Intermediate accounting

Intermediate AccountingCasePresentation

Troubled Debt Restructuring

Zheng Yuchuan

Lu Huiping

SalmanKamani

Qu Xin

Presentation FlowPresentation FlowPart IBackgroundIntroduction

Part IIDebtRestructuring

Part IIIRationalesBehind

Part IVInfluence onFinancialStatements

Part VInfluence onStakeholders

Part VIEconomics ofTransactions

Part VIIConclusion

Q&A

Part I

BackgroundIntroduction

$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 VIIConclusion

Bondsto

Preference Shares

$30 million$30 million







Part VIIConclusion

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 VIIConclusion

What should we do?

??

?

?

?

?

? ?

Part II

DebtRestructuring

Debt Restructuring

“

”

• Outstanding debt

• Alter debt agreements

• Achieve advantages.







Part VIIConclusion

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 VIIConclusion

Then…

When shall we recognize gains?

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 VIIConclusion

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 VIIConclusion

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 VIIConclusion

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 VIIConclusion

Part III

RationalesBehind

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 VIIConclusion

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 VIIConclusion

Part IV

Influence onFinancial Statements

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


Auditor’s Way







Part VIIConclusion

Income Statement

Company’s Way

Auditor’s Way

No gainNo interestexpense

$20MExtraordinary Gain

No interest expense







Part VIIConclusion

Balance Sheet

Company’s Way

ReducedBond Liability

IncreasedPreference Share Capital

$50M$50M

Auditor’s Way

$50MReducedBond Liability

$30M

$20MIncreased

Preference Share Capital

IncreasedRetainedProfits







Part VIIConclusion

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 VIIConclusion

Statement of Shareholders’ Equity

Company’s Way

IncreasedPreference Share Capital

$50M

Auditor’s Way

$30MIncreasedPreference Share Capital

$20MIncreasedRetained Profits







Part VIIConclusion

Part V

Influence onStakeholders

Stakeholders

Shareholders

Creditors

InvestorsExternalAuditors

Government

CustomersEmployeesCommunities







Part VIIConclusion

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


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


Company’s way•Misinterpret

reported income







Part VIIConclusion

Part VI

Economics of Transaction

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 VIIConclusion


Auditor’s Way

$20m GainRealized

Favorabledebt-to-equity

ratio

ReflectsEssence of transaction







Part VIIConclusion

Aftermath Credibility Difficult Financing

•Damaged reputation and lower credibility.

•Investors: reluctant to invest

•Investors demand higher premium.

•Higher cost of debt/equity financing







Part VIIConclusion

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.

Intermediate accounting

Economy & Finance

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