing

C. MERGERS

ABCarter Manufacturing
ABC Manufacturing

THE 2-PRONGED APPROACH

THE 2-PRONGED APPROACH

Corporate Restructuring

Debt-Equity Restructuring

LESSON LEARNT

FASBs Statement No. 15: Accounting by Debtors and Creditors for Troubled Debt Restructuring.
Equity swap is to be accounted for at the fair market values of the debt or equity involved. Gain/ loss should be reflected if economic transaction is significant.

LESSON LEARNT

Users would misinterpret reported gain in the midst of poor operating conditions
Alternative reporting systems (e.g. extraordinary gain) may be necessary to distinguish the gain

Q&A