PCOA 008 – INTERMEDIATE ACCOUNTING II

MODULE 5: Debt Restructure

Introduction
• This module is all about debt restructuring.
• The module is organized as follows:
o Asset Swap
o Equity Swap
o Modification of Terms
• This module tackles the purpose and accounting for debt restructuring.
• This topic requires knowledge of Time value of money, critical thinking and analysis.
• Assessment is the theoretical and application of accounting standards for Asset swap,
Equity Swap and Modification of Terms.
Learning Outcomes:
At the end of this module, the students can:
• Understand the nature and purpose of debt restructuring.
• Identify the types of debt restructuring.
• Learn the accounting for an asset swap, equity swap and modification of terms of the old
liability.
Debt Restructuring
Debt restructuring is a situation where the creditor, for economic or legal reasons related to the
debtor’s financial difficulties grants 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.
Type of debt restructuring
There are three types of debt restructuring, namely:
1. Asset swap
2. Equity swap
3. Modification of terms

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 Asset Swap
An asset swap is 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 the creditor 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 900,000

Journal entry
Note payable 2,000,000
Accrued interest payable 400,000
Land 1,500,000
Gain on extinguishment 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.

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 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 2,200,000
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
Less: 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

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 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
Gain on debt restructuring 500,000
Land 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
An equity swap is a transaction whereby a debtor and creditor 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 of 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 IFRIC 19.

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 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 entity 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 liability and the initial measurement
of the equity instruments issued shall be recognized in 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 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

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 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

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

If the carrying amount of the liability is used, there is no 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.
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 if 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 a gain or loss extinguishment of 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:

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 Note payable - due January 1, 2020 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 period is 0.5921 and the present value of an ordinary annuity
of 1 at 14% at 4 periods is 2.92137.
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

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 Journal entries
To record the extinguishment of 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

To record the interest payment on the new note payable for 2020:
Interest expense (10% 4,000,000) 400,000
Cash 400,000
To amortize the discount on note payable for 2020
Interest expense 94,743
Discount on note payable 94,743

Interest Interest Discount Carrying

Date
paid Expense Amortization amount
01/01/2020 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 400,000 523,128 132,128 3,859,758
12/31/2023 400,000 540,242 140,242 4,000,000

December 31, 2020

Interest paid 400,000
Interest expense 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 508,007
Discount amortization 108,007

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 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 - old 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

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
annuity of 1 at 10% for three periods is 2.4869.
PV of principal (5,000,000 x .7513) 3,756,500
PV of interest payments
(5,000,000 x 14% x 2.9137) 1,740,830
Present value of new liability 5,497,330

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 Note payable 6,000,000
Present value of new note payable 5,497,330
Gain on modification 502,670

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 the 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 in profit or loss even if there is 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
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
To record the annual interest payment for 2020:
Interest expense 700,000
Cash 700,000
To amortize the premium on note payable:
Premium on note payable 150,267
Interest expense 150,267

Interest Interest Discount Carrying

Date
paid Expense Amortization amount
01/01/2020 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

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 *10% times P5,181,769 equals P518,177. There is a difference of P54 due to rounding of present
value factor.
Interest paid equals face value times modified stated rate.
Thus, for 2020, P5,000,000 x 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.

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 Assessment
Multiple Choice: (1 pt. each)
1. In a debt restructuring that is considered an asset swap, the gain on extinguishment is equal
to
a. Excess of the fair value of the asset over its carrying amount.
b. Excess of the carrying amount of the debt over the fair value of the asset.
c. Excess of the fair value of the asset over the carrying amount of the debt.
d. Excess of the carrying amount of the debt over the carrying amount of the asset.
2. For a debt restructuring involving substantial modification of terms, it is appropriate for a
debtor to recognize a gain when the carrying amount of the debt
a. Exceeds the total future cash payments specified by the new terms.
b. Is less than the total future cash payments specified by the new terms.
c. Exceeds the present value of the future cash payments specified by the new terms.
d. Is less than the present value of the future cash payments specified by the new
terms.
3. For a debt restructuring involving a substantial modification of terms, which of the
following specified by the new terms would be compared to the carrying amount of the
debt to determine if the debtor should report a gain on extinguishment?
a. The total future cash payments
b. The present value of the new debt at the original interest rate
c. The present value of the new debt at the modified interest rate
d. The amount of future cash payments
4. Under a debt restructuring involving substantial modification of terms, the future cash
flows under the new terms shall be discounted using
a. Original effective interest rate
b. Interest rate under the new terms
c. Market rate of interest
d. Prime interest rate
5. An entity shall initially measure equity instruments issued to extinguish a financial liability
at
a. Fair value of the equity instruments issued
b. Fair value of the liability extinguished
c. Par value of the equity instruments issued
d. Carrying amount of the liability extinguished
6. If the fair value of the equity instruments issued cannot be reliably measured, the equity
measurements issued to extinguish a financial liability shall be measured at
a. Fair value of the liability extinguished
b. Par value of the equity instruments issued
c. Carrying amount of the liability extinguished

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 d. Book value of the equity instruments issued
7. If both the fair value of the equity instruments issued and the fair value of the financial
liability extinguished cannot be measured reliably, the equity instruments issued shall be
measured at
a. Carrying amount of the liability extinguished
b. Par value of equity instruments issued
c. Carrying amount of the equity instruments issued
d. Value assigned by the board of directors
8. The difference between the carrying amount of the financial liability extinguished and the
fair value of equity instruments issued shall be recognized is
a. Profit or loss
b. Other comprehensive income
c. Retained earnings
d. General reserve
9. The gain or loss from extinguishment of a financial liability by issuing equity instruments
is presented as
a. Other income or other expense
b. Separate of other comprehensive income
c. Component of other comprehensive income
d. Component of finance cost
Problem Solving: (1 pt. each)
1. The following information pertains to the transfer of real estate pursuant to a debt
restructuring by Knob Company to Mane Company in full liquidation of Knob Company’s
liability to Mane.
Carrying amount of liability liquidated 1,500,000
Carrying amount of real estate transferred 1.000,000
Fair value of real estate transferred 1.200,000
What amount of pretax gain on extinguishment should Knob Company report as
component of income from continuing operations?

2. During 2020, Mann Company experienced financial difficulties and is likely to default on
a P5,000,000, 15% three-year note dated January 1, 2018 payable to Summit Bank. On
December 31, 2020, the bank agreed to settle the note and unpaid interest of P750,000 for
P4,100,000 cash payable on January 31, 2021. What amount should be reported as gain
from extinguishment of debt in the 2020 income statement?

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 3. Hull company is indebted to Apex Company under a P5,000,000, 12%, three-year note
dated December 31, 2018. Because of financial difficulties developing in 2020, Hull
Company owed accrued interest of P600,000 on the note on December 31, 2020.

Under a debt restructuring on December 31, 2020, Apex Company agreed to settle the note
and accrued interest for a tract of land having a fair value of P4,500,000. The acquisition
cost of the land is P3,600,000.

What amount of pretax gain on extinguishment should Hull Company report as component
of income from continuing operations in 2020?

4. Due to adverse economic circumstances and poor management. Tagaytay Highlands

Company had negotiated a restructuring of a 9%, P6,000,000 note payable to Second Bank
due on January 1, 2020. There was no accrued interest on the note on January 1, 2020.

The bank reduced the principal obligation from P6,000,000 to P5,000,000 and extended
the maturity to three years on December 31, 2022. However, the new interest rate is 13%
payable annually every December 31. The present value of 1 at 9% for three periods is .77
and the present value of an ordinary annuity of 1 at 9% for three periods is 2.53.

a. What is the present value of the new note payable on January 1, 2020?
b. What is the gain on modification of debt to be recognized for 2020?
c. What is the interest expense for 2020 as a result of the modification?

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 Reference

Valix, C. T., Peralta, J. F., & Valix, C. A. M. (2020). Debt Restructuring. In Intermediate

Accounting (2020th ed., Vol. 2, pp. 304–329). GIC ENTERPRISES & CO., INC.

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