Question

(Debtor/Creditor Entries for Continuation of Troubled Debt) Daniel Perkins is the sole shareholder of Perkins Inc., which is currently under protection of the U.S. bankruptcy court. As a “debtor in possession,” he has negotiated the following revised loan agreement with United Bank. Perkins Inc.’s \(600,000, 12%, 10-year note was refinanced with a \)600,000, 5%, 10-year note.

Instructions

(a) What is the accounting nature of this transaction?

(b) Prepare the journal entry to record this refinancing:

(1) On the books of Perkins Inc.

(2) On the books of United Bank.

(c) Discuss whether generally accepted accounting principles provide the proper information useful to managers and investors in this situation.

Short answer

1. The transaction of refinancing is classified as trouble debt restructuring.
2. Creditor will lose$237,300.
3. The GAAP principle in the above situation does not provide fair information to the investors and the managers.

Step-by-step solution

Definition of Shareholder

A shareholder can be defined as an individual interested in the company’s ownership. Such an individual becomes the owner of the company by purchasing the equity security issued by the company.

Accounting Nature of the transaction

The transaction will be classified as trouble debt restructuring because, under this type of transaction, the creditor refinances the loan because of the financial and economic difficulties faced by the business entity. Under this transaction, the debtor is provided with the concession.

Journal entry to record refinancing

Date	Accounts and Explanation	Debit $	Credit $
In the books of Perkins
	No journal entry will be made by the Perkins Inc.
In the books of United bank
	Bad debt expenses	237,300
	Allowance for doubtful accounts		237,300

Working note:

Calculation creditor’s loss due to restructuring

Particular	Amount $
Carrying cost before restructuring	$600,000
Less: Present value of debt of $600,000 due after 10 years @ 12% (0.322)	(193,200)
Less: PVOAF of annual interest of $30,000 @ 12% for 10 years (5.65)	(169,500)
Creditor’s loss due to restructuring	$237,300

Information provided by the GAAP principles in the above situation to the managers and the investors

The GAAP principle in the above situation does not provide useful information because the loss faced by the creditor is calculated using the discounted value of the future cash flow (present value of the future cash flow). At the same time, the gains generated by the debtors are not calculated using the discounted present value. Therefore, it will not provide fair information relating to the benefits generated by the debtor due to refinancing.