Welcome back. In this module we're going to talk about modifications.

Sometimes the bonds are modified or refinanced prior to maturity.

The accounting for modification does differ from the accounting for an extinguishment.

GAAP has specific procedures for how you tell the difference

between a modification and extinguishment and we'll go through that right now.

Let's start with a review of extinguishment.

You recall that a gain or loss is recognized on the extinguishment of debt.

And that's the difference between the reacquisition price

of the debt and the net carrying amount of the debt,

and it's going to be recognized as a gain or loss

in a separate item on the income statement.

So, if it's a modification though,

if it's refinanced or otherwise modified,

no gain or loss is recognized unless the modification is deemed to be an extinguishment.

Deemed is a very dangerous word in GAAP.

You'll come across it in various standards.

It means that we're going to account for something

differently than what it looks like perhaps on its face.

It's a form of substance over form.

So, we're saying here that you may have some modifications that are in substance,

an extinguishment and they're are going to be deemed to be an extinguishment.

So, if it's a regular modification,

there is no gain or loss on that modification.

If it's a refinancing transaction that involves

contemporaneous exchanges of cash between the same debtor and creditor. That's important.

That would be the same debtor and creditor in

connection with the issuance of new obligation and satisfaction.

It would only be accounted for as

a debt extinguishment if the debt instruments have substantially different terms.

So, once a modification, once an extinguishment.

Why is this important?

It's important because you've got this discount

or premium out there that could and issuance

costs that could be recognized as a loss or possibly a gain if it's an extinguishment.

But if it's a modification,

we're going to roll forward and continue to be

deferred and recognized over the long term.

How do we tell the difference?

Well, GAAP has a test.

It's a 10% test.

Again, this is a form of legacy GAAP where we had

specific rules and calculations and so-called bright lines.

You don't see this type of thing there often in

new standards occasionally but this was very common once upon a time.

So an exchange of debt instruments or a modification by a debtor

and creditor if it's a non troubled debt situation,

we'll talk about a troubled debt situation separately,

it can be accomplished if the present value of

the cash flows under the terms of the new debt is

at least 10% different from

the present value of the remaining cash flows under the terms of the original instrument.

So we're looking for a 10% difference between the present value of the cash flows of

the new instrument and the present value of

the remaining cash flows under the terms of the original instrument.

So there's complex procedures for determining the cash flows,

some of which are anti-abuse provisions to prevent gaming of the rules.

So, what are the main provisions?

The cash flows of the new debt instrument include all cash flows

specified by the terms of the new debt agreement plus any amounts paid

by the debtor to the creditor which could be viewed as an early repayment of

the debt less any amounts received by the debtor from the creditor.

And then the discount rate used to calculate that present value is

going to be the original debt instrument discount rate,

the effective interest rate for the original debt instrument.

Now that may no longer be really relevant because market rates may have

moved on and the credit standing of the customer,

of the borrower may have changed.

But we're still going to use that original debt for purposes of

this test to see whether there's

been a significant change in the present value of the future cash flows.

So what if the change in the cash flows is greater than or equal to 10%?

Well, if that case and the terms are considered to be substantially different,

the new debt instrument will initially be

recognized at its fair value and the debt extinguishment gain or

loss will be recognized as the difference between

the fair value the new debt and the carrying amount of the old debt.

So I'm going to account for the new debt at its fair value.

And I'm going to account for any difference between

that amount and the carrying amount of

the old debt including any amortized discount or premium as a gain or loss.

What if it's less than 10%?

If it's determined that the original and new debt are not substantially different,

then a new effective interest rate is calculated

based on the carrying amount of the original debt instrument.

And I'm going to adjust that rate for

an increase in the fair value of any embedded conversion option but not a decrease,

because an increase reduces the carrying amount of

the debt instrument with a credit to additional paid

in capital like a beneficial conversion feature.

It's similar to the accounting for that beneficial interest but you don't recognize

any new beneficial conversion feature or reassess an existing beneficial conversion.

So, a modification is a kind of for more or less

prospectively adjusting the effective interest rate.

Troubled debt restructuring will be the topic we'll discuss next.

There is a different procedure if it's a troubled debt.

This wraps up our discussion for modifications.

Again, the important thing to remember here is that there is a bright line at 10%.

If the present value of

the revised cash flows using the original disk effective yield as a discount rate

and the present value of the remaining cash flows from the original instrument

are different that if the difference is more than 10%,

it's an extinguishment and you account for it as new debt at

fair value recognize a gain or loss on settlement of the old debt.

If it's less than 10%,

it's not considered to be a significant change in terms,

you account for that change prospectively by changing the effective interest rate

at the date of the modification.

So, let's move on then.

Next we'll talk about a troubled debt restructuring.

Bonds Modifications

Accounting Analysis II: Measurement and Disclosure of Liabilities

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