Question

On December 31, 2017, American Bank enters into a debt restructuring agreement with Barkley Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, \(3,000,000 note receivable by the following modifications:

1. Reducing the principal obligation from \)3,000,000 to \(2,400,000.
2. Extending the maturity date from December 31, 2017, to January 1, 2021.
3. Reducing the interest rate from 12% to 10%.

Barkley pays interest at the end of each year. On January 1, 2021, Barkley Company pays \)2,400,000 in cash to American Bank.

Instructions

1. Will the gain recorded by Barkley be equal to the loss recorded by American Bank under the debt restructuring?
2. Can Barkley Company record a gain under the term modification mentioned above? Explain.
3. Assuming that the interest rate Barkley should use to compute interest expense in future periods is 1.4276%, prepare the interest payment schedule of the note for Barkley Company after the debt restructuring.
4. Prepare the interest payment entry for Barkley Company on December 31, 2019.
5. What entry should Barkley make on January 1, 2021?

Short answer

1. No, Barkley should not record gain.
2. No, Barkley Company cannot record a gain under the mentioned term modification.
3. The total cash paid is $720,000.
4. Interest expense is $40,013.
5. Notes payable is $2,400,000.

Step-by-step solution

Meaning of Debt Restructuring

The company is experiencing cash flow problems agreeing with lenders to renegotiate and expects them to agree with some favorable or flexible conditions so that the company can avoid bankruptcy. This process is known as debt restructuring.

(a) Explaining whether Barkley should record gain

No, by the debt restructuring arrangement, Barkley's gain does not equal American Bank's loss. (In the four following activities, you'll discover why this occurs.) The FASB was concerned that expanding the scope of its announcement would cause a delay in the release of GAAP for the creditor. Therefore, GAAP did not deal with debtor accounting about this "accounting asymmetry" treatment.

(b) Explaining whether Barkley Company records a gain under the term modification

The future cash flows following the restructuring are more than the whole pre-restructuring carrying value of the note (principal). Hence there is no gain under the new conditions.

Calculation of total cash flow after restructuring

Total future cash flows after restructuring are:
Principal	$2,400,000
Interest $\left(\$2,400,000\times 10\%\times 3\right)$	720,000
	$3,120,000
The total pre-restructuring carrying amount of note(principal)	$3,000,000

(c) Preparing interest payment schedule

BARKLEY COMPANY Interest Payment Schedule After Debt Restructuring Effective Interest Rate 1.4276%

Date	Cash paid (10%)	Interest Expense (1.4276%)	Reduction Of Carrying Amount	Carrying Amount of Note
12/31/17				$3000,000
12/31/18	$240,000	$42,828	$197,172	2,802,828
12/31/19	240,000	40,013	199,987	2,602,841
12/31/20	240,000	37,159	202,841	2,400,000
Total	$720,000	$120,000	$600,000

Working notes:

Calculation of Cash paid on 12/31/18

$\begin{array}{rcl}\mathbf{Cash}\mathbf{}\mathbf{Paid}& \mathbf{=}& \mathbf{Principal}\mathbf{}\mathbf{Obligation}\mathbf{\times }\mathbf{Interest}\mathbf{}\mathbf{rate}\\ & \mathbf{=}& \mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{10}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{240}\mathbf{,}\mathbf{000}\end{array}$

Calculation of interest expense on 12/31/18

$\begin{array}{rcl}\mathbf{Interest}\mathbf{}\mathbf{Expense}& \mathbf{=}& \mathbf{Principal}\mathbf{}\mathbf{Obligation}\mathbf{\times }\mathbf{Interest}\mathbf{}\mathbf{rate}\\ & \mathbf{=}& \mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{1}\mathbf{.}\mathbf{4276}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{42}\mathbf{,}\mathbf{828}\end{array}$

Calculation of Reduction of carrying amount on 12/31/18

$\begin{array}{rcl}\mathbf{Reduction}\mathbf{}\mathbf{of}\mathbf{}\mathbf{carrying}\mathbf{}\mathbf{amout}& \mathbf{=}& \mathbf{Cash}\mathbf{}\mathbf{paid}\mathbf{-}\mathbf{Interest}\mathbf{}\mathbf{expense}\\ & \mathbf{=}& \mathbf{\$}\mathbf{240}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{42}\mathbf{,}\mathbf{828}\\ & \mathbf{=}& \mathbf{\$}\mathbf{197}\mathbf{,}\mathbf{712}\end{array}$

(d) Preparing journal entry

Interest payment entry for Barkley Company is:

Date	Particulars	Debit ($)	Credit ($)
Dec. 31, 2019	Notes payable	199,987
	Interest expense	40,013
	Cash		240,000

(e) Preparing journal entry

The payment entry at maturity is:

Date	Particulars	Debit ($)	Credit ($)
Jan. 1, 2021	Notes payable	2,400,000
	Cash		2,400,000