Debt Restructuring: Solutions for Companies
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Trice Domingo- Problem 1: Asset Swap
- Problem 2: Equity Swap
- Introduction to Debt Restructuring
- Problem 4: Modification of Terms
- Problem 3: Class of Share
- Problem 5: Continuation without Substantial Modification
Common questions
Powered by AITo record the asset swap, debit the mortgage payable for P5,000,000, debit the accrued interest payable for P1,000,000, debit a loss on debt extinguishment of P100,000, and credit land for P1,500,000 and building for P6,000,000.
Upon waiving P600,000 of accrued interest, La Velle Company should debit the accrued interest payable and credit Gain from restructuring for the waived amount. The unchanged principal obligation requires continued recognition, where the restructuring allows for the principal to remain while new annual interest payments and a new maturity date reshape cash flows, creating journal entries to accommodate new payment schedules at negotiated lower rates under the market rate.
An equity swap affects a company's financial statements by exchanging debt liabilities for equity, thereby reducing liabilities and potentially altering equity breakdown. For Seve Company, issuing shares at current fair value of P130 per share satisfies the P5,500,000 liability (mortgage P5,000,000 and accrued interest P500,000), adjusting equity by this amount, with 35,000 shares issued covering a fair value of P4,550,000. The difference indicates that the liability was settled for less than the carrying amount, resulting in a gain.
Rona Company would debit the note payable (P5,000,000) and accrued interest payable (P400,000) for P5,400,000, credit ordinary shares for 300,000 common shares at P10 market value (P3,000,000) and preference shares for 25,000 at P60 market value (P1,500,000), acknowledging a gain on debt restructuring for the remaining P900,000 of differences.
A substantial modification significantly changes a debt's cash flows by more than 10%, effectively creating a new debt instrument per IFRS guidelines. A non-substantial modification, like La Velle Company’s waiver of accrued interest without adjusting principal or maturity period by more than 10%, only slightly alters terms without effectively being a new liability. Despite a revision in the interest rate structure and the waiver of P600,000 interest, this situation does not redefine the debt’s purpose or agreement to a marked degree.
A 'substantial modification' occurs when there are significant changes to the terms of a financial obligation that effectively alter the costs and benefits from the creditor's perspective, sufficient to be considered an extinguishment. For Rona Company, forgiving unpaid interest (P720,000), reducing principal by P500,000, and lowering interest rate from 12% to 8% constitute substantial modifications because they significantly change the net present value of cash flows compared to the original terms, as shown by recalculating present values at a market rate of 10%.
The gain or loss on the extinguishment of debt for KDC Company is calculated by comparing the carrying amount of the debt and the combined fair value of the land and building. The carrying amount of the debt was the principal of P5,000,000 and accrued interest for 2021 and 2022 at P500,000 each, totaling P6,000,000. The fair value of the land and building was P5,900,000. Therefore, the loss is the difference: P100,000.
Evaluating the present value of liabilities is critical for companies in financial distress to ensure terms under restructuring agreements are viable, accurately reflect liabilities' fair value, and align with IFRS’s fair representation of financial positions. For Rona Company, recalculating liability present values post-term modification highlights real economic impacts by considering reduced principal, adjusted interest rates, and corresponding cash flow changes, as credible valuation supports transparent restructuring and ensures stakeholders recognize realistic obligations.
An arrangement fee is a direct cost associated with modifying terms and should be considered part of the transaction’s cash flows. In Rona Company's case, the P100,000 arrangement fee increases both the present value of cash flows and costs for restructuring. These costs need to be deducted to compute the gain or loss due to debt modification, the new adjusted carrying amount should reflect the reduced outstanding liability’s present value at the new rate, less fees incurred.
Under IFRS, modification of terms is considered as resulting in a new financial liability if there is a significant difference in terms, generally quantified as a change exceeding 10% in present value of cash flows. For Rona Company, forgiving accrued interest, reducing principal, adjusting the interest rate and extending maturity—all change the timing and amount of cash flows, significantly reducing the original liability by more than 10%. Thus, IFRS guidelines suggest recognizing it as a new financial liability.
