Due to recent economic conditions, many entities have sought to modify the terms of their debt agreements to allow for cash flow improvement. Conversely, creditors might initiate a restructuring of an existing agreement to modify the terms of the current debt agreement given the financial condition of the borrower. Once an agreement is reached, the debtor must consider how the change in terms of the debt agreement will be reflected in the financial statements, if at all. Appropriate accounting for a modified debt agreement is determined by consideration of several factors. Insignificant changes, such as a change in covenants, might not require any changes to the financial statements other than by disclosure.
Does the revision in terms constitute a troubled debt restructuring? A troubled debt restructuring occurs when the debtor is experiencing financial difficulties such as default on any of its current debt or when substantial doubt exists about the entity’s ability to continue as a going concern, and the bank or creditor agrees to modify the terms of existing debt as a result of the financial condition of the borrower.
If the modification meets the definition of a troubled debt restructuring, a calculation is required to determine whether future undiscounted cash flow required under the new agreement is greater or less than the remaining balance of the original debt. If undiscounted cash flows are less than the carrying amount of the original debt, a gain is recognized and the carrying value of the new debt is established at the estimated future cash flow required. In this case, all future payments are treated as a reduction of the carrying value of the new debt, and no interest expense is recognized. If undiscounted cash flow is greater, no gain is recognized and a new effective interest rate is established and used in allocating future payments to principal and interest.
If the definition of a troubled debt restructuring is not met, you must determine whether or not the change is considered substantial. Substantial is defined as a change of 10% or more of required cash flow from the original to the new debt agreements. A substantial change in the cash flow results in an extinguishment of debt, which is accounted for by recognizing a gain or loss. The gain or loss is calculated based on comparing the balance outstanding on the old debt to fair value of the new debt. Future payments on the new debt are allocated to principal and interest using the effective interest rate of the new debt. If the change is not determined to be substantial, a modification of the debt has occurred and no gain or loss is recognized. Interest expense is recognized on future payments based upon the effective interest rate calculated on the new debt and the revised cash flow requirements.
What otherwise would appear to be a rather straightforward transaction can result in significantly different accounting treatment based on the facts and circumstances surrounding the debt restructuring.
For more information on debt restructuring, contact Jay Meglich at (614) 586-7124 or firstname.lastname@example.org.
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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.