FRA Packet 4

Creditor concessions: This occurs when a creditor grants a concession to a debtor.
Trouble: A borrower is described as troubled when they are unable to pay the original loan.

Settlement
- Cancels the original loan through payment of consideration, which can be in cash or other assets.
- The fair value (FV) of the consideration must be less than the original loan amount.
- Borrower's Accounting:
  - Recognizes gain due to debt restructuring (this is a writedown of debt) and may also recognize gain or loss on asset transfer.
- Lender's Accounting:
  - Recognizes a loss on debt restructuring calculated as (original NBV - new NBV).
Continuation with Moderation of Terms
- An alternative to a direct settlement where modifications are made to the existing loan terms.
- This may include lowering interest rates and/or extending payment terms (i.e., creating a new loan agreement).
- Borrower's Accounting:
  - May or may not recognize gain on debt restructuring and possibly gain or loss on asset transfer.
- Lender's Accounting:
  - Recognizes loss on debt restructuring calculated as (original NBV - new NBV).

Combination: Both settlement and continuation with moderation can occur simultaneously.

Lender:
- DR: Consideration received (FMV)
- DR: Loss on restructuring (plug)
- CR: Note Receivable (NBV)
Borrower:
- DR: Note Payable (NBV, same as above)
- CR: Consideration paid (FMV, same as above)
- CR: Gain on restructuring (plug, same as above)
Note: The lender's loss is equal to the borrower's gain in a settlement scenario.

Two cases to consider:
1. Case 1: Undiscounted sum of new cash flows (CFs) is greater than the lender’s discounted NBV of the loan.
2. Case 2: Undiscounted sum of new CFs is less than the lender’s discounted NBV of the loan.

No restructuring gain for the borrower (no writedown of debt).
The borrower must recompute the new interest rate such that the lender’s NBV equals the discounted sum of CFs, using this to calculate future interest expense.
This results in a new interest rate that is lower than the original rate (due to lower CFs), while the lender continues with the original (higher) rate.
The new (lower) NBV is derived from new (lower) CFs discounted at the original rate.
The lender recognizes a restructuring loss, calculated as follows:
ext{Loss} = ext{original NBV} - ext{new NBV}
Note: The lender's interest income will be greater than the borrower's interest expense due to the differing rates.

Borrower: No journal entry required; adjustment is made to compute interest expense using the new (lower) rate and amortize the loan accordingly.
Lender: Writes down the loan to the new NPV; loss calculated as follows:
- DR: Loss on restructuring (Change in NPV)
- CR: Note Receivable (Change in NPV)

The same note from slide 5 is used with pre-restructuring NBV of $793,832.
Assume modification requires the borrower to repay $867,442 at maturity.
The implicit interest rate is determined as follows:
867,442/(1.03)^3 = 793,832
Lender’s new NBV calculation:
ext{New NBV} = 867,442/(1.08)^3 = 688,603
The lender's loss is then calculated as:
ext{Loss} = 793,832 - 688,603 = 105,229
Borrower's Entries:
- DR: Interest Expense $23,815 (calculated as $793,832 * 0.03)
- CR: Note/Payable $23,815
Lender's Entries:
- DR: Restructuring Loss $105,229
- CR: Note Receivable $105,229
- DR: Note Receivable $55,088
- CR: Interest Revenue $55,088
- Interest revenue example: 688,603 * 0.08 = 55,088

The borrower recognizes a gain on debt restructuring (writedown of debt).
Gain is calculated as:
ext{Gain} = ext{Previous NBV} - ext{Undiscounted sum of new CFs}
The borrower continues with a zero interest rate, resulting in zero future interest expense, and all future cash payments are treated as a return of principal, which involves a debit (DR) to the liability.
Borrower's Entries:
- DR: Note Payable (Change in NPV)
- CR: Gain (Change in NPV)
Lender will follow a similar procedure as outlined in the previous case.

Using the same values as Case 1, with the borrower requiring a repayment of $700,000 at maturity.
Borrower’s Entries:
- DR: Note/Payable $93,832
- CR: Gain $93,832 (this is calculated as $793,832 - $700,000)
When the loan is repaid, entries include:
- DR: Note/Payable $700,000
- CR: Cash $700,000
- Note: There is zero interest expense recorded.
For the lender:
- The values lead to calculations, as shown:
  1. 700,000/(1.08)^3 = 555,683
  2. Gain calculation, 793,832 - 555,683 = 238,149
  3. Thus, the lender’s loss:
    - DR: Loss $238,149
    - CR: Note/Receivable $238,149
The lender’s interest revenue calculation:
- DR: Note Receivable $44,455
- CR: Interest Revenue $44,455
- Interest revenue = 555,683 * 0.08

There is a notable difference in accounting between the borrower and lender due to the nature of their transactions.
Different loan values may result in differing interest rates leading to distinct gains and losses for each party.
Recognized gains and losses do not equate to economic gains and losses.
The borrower's true new interest rate could exceed the original rate; however, GAAP may assign a lower rate (possibly zero in Case 2) for practical consideration since accurately determining the true rate is complex.