Chapter 27 – Debt Restructuring & Release of Liability

Extinguishment of Financial Liability

General principles:
A trading liability or other debt from the balance sheet when it is extinguished, that is when
the obligation is discharged, cancelled or expired.
This condition is met when the debtor either:
1. Discharges the liability (or part of it) by paying the creditor, normally with cash, other
financial assets, goods or services, or
2. Is legally released from primary responsibility for the liability (or part of it) either by
process of law or by the creditor.

The condition for extinguishment is also met if an entity repurchases a bond that it has
previously issued, even if the entity is a market maker or intends to sell it in the near term.

Legal release by the creditor:

It is clear the general condition that debt is extinguished only if the debtor is legally released
from its obligation by the creditor. This condition is met even if a creditor releases a debtor
from its present obligation to make payments, but the debtor assumes a guarantee
obligation to pay if the party assuming responsibility defaults, In this circumstance the
debtor:
a.) Recognizes a new financial liability based on the fair value of its obligation for the
guarantee, and
b.) Recognizes a gain or loss based on the differences between (1) any amount paid and
(2) the carrying amount of the original financial liability less the fair value of the new
liability.

Debt Restructuring – is a situation in which “the creditor for economic or legal reasons
related to the debtor’s financial difficulties grants a concession to the debtor that it would not
otherwise consider. That the concession either from an agreement between the creditor and
the debtor or is imposed by law or a court”.

Types of Restructuring:
Asset Swap – transfer of non-cash asset, such as real estate, inventories, receivables or
investment, to fully settle a payable. This type of restructuring usually recognizes gains or
losses on the release of financial liability and disposal of non-cash assets.

Equity Swap – PAS 32 does not specifically deal with debt to equity conversions and so the
question arises as to how such transactions should be accounted for. One argument is that
the accounting treatment should be the same as when convertible debt is converted, into
shares, the carrying value of the existing debt instrument is simply transferred to equity and
no gain or loss on the conversion is recognized. This accounting treatment is consistent with
the usual accounting for the issue of shares that are recorded at the proceeds received
rather than the fair value of shares and does not result in gain or loss. Alternatively, one
could argue that the replacement or exchange of an issuer’s existing debt instrument with
new equity instruments of the issuer is an extinguishment of existing financial obligation as
the entity is legally released from its obligation to pay cash. Therefore in accordance with
PAS 39 par 40, the debt instrument should be derecognized and new equity instrument,
issued should recognize at fair value. Furthermore, par 41 of PAS 39, provides that the
difference between the carrying amount of the existing debt instrument extinguished and the
consideration paid (including non-cash assets or liabilities assumed) should be recognized in
profits or loss.

Modification of Terms – This type of restructuring may or may not derecognize the carrying
value of the original liability. If the modification is considered substantial, the carrying value
of the original financial liability is derecognized; the restricted debt is recognized; any gain or
loss on debt restructuring is recognized in the profit and loss. Any transaction costs incurred
is included in the measurement of gain or loss. If the modification is not considered
substantial, the carrying value of the original financial liability is not derecognized; the gain or
loss is not given accounting recognition and any transaction
costs incurred is being deferred and amortized based on the restructured term of the
contract using the effective interest method.

The modification may involve the interest, the maturity value, or both. Interest concession
may involve a reduction of the interest rate, forgiveness of unpaid interest; or a moratorium
on interest payments for a period of time. Maturity value concessions may involve an
extension of the maturity date or a reduction in the amount to be repaid at maturity.

The amount of gain or loss on modification of terms is measured as the difference between
the carrying value of the original financial liability and the remaining cash outflows required
to settle the restructured debt discounted at the original effective interest rate . If the amount
of gain or loss is at least 10% of the carrying value of original financial liability, the
restructuring is considered substantial; however, if the amount of gain or loss is below 10%
of the carrying value of the original financial liability, the restructuring is considered not
substantial modification.

Chapter 27-1: (Asset Swap)

Brite Company is indebted to Scotch Company under a P1,000,000, 12%, three-year note
dated December 31, 2011. Because of Brite’s financial difficulties developing in 2014, Brite
owed accrued interest of P120,000 on the note at December 31,2014. Scotch agreed to
settle the note and accrued interest for a tract of land having a fair market value of
P900,000. Brite’s acquisition cost of land is P950,000. Ignoring income taxes, in its 2014
profit or loss, how much should rite report as finance income as a result of the settlement?
a.) None c.) P220,000
b.) P170,000 d.) P440,000

Solution:
Note Payable 1000000
Accrued interest payable 120000
Total liability 1120000
Carrying amount – Land (950000)
Gain on extinguishment of debt 170000

Problem 27-2: (Asset Swap)

Island Company owes P2,000,000 plus P180,000 of accrued interest to First State Bank.
The debt is a 10-year, 10% note. During 2011, Island’s businesses deteriorated due to a
faltering regional economy. On December 31, 2014, First State Bank agrees to accept an old
machine and cancel the entire debt. The machine has a cost of P3,900,000, accumulated
depreciation of P2,210,000 and a fair market value of P1,900,000. How much should Island
Company recognize as a finance income in its profit or loss as a result of the financial
liability’s derecognition?
a.) P210,000 c.) P310,000
b.) P280,000 d.) P490,000

Solution:
Total liability 2180000
Fair market value – old machine (1900000)
Gain on derecognition of liability 280000

Problem 27-3: (Asset Swap)

Purity Company owes P1,998,000 to Sanctity, Inc. The debt is a 10-year, 11% note,
because Purity Company is in financial trouble, Sanctity, Inc. agrees to accept some
property and cancel entire debt. The property has a book value of P800,000 and fair market
value of P1,200,000. How much gain on the disposal of the property should Purity Company
recognize?
a.) None c.) P 798,000
b.) P400,000 d.) 1,198,000

Solution:
Total liability ((1998000*11%) + 1998000) 2217780
Fair value market– old machine (1200000)
Gain on extinguishment of debt 1017780

Total liability 2217780

Book value – old machine (800000)
Gain on extinguishment of debt (1017780)
Gain on disposal of property 400000

Problem 27-4: (Asset Swap)

The Prayer Novelty Company has a P1,500,000 outstanding note payable to Lead Me
Corporation. Because of the financial difficulties, Prayer negotiates with Lead Me
Corporation to exchange inventory of novelties to satisfy the debt. The cost of the inventory
transferred is carried on Prayer’s books at P900,000. The estimated selling price of the
inventory is P1,400,000. Prayer uses a perpetual inventory system. What is the amount of
gain or loss on the release of the liability?
a.) None c.) P500,000
b.) P100,000 d.) P600,000
Solution:
Total liability 1500000
Cost of inventory (900000)
Gain on the release of liability 600000

Problem 27-5: (Asset Swap)

At December 31, 2010, Action Manufacturing Company had outstanding P3,000,000, 12%
note payable to Uno Bank dated January 1, 2008. The note was due on December 31, 2011
with interest payable every December every December 31. During 2011, Action notified Uno
that it might be unable to meet the scheduled December 31, 2011 payment of principal and
interest because of financial difficulties. On September 30, 2011, Uno sold the note,
including interest accrued since December 31, 2010 for P2,800,000 to Comedy Corporation,
one of Action in full settlement of the note. Ignore income tax, what total amount of gain or
loss to be reported in Action’s profit or loss as a result of the liabilities derecognition?
a.) None c.) P210,000
b.) P150,000 d.) P960,000

Problem 27-6: (Equity Swap)

Turtle Company is experiencing financial difficulty and is negotiating trouble debt
restructuring with its creditors to relieve its financial stress. Turtle has a P5,000,000 note
payable to Metrobank. The bank is considering acceptance of an equity interest in Turtle
Company in the form of 400,000 ordinary shares with a fair value P12 per share. The par
value of the ordinary share is P10 per share.
Question 1: If the issue of equity is treated as a conversion of an existing debt, what is the
amount of gain to be reported by Turtle in its profit or loss statement as a result of the
restructuring?
a.) None c.) P 500,000
b.) P200,000 d.) P1,000,000

Question 2: If the issue of equity is treated as an extinguishment of an existing debt

instrument, what amount of gain or loss should Turtle Company report in its profit or loss
statement as a result of the restructuring?
a.) None c.) P 500,000
b.) P200,000 d.) P1,000,000

Solution:
Notes payable 5000000
Fair value shares issued (4800000)
Gain on extinguishment of debt 200000
Problem 27-7: (Equity Swap)
Monkey Company is experiencing financial difficulty and is negotiating trouble debt
restructuring with its creditors to relieve its financial stress. Monkey has a P3,000,000 note
payable to Megabank. The bank is considering acceptance of an equity interest in Monkey
Company in the form of P200,000 ordinary share valued at P12 per share. The par value of
the ordinary share is P10 per share. Monkey Company incurred total transaction costs of
P80,000 related to the issue of shares. What is the amount of share premium to be reported
by Monkey in its statement of financial position as a result of the restructuring assuming the
issue of equity is a conversion of debt?
a.) None c.) P 920,000
b.) P200,000 d.) P1,000,000

Problem 27-8: (Modification of Terms)

In 2014, Bunny Corporation acquired land by paying P300,000 and signing a note with a
maturity value of P4,000,000, on the note’s due date, December 31, 2014. Bunny owed
P320,000 of accrued interest and P4,000,000 principal on the note. Bunny was in financial
difficulty and was unable to make any payments. Bunny and the bank agreed to amend the
note as follows:
□ The P320,000 interest due on December 31, 2014 was forgiven
□ The principal of the note was reduced by P200,000 and the maturity date was made
payable December 31, 2015
□ Bunny would be required to make one interest payment totaling P342,000 on
December 31, 2015
On December 31, 2014 the prevailing rate of interest for a similar instrument is 9%.
Question 1: As a result of the restructuring of debt, how much should Bunny report as gain,
before income taxes, in its 2014 profit or loss?
a.) P160,000 c.) P484,508
b.) P240,000 d.) P563,508

Solution:
Face value P4,000,000
Accrued interest 320,000
Carrying amount of old liability P4,320,000
New principal (3,800,000)
Future interest (342,000)
Total P4,142,000
PV of 8% after 1 year x 0.926
PV of principal (3,835,492)
Gain on restructuring P 484,508
Question 2: Assuming Bunny Company incurred a total transaction cost of P30,000 directly
related to the restructuring, what amount of net gain should be reported in its 2014 profit or
loss?
a.) None c.) P454,508
b.) P148,000 d.) P484,508

Solution:
Amount of gain recognized 484508
Transaction cost (30000)
Adjustment amount of gain 454508

Problem 27-9: (Modification of Terms)

Crow, Inc, is indebted to Scare under an P8,000,000, 10%, four-year note dated December
31, 2011. Annual interest of P800,000 was paid on December 31, 2012 and 2013. During
2014, Crow experienced financial difficulties and is likely to default unless concessions are
made. On December 31, 2014, Scare agreed to restructure the debt as follows:
□ Interest of P800,000 due December 31, 2014 was waived.
□ Extended the maturity to December 31, 2015
□ The principal amount is reduced to P7,000,000
□ Interest of P770,000 of the new principal will be paid on maturity date.
Question 1: Assuming an income tax rate of 32%, how much should Crow report as gain in
restructuring in its profit or loss for the year ended December 31, 2014? (Carry present value
factors up to three decimal places)
a.) P320,000 c.) P1,181,208
b.) P680,000 d.) P1,205,626

Question 2: What is the amount of loss on restructuring should the creditor recognize?
a.) None c.) P1,181,208
b.) P320,000 d.) P1,205,626

Solution:
PV of principal (7000000*0.636) 4452000
PV of interest payments (770000*3.17) 2440900
Present value of new note payable 6892900
Face value of new note payable (7000000)
Discount on note payable 107100

Note payable – old 8000000

Accrued interest payable 800000
Carrying amount of old liability 8800000
Present value of new note payable (6892900)
Gain on extinguishment of debt 1907100

Problem 27-10: (Modification of Terms)

On December 31, 2011, Gorilla Company was experiencing financial difficulties and entered
into a debt restructuring agreement with the creditor. The creditor restructured the obligation
as follows:
□ The principal was reduced from P10,000,000 to P9,000,000
□ Forgave the accrued interest of P1,200,000
□ Extended the maturity date from Dec. 31, 2011 to Dec. 31, 2014
□ Reduced the interest from 12% to 10%. Interest is payable annually on December
31, 2012, 203, and 2014.
How much should be the creditor report as loss on debt restructuring? (Carry present value
factors to 3 decimal places)
a.) None c.) P2,421,400
b.) P1,954,200 d.) P2,630,200

Solution:
PV of principal (9000000*0.712) 6408000
PV of interest payments (900000*2.402) 2161800
Present value of new note payable 8569800
Face value of new note payable (9000000)
Discount on note payable 430200

Note payable – old 10000000

Accrued interest payable 1200000
Carrying amount of old liability 11200000
Present value of new note payable (8569800)
Gain on extinguishment of debt 2630200

Problem 27-11: (Modification of Terms)

In 2009, Runny Corporation acquired land by paying P2,000,000 and signing a note with a
face value of P6,000,000. On the note’s due date, December 31, 2011, Runny owed
P480,000 of accrued interest and P6,000,000 principal on the note. Runny was in financial
difficulty and was unable to make any payments. Runny and the bank agreed to amend and
the note as follows:
 Extended the maturity to December 31, 2013.
  The P480,000 interest due on December 31, 2011 was forgiven.
 Runny would be required to make an annual interest payment of P540,000 every
December 31 starting 2012
 Transaction cost incurred that is directly related to the debt restructuring was
P16,850
As of December 31, 2011, the yield rate based on the restricted debt and after considering
the amount of transaction cost is 6.24%
Question 1: What amount should Runny report as gain, before income taxes, in its 2011
profit or loss?
a.) None c.) P375,180
b.) P80,000 d.) P480,000

Solution:
Face value P6,000,000
Accrued interest 480,000
Carrying amount of old liability P6,480,000

Question 2: What is the carrying value of the obligation should Runny Company report in its
2012 statement of financial position?
a.) P5,893,150 c.) P6,302,580
b.) P6,155,861 d.) P6,480,000