Troubled Debt Restructuring: Recording Gains and Losses on Debt Settlements, Exams of Accounting

Download Troubled Debt Restructuring: Recording Gains and Losses on Debt Settlements and more Exams Accounting in PDF only on Docsity! Exam #___________ Time Started: ________AM Time Ended: ________AM Name: __________________________________ Exam 1 Acct 414 – Corporate Accounting & Reporting II Fall 2007 Show any necessary computations if you want to be eligible for partial credit. Present your work in a neat, well-organized manner. When you are using a financial calculator, spell out what you put in for n, i, PMT, FV, PV, etc. Draw a time-line if that would explain your thinking to me. You may use abbreviations in your essay answers but I need complete thoughts. Follow the instructions and answer all parts of the question as directed. 1-4. Time Value of Money (60 points total) 5. Troubled debt (30 points total) 6-7. Leases. (70 points total) 8. Long-term contracts (20 points) 9. Serial Bonds (20 points) 10. Extra credit points (if any) total: __________ (max = 10) Total points earned (max = 200) Do not attempt the extra credit section until you have completed all other sections of the exam! To be completed by professor: After Exam 1 - Course Grade Total Points = __________/__________ = _________% Quiz and HW percentage = ___________% Projects percentage = ___________% Exam 1 – Acct 414 – Fall 2007 Page 2 Are assets or an ownership interest transferred from debtor to creditor in settlement of debt? Is the debt settled in full? Is entity the CREDITOR? CREDITOR discounts expected future cash flows to be received under modified terms using original (historical) interest rate No No Yes Record ordinary gain or loss on asset. Difference between fair value of asset or equity interest and amount due on debt is ordinary gain for debtor and ordinary loss for creditor Yes Difference between carrying value of receivable and present value of expected future cash flows is ordinary loss for CREDITOR Are the cash flows to be made under the modified terms greater than the carrying value of the debt after transfer of any asset or equity interest? (Debtor pays LESS than amount owed at restructuring) The difference between carrying value of debt and total future cash flows is recorded as a gain from restructuring for DEBTOR. No interest expense will be recorded in future years. No (Debtor pays MORE than amount owed at restructuring) No gain is recorded by DEBTOR. Find interest rate to set cash flow equal to carrying value of debt. Use this interest rate to amortize the restructured debt over its term. Yes TROUBLED DEBT RESTRUCTURING (FASB 15, 114, 118 & 145) Prepared by T. Gordon 8-31-06 Record ordinary gain or loss on asset or equity interest transferred. Difference between fair value of asset or equity interest and carrying value of debt is recognized as an ordinary gain from restructuring for debtor and an ordinary credit loss for creditor. No Yes Exam 1 – Acct 414 – Fall 2007 Page 5 [5] Troubled Debt Restructuring (30 points) On May 1, 2007, a $100,000 note due to Idaho Last Bank & Trust came due but Henry’s Hardware does not have enough cash to make the payment. Henry’s Hardware has already recorded as interest expense the $12,000 unpaid accrued interest and the bank has, likewise, booked the interest revenue receivable. The note specified annual payments of $25,000 per year plus 12% interest on the unpaid balance. Since Henry’s Hardware is unable to make the payments, the bank has agreed to restructure the terms of the loan. Under the new terms, Henry’s Hardware will pay interest only for four years at a 10% rate on a reduced principal amount of $80,000. Five years from now, the balloon payment will come due, i.e., $80,000 principal plus $8,000 interest. a. Creditor: What is the fair value of the restructured receivable on Idaho Last Bank & Trust’s books immediately on May 1, 2007? b. Creditor: What amount of interest revenue on the restructured note will be recognized by Idaho Last Bank & Trust for the fiscal year ending 12/31/07 if it uses the effective interest method? c. Debtor (a variation of creditor problem). If Henry’s Hardware settled the full amount of the debt on May 1, 2007 by transferring to the bank land worth $50,000 without paying any cash, what would be the gain recognized from the restructuring? Exam 1 – Acct 414 – Fall 2007 Page 6 [6] Lease Classification (20 points). On March 1, 2007, Idaho Telephone Co. (lessee) and Colton Computer Industries (lessor) sign a lease with the following terms: 1. Term: 5 years 2. Annual payments of 43,996 3. Implicit interest rate (not known to lessee) 10% 4. Lessor retains ownership of asset at end of lease 5. Fair value of asset $200,000 6. Cost of asset $175,000 (not known to lessee) 7. Incremental borrowing rate: 12% 8. First payment due at inception of lease 9. Estimated useful life of asset: 7 years 10. No collection or cost uncertainties for lessor 11. Est. fair value of asset at end of lease: $30,000 12. The residual value is NOT guaranteed by lessee 13. Initial direct costs (attorney's fee) are incurred by the Lessor in the amount of $1,000. 14. Lessor and lessee both use straight-line depreciation method for fixed assets. 15. The Lessor is responsible for property taxes on the leased asset. Property taxes are expected to be $500 per year. To save time, you should use the following present values to work this problem: The PV of $30,000 (n=5, i=10%) = 18,628 The PV-AD of 43,496 (n=5, i=10%) = 181,372 The PV of $30,000 (n=5, i=12%) = 17,023 The PV-AD of 43,496 (n=5, i=12%) = 175,609 The FV of $30,000 (n=5, i=10%) = 48,315 The PV-AD of 43,996 (n=5, i=10%) = 183,457 The FV of $30,000 (n=5, i=12%) = 59,215 The PV-AD of 43,996 (n=5, i=12%) = 177,627 a. Classify this lease from the perspective of the lessee, Idaho Telephone Co. Explain. This is an SHORT essay question. Abbreviations are fine. Use complete sentences and let me know that you know the criteria! Give me the “numbers” for the numeric tests! If the lease is a capital lease, tell me the amount that would be capitalized as an asset. b. Classify this lease from the perspective of the lessor, Colton Computer Industries (CCI). Explain. This is an SHORT essay question. Use complete sentences and let me know Exam 1 – Acct 414 – Fall 2007 Page 7 that you know the criteria! Abbreviations are fine and you may refer to your Part a answer above. Exam 1 – Acct 414 – Fall 2007 Page 10 [9] Serial Bonds (20 points maximum). On Nov. 1, 2007, Moses Corporation issued $2,000,000 in serial bonds. The bond principal will be repaid in $1,000,000 increments beginning on Nov. 1, 2008 with the final payment to be made on Nov. 1, 2009. The bonds pay interest semi-annually on May 1 and Nov. 1. The coupon rate is 10% per annum. An investment banker handled the transaction and you have just received a check for $2,055,160. Moses’ fiscal year ends on December 31. You may choose either the bonds outstanding method or the effective interest method of amortizing bond premiums. Check the appropriate box so I’ll know what you are attempting! Prepare the journal entry that would be needed on December 31, 2007. You do NOT need to prepare an amortization table – just the journal entry. [ ] I’m using the bonds outstanding method for a maximum of 20 points. [ ] I’m using the effective interest method for a maximum of 18 points. If you choose this option, you may assume that the effective simple interest rate per year is 8%. December 31, 2007 Exam 1 – Acct 414 – Fall 2007 Page 11 10. Extra credit - MATCHING: [1 point each, maximum 10 points] Do not attempt the extra credit section until you have completed all other sections of the exam! For each term, select the best phrase or description from the answers listed below. An answer may be used once, more than once, or not at all. _______ 1. Operating lease _______ 2. Present value of minimum lease payments _______ 3. Initial direct costs _______ 4. Bargain renewal option _______ 5. Implicit interest rate _______ 6. Residual value _______ 7. Unearned interest _______ 8. Nonrenewal penalty _______ 9. Guaranteed residual value _______ 10. Capital lease A. The present value of this amount is never included in the minimum lease payments for the fair value test. B. The rate that is never used by the lessor to determine the present value of the minimum lease payments. C. Is included in the minimum lease payments if it is too small to assure that the lease will be renewed. D. Minimum lease payments plus any unguaranteed residual value. E. Depreciation expense related to the leased asset is reported on the lessor's income statement over the lease term. F. The lessor is a manufacturer or a dealer. G. Costs which are capitalized and amortized over the term of an operating lease. H. Amortized over the term of the lease using the effective interest method. I. The fair value of the leased asset is equal to the cost of the asset to the lessor. J. The rate used by the lessee to determine the present value of the minimum lease payments if the lessee's incremental borrowing rate is greater than the lessor's implicit interest rate (known to lessee). K. Included in the lessee’s minimum lease payments. L. Always included in minimum lease payments unless there is a title transfer or a bargain purchase option. M. Included in the lessor's gross investment N. Includes all periods up to the date of a bargain purchase option. O. Increases or decreases in lease payments based upon sales volume or machine useage. P. Amount recorded as sales revenue when the cost of the leased asset is less than its fair value. Q. Costs normally paid by the owner of property. R. Depreciation expense is recognized on the lessee’s income statement. Exam 1 – Acct 414 – Fall 2007 Page 12 SOLUTIONS Problem 1 - determine lease payment for lessor Problem 2 - Sinking fund Annual rate= n= 48 mos. n= 60 5% i= 1.08% per mo. i= 0.42% pmt= ? PMT= pv= (360,000.00) pv= 100,000 fv= 80,000.00 Face value = (1,000,000) ordinary annuity = 0; annuity due = 1 1 ordinary annuity=0;annuity due=1 0 =PMT $8,288.57 Solve for pmt 12,817.44$ Problem 4 - Debtor's interest rate Problem 3 - Fair value of bonds Stated rate= Carrying value of debt before TDR 65,000 Principal (FV) 1,000,000$ 4.50% Future cash flows - new terms: 60,000 Yield rate 5% =i n= 5 Number of payments 12 =n PV= 65,000.00 PMT= 45,000 =PV pmt= (4,000.00) Gain= ordinary=0; due=1 0 fv= (40,000.00) 5,000 Solve for PV $955,683.74 =PVMLP ordinary annuity = 0; annuity due = 1 0 0% Solve for implied interest -1.82% Since the entire amount will NEVER be repaid, per flow chart, there will be no interest recognized at all (0%). This is also apparent from the negative interest rate you might get on your calculator - meaningless! 5a n=12% original rate, new interest pmt=8,000, new principal is the FV=80,000, n=5, Solve for PV = $74,232.36 5b Interest is based on the fair value from 5a: $74,232.36 * 12% = $8,907.88 but we have to prorate for the 8 months between restructure date and end of year. $8,907.88 * 8/12 = $5,938.60 5c If the debt is settled, the debtor and creditor have “mirror image” gain/loss. For the debtor, the carrying value is $112,000 - $50,000 fair value of the asset given up = $62,000 gain. There might also be a gain or loss depending on the purchase price of the asset but that is not part of the gain from the troubled debt restructuring. Lease Solution [6] Note that executory costs paid by the lessor should not be included in the minimum lease payments. In other words, the lease portion of the payment is $43,496. Knowing this was worth 2 point. Also note that neither party includes the unguaranteed residual value in the minimum lease payments. The lessee uses 12% interest rate because they do not know the lessor’s implicit interest rate. Lessors always use their implicit interest rate, never the lessee’s incremental borrowing rate! 6-a This is an operating lease for the lessee because there is no title transfer, no bargain purchase option, the lease term is only 71% of the economic life and the present value of the minimum lease payments is $175,609 which is less than 90% of $200,000. 6-b While there was no title transfer or bargain purchase option, and the lease term was only 71% of the economic life, this is a sales type lease for the lessor because the present value of the minimum lease payments is $181,372 which is more than 90% of the $200,000 fair value. The lease also satisfied both of the 2 extra rules for lessors: the lessor expects to be able to collect the lease payments and there are no important cost uncertainties for the lessor. It is a sales type lease rather than a direct financing lease because there is a profit, i.e., the fair value is greater than the cost of the asset. Note: An unguaranteed residual value does not necessarily cause it to be an operating lease.