Troubled debt restructuring definition
/What is a Troubled Debt Restructuring?
A troubled debt restructuring occurs when a creditor grants a concession to a debtor that it would not normally consider. A concession may involve restructuring the terms of a debt (such as a reduction in the interest rate or principal due, or an extension of the maturity date) or payment in some form other than cash, such as an equity interest in the debtor. A restructuring is done for economic or legal reasons related to the debtor's financial difficulties. A debtor is experiencing financial difficulties when one of the following conditions is present:
It is in default on any of its debt;
It is in bankruptcy;
It has securities that have been delisted;
It cannot obtain funds from other sources;
It projects that it cannot service its debt; or
There is significant doubt about whether it can continue to be a going concern.
A bank may allow a restructuring when the alternative is for it to take a complete loss on the debt when the borrower enters bankruptcy proceedings.
A debtor that can obtain funds from sources other than the lender at market interest rates is generally not involved in a troubled debt restructuring.
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Accounting for a Troubled Debt Restructuring
The accounting for a troubled debt restructuring differs for the debtor and creditor. The differences are noted below.
Accounting by the Debtor
The debtor must recognize any gain if the total future payments after restructuring are lower than the original carrying amount of the debt. There are several variations on this concept, which are as follows:
If debt is modified. If total cash flows (principal + interest) under the new terms exceed or equal the old carrying amount, no gain is recorded. Interest expense is recalculated using the new effective interest rate.
If debt is partially forgiven. If the lender reduces the principal or accrued interest, the debtor records a gain, which is calculated as follows:
Gain on Debt Restructuring = Carrying Amount of Debt – New Debt Obligation
If debt is settled with assets. If the debtor transfers assets to settle debt, it recognizes a gain or loss based on the following calculation:
Gain/Loss = Fair Value of Transferred Asset – Book Value of Asset
If debt is settled with equity. If the debt is settled by issuing equity, the gain is based on the following calculation:
Gain = Carrying Amount of Debt – Fair Value of Issued Equity
Accounting by the Creditor
The lender determines whether the restructured loan is impaired and recognizes a loss if necessary. There are two variations on the concept, which are as follows:
If loan is modified. If the loan is modified with no asset received the lender calculates the present value of expected future cash flows using the original effective interest rate. If the present value is less than the loan’s carrying amount, a bad debt expense (loan loss) is recorded.
If debt is settled with assets. If the debtor transfers assets, the lender records the asset at fair value and recognizes a loss for the difference between the asset’s fair value and the loan’s carrying amount.
If debt is settled with equity. If the debtor issues equity, the lender records the equity at fair value and recognizes a loss if it is lower than the loan’s carrying amount.