Question

Using the same information as in E14-22, answer the following questions related to American Bank (creditor).

Instructions

1. What interest rate should American Bank use to calculate the loss on the debt restructuring?
2. Compute the loss that American Bank will suffer from the debt restructuring. Prepare the journal entry to record the loss.
3. Prepare the interest receipt schedule for American Bank after the debt restructuring.
4. Prepare the interest receipt entry for American Bank on December 31, 2019.
5. What entry should American Bank make on January 1, 2021?

Short answer

1. Historical interest rate.
2. Loss on the restructuring of debt is $715,289.
3. The total increase in carrying amount is $115,289.
4. Allowance for doubtful accounts is $38,265.
5. Allowance for doubtful accounts is $600,000.

Step-by-step solution

Meaning of Debt Restructuring

Debt restructuring refers to a procedure adopted by a company struggling with cash flow crises to avoid bankruptcy and may agree with the lenders to renegotiate some flexible conditions.

Mentioning the rate should be used by American Bank

American Bank should utilize the historical interest rate of 12 percent to determine the loss.

Computing loss and preparing journal entry.

The loss can be calculated as follows:

The pre-restructuring carrying amount of note	$3,000,000
Less: Present value of restructured future cash flows:
Present value of principal $2,400,000 due in 3 years at 12% $1,708,272
Present value of interest $240,000 Paid annually for 3 years at 12% 576,439	2,284,711
Loss on the restructuring of debt	$715,289

Working note:

Calculation of Present value of principal $2,400,000 due in 3 years at 12%

$\begin{array}{c}\mathbf{Present}\mathbf{value}\mathbf{=}\mathbf{Principal}\mathbf{value}\mathbf{\times }\mathbf{PV}\mathbf{factor}\\ \mathbf{=}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{0}\mathbf{.}\mathbf{71178}\\ \mathbf{=}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{708}\mathbf{,}\mathbf{272}\end{array}$

Calculation of Present value of interest $240,000 Paid annually for 3 years at 12%

$\begin{array}{c}\mathbf{Present}\mathbf{value}\mathbf{=}\mathbf{Principal}\mathbf{value}\mathbf{interest}\mathbf{\times }\mathbf{PV}\mathbf{factor}\\ \mathbf{=}\mathbf{\$}\mathbf{240}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{2}\mathbf{.}\mathbf{40183}\\ \mathbf{=}\mathbf{\$}\mathbf{576}\mathbf{,}\mathbf{439}\end{array}$

Date	Particulars	Debit ($)	Credit ($)
Dec. 31, 2017	Bad debt expense	715,289
	Allowance for doubtful accounts		715,289

Preparing interest receipt schedule

AMERICAN BANK Interest Receipt Schedule After Debt Restructuring Effective Interest Rate 12%
Date	Cash received (10%)	Interest Revenue (12%)	Increase In Carrying Amount	Carrying Amount of Note
12/31/17				$2,284,711
12/31/18	$240,000	$274,165	$34,165	2,318,876
12/31/19	240,000	278,265	38,265	2,357,141
12/31/20	240,000	282,859	42,859	2,400,000
Total	$720,000	$835,289	$115,289

Calculation of Cash paid on 12/31/18

$\begin{array}{c}\mathbf{Cash}\mathbf{paid}\mathbf{=}\mathbf{Principal}\mathbf{obligation}\mathbf{\times }\mathbf{Interest}\mathbf{rate}\\ \mathbf{=}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{10}\mathbf{\%}\\ \mathbf{=}\mathbf{\$}\mathbf{240}\mathbf{,}\mathbf{000}\end{array}$

Calculation of interest revenue on 12/31/18

$\begin{array}{c}\mathbf{Interest}\mathbf{revenue}\mathbf{=}\mathbf{Principal}\mathbf{obligation}\mathbf{\times }\mathbf{Interest}\mathbf{rate}\\ \mathbf{=}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{284}\mathbf{,}\mathbf{711}\mathbf{\times }\mathbf{12}\mathbf{\%}\\ \mathbf{=}\mathbf{\$}\mathbf{274}\mathbf{,}\mathbf{165}\end{array}$

Calculation of increase in carrying amount on 12/31/18

$\begin{array}{c}\mathbf{Increase}\mathbf{in}\mathbf{carrying}\mathbf{amount}\mathbf{=}\mathbf{Cash}\mathbf{paid}\mathbf{-}\mathbf{Interest}\mathbf{expense}\\ \mathbf{=}\mathbf{\$}\mathbf{274}\mathbf{,}\mathbf{165}\mathbf{-}\mathbf{\$}\mathbf{240}\mathbf{,}\mathbf{000}\\ \mathbf{=}\mathbf{\$}\mathbf{34}\mathbf{,}\mathbf{165}\end{array}$

Note: The increase in carrying amount on 12/31/18 is rounded off at $2.

Preparing journal entry

Interest receipt entry for American Bank is:

Date	Particulars	Debit ($)	Credit ($)
Dec. 31, 2019	Cash	240,000
	Allowance for doubtful accounts	38,265
	Interest Revenue		278,265

Preparing journal entry

The receipt entry at maturity is:

Date	Particulars	Debit ($)	Credit ($)
Jan. 1, 2021	Cash	2,400,000
	Allowance for doubtful accounts	600,000
	Notes receivable		3,000,000