DEBT RESTRUCTURING

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 thecreditor 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
- 41%
ration to
the CA of
old
liability.
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 - 9%

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 n profit or loss even if there 1s 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.