Unit 5. Current liabilities, Provisions and Contingences.

A liability is a present obligation of the entity to transfer an economic resource as a result of

past events. It has three essential characteristics: it’s a present obligation, it requires a transfer
of economic resources, and it arises from past events. One of their most important features is
the date on which they are payable, depending on it, liabilities could be current or non-current

The first recognition of any liability (initial valuation) is recorded assuming the IFRS 9. The
standard states two different forms to record a liability: Present value of future cash out flows,
or also, fair value of what is received minus expenses (issuance costs).

Current liability

Current liabilities are those which follow the following two conditions: liability expected to be
settled within its normal operating circle; or, liability expected to be settled within 12 months
after the reporting date. Amongst both, the higher one will be chosen.

The operating cycle is the period of time elapsing between the acquisition of goods and
services and the final cash realization resulting from sales and subsequent collections.

Types of current liabilities:

1. Accounts payable. 6. Customer advances and deposits

2. Notes payable. 7. Unearned revenues
3. Current maturities long term debt 8.Sales and value-added taxes payable
4.Short-term obligations expected to be 9. Income tax payable
refinanced
5.Dividends payable 10. Employee-related liabilities

Accounts payable

Accounts payable are balance owed to others for goods, supplies, or services purchased on
open account. Accounts payable arise because of the time lag between the receipt of services
or acquisition of title to assets and the payment for them.
Initial assessment: the invoice received specifies the due date and the exact outlay in money.
Terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state period of extended credit,
commonly 30 to 60 days. Usually, the Present Value equals the Face Value and there is not
explicit interest rate either.

Notes payable

Notes payable are written promises to pay a certain sum of money on a specified future date.
They may arise from purchases (“trade notes”), financing, or other transactions (“non-trade”).
Companies classify notes as short-term or long-term. Notes may be interest-bearing or zero-
interest-bearing.
Example interest-bearing note issued. Present Value = Face value. No implicit (only explicit).
Castle Bank agrees to lend €100,000 on March 1, 2022, to Landscape Co. if Landscape signs a
€100,000, 6 percent, four-month note. Landscape records the cash received on March 1 as
follows:
03/01/22
Dr. Cash 100,000
Cr. Notes Payable 100,000
If Landscape prepares financial statements semiannually, it makes the following adjusting entry
to recognize interest expense and interest payable at June 30, 2022:
06/30/22
Dr. Interest expense 2,000
4
Cr. Interest payable 2,000 (100,000 *0.06* )=2,000
12
At maturity (July 1, 2022), Landscape records payment of the note and accrued interest as
follows.
07/01/22
Dr. Notes payable 100,000
Dr. Interest payable 2,000
Cr. Cash 102,000

Example. Zero-bearing note issued. Present Value < Face Value. No explicit (only implicit).
On March 1, 2022 Landscape issues a €102,000, four-month, zero-interest-bearing note to
Castle Bank. The present value of the note is €100,000. Landscape records this transaction as
follows.
03/01/22
Dr. Cash 100,000
Cr. Notes payable 100,000
If Landscape prepares financial statements semiannually, it makes the following adjusting entry
to recognize interest expense and the increase in the note payable of €2,000 at June 30, 2022.
06/30/22
Dr. Interest expense 2,000
Cr. Notes payable 2,000
At maturity (July 1, 2022), Landscape must pay the note, as follows.
07/01/22
Dr. Notes payable 102,000
Cr. Cash 102,000

Current maturities of long-term debt

The current maturities of long-term debt are those including portion of bonds, mortgage notes,
and other long-term indebtedness that matures within the next fiscal year. Long-term debts
are going to be excluded if they are to be refinanced, or retired from the proceeds of a new
debt issue, or converted into ordinary shares.

Liabilities often become callable by the creditor when there is a violation of the debt
agreement (i.e., breach of a covenant). A debt covenant is a clause that requires the borrower
to fulfill certain conditions or which forbids the borrower from undertaking certain actions.
Violation of a covenant may result in penalties being applied, or the loan being called.

Short-term obligations expected to be refinanced

Short-term obligations are debts scheduled to mature within one year after the date of a
company’s statement of financial position or within its normal operating cycle. Some short-
term obligations are expected to be refinanced on a long-term basis. These short-term
obligations will not require the use of working capital during the next year or operating cycle.

Some current liabilities can be excluded if both of the following conditions are met: must
intend to refinance the obligation on a long-term basis, and must have an unconditional right
to defer settlement of the liability for at least 12 months after the reporting date. Both
agreements must have been reached before the reporting date.

Example. Refinancing.

Assume that Haddad Company Issued note payable of €3,000,000 on November 30, 2022, due
on February 28, 2023. Haddad's reporting date is December 31, 2022. Haddad intends to
extend the maturity date of the loan (refinance the loan) to June 30, 2024. Its December 31,
2022, financial statements are authorized for issue on March 15, 2023. The necessary
paperwork to refinance the loan is completed on January 15, 2023. Haddad did not have an
unconditional right to defer settlement of the obligation at December 31, 2022.
What is the accounting treatment for Haddad’s short-term debt to be refinanced if a contract
to refinance is completed on January 15, 2023?
Haddad must classify its note payable as a current liability because the refinancing was not
completed by December 31, 2022, the financial reporting date.

What is the accounting treatment for Haddad’s short-term debt to be refinanced if a contract
to refinance is completed by December 31, 2022?
Haddad should classify the note payable a non-current because it has a contract, which gives
it the right to defer payment to June 30, 2024, and the contract is in effect as of December
31, 2022.

Dividends payable

A cash dividend payable is an amount owed by a corporation to its stockholders as a result of

board of director’s authorization. Generally paid within three months.

Example. On August 1, the board of directors declared a €300,000 cash dividend that was
payable on September 10 to shareholders of record on August 31.
08/01/22
Dr. Retained earnings dividends 300,000
Cr. Dividend payable 300,000
09/10/22
Dr. Dividend payable 300,000
Cr. Cash 300,000

Customer advances and refundable deposits

Current liability may include returnable cash deposits received from customers and employees.
Companies may receive deposits from customers to guarantee performance of a contract or
service or as guarantee to cover payment of expected future obligations. Additionally, some
companies require their employees to make deposits for the return of keys or other company.
They may be classified as current or non-current liabilities.

Example.
Dr. Cash
Cr. Customer advance
Dr. Customer advance
Cr. Sales revenue
Unearned revenue

When a company receives an advance payment, and afterward sit recognizes its revenue.

Example. Sports Pro Magazine sold 12,000 annual subscriptions on August 1, 2022, for €18
each. Prepare Sports Pro’s August 1, 2022, journal entry and the December 31, 2022, annual
adjusting entry.
08/01/22
Dr. Cash 216,000
Cr. Unearned revenue 216,000 (12,000*18)

12/31/22
Dr. Unearned revenue 90,000
5
Cr. Subscription revenue 90,000 (216,000* )
12
Sales and value-added taxes payable

Consumption taxes are generally either a sales tax or a value added tax (VAT). The purpose of
these taxes is to generate revenue for the government similar to the company or personal
income tax. These taxes accomplish the same objective-to tax the final consumer of the good
or service.

1) Sales taxes payable

Example. Halo Supermarket sells loaves of bread to consumers on a given day for €2,400.
Assuming a sales tax rate of 10 percent, Halo Supermarket makes the following entry to record
the sale.

Dr. Cash 2,640

Cr. Sales revenue 2,400
Cr. Sales taxes payable 240

Sometimes, the sales tax collections credited to the liability account are not equal to the
liability as computed by the governmental formula. In such a case, companies make an
adjustment of the liability account by recognizing a gain or a loss on sales tax collections.
Many companies do not segregate the sales tax and the amount of the sale at the time of sale.
Instead, the company credits both amounts in total in the Sales Revenue account. Then, to
reflect correctly the actual amount of sales and the liability for sales taxes, the company debits
the Sales Revenue account for the amount of the sales taxes due the government on these
sales and credits the Sales Taxes Payable account for the same amount.

Example. The amount recorded in the Sales Revenue account is comprised of the sales amount
plus sales tax of 4 percent of the sales amount. Sales therefore are €144,230.77(€150,000 ÷
1.04) and the sales tax liability is €5,769.23 (€144,230.77 × 0.04, or €150,000 − €144,230.77).
Dr. Sales revenue 5,769.23
Cr. Sales Taxes Payable 5,769.23

2) Value-added taxes payable

A value-added tax is a consumption tax. This tax is placed on a product or service whenever
value is added at a stage of production and at final sale. A VAT is a cost to the end user,
normally a private individual, similar to a sales tax.

VAT should not be confused with a sales tax. A sales tax is collected only once at the
consumer’s point of purchase. No one else in the production or supply chain is involved in
the
collection of the tax. In a VAT taxation system, the VAT is collected every time a business
purchases products from another business in the product’s supply chain.

Example. Dillons AS made credit sales of €30,000 which are subject to 6% VAT. The company
also made cash sales which totaled €20,670 including the 6% VAT. (1) Prepare the entry to
record
Dillons’ credit sales. (2) Prepare the entry to record Dillons’ cash sales.
1) Credit sale
Dr. Accounts receivable 31,800
Cr. Sales revenue 30,000
Cr. VAT payable 800 (30,000*0.06)
2) Cash sale
Dr. Cash 20,670
20,670
Cr. Sales revenue 19,500 ( )
1.06
Cr. VAT payable 1,170 (20,670-19,500)
Income taxes payable

Most income tax varies in proportion to the amount of annual income. A business must
prepare an income tax return and compute the income taxes payable resulting from the
operations of the current period. Companies should classify as a current liability the taxes
payable on net income, as computed per the tax return.
Most companies must make periodic tax payments throughout the year to the appropriate
government agency. Income tax liabilities do not appear on the financial statements of
proprietorships and partnerships
Provisions

A provision is a liability of uncertain timing or amount. Main examples are: obligations related
to litigation, warrantees or product guarantees, business restructurings, and environmental
damage.

According to recognition, companies accrue an expense and related for a provision only if the
following three conditions are met:
1) A company has a present obligation as a result of a past event.
2) It’s probable that an outflow of resources embodying economic benefits will be
required to settle the obligation.
3) A reliable estimate can be made of the amount of the obligation.
If these three conditions are not met, no provision is recognized.

Considering the assessment of provisions, the amount recognized should be the best estimate
of the expenditure required to settle the present obligation. Best estimate represents the
amount that a company would pay to settle the obligation at the statement of financial
position date. There are cases in which the time value of money must be considered if
material.

Remark. Provisions’ Present value ≠ Fair Value ≠ Face Value

Types of provisions: warranties

A warranty is a promise made by a seller to a buyer to make good on a deficiency of quantity,

quality, or performance in a product. Warranties and guarantees entail future costs. These
additional costs, sometimes called “after costs” or “post-sale costs”, frequently are significant.
Companies should recognize this liability in the accounts if they can reasonably estimate it. The
estimated amount of the liability includes all the costs that the company will incur after sale
and delivery and that are incidental to the correction of defects or deficiencies required under
the warranty provisions. There are two types of warranties to customers:
1) Assurance-type warranty.
This type of warranty is a quality guarantee that the good or service is free from defects at the
point of sale. These types of obligations should be expensed in the period the goods are
provided or services performed. In addition, the company should record a warranty liability.
The estimated amount of the liability includes all the costs that the company will incur after
sale due to the correction of defects or deficiencies required under the warranty provisions.
Example. Streep factory provides a 2-year warranty with one of its products which was first
sold in 2022. Streep sold $1,000,000 of products subject to the warranty. Streep expects
$125,000 of warranty costs over the next two years. In that year, Streep spent $70,000
servicing warranty claims. Prepare Streep’s journal entry to record the sales (ignore cost of
goods sold) and the December 31 adjusting entry, assuming the expenditures are cash
refunding.

2022.
Dr. Cash 1,000,000
Cr. Sales revenue 1,000,000
2022.
Dr. Warranty expense 70,000
Cr. Cash 70,000
12/31/2022. Adjustment entry.
Dr. Warranty expense 55,000
Cr. Warranty liability 55,000 (125,000-70,000).

Example. Denson Machinery Company begins production of a new machine in July 2022 and
sells 100 of these machines for $5,000 cash by year-end. Each machine is under warranty for
one year. Denson estimates, based on past experience with similar machines, that the warranty
cost will average $200 per unit. Further, as a result of parts replacements and services
performed in compliance with machinery warranties, it incurs $4,000 in warranty costs in 2022
and $16,000 in 2023. What are the journal entries for the sale and the related warranty costs
for 2022 and 2023?

2022. Recognize sales of machines and accrual of warranty liability

Dr. Cash 500,000
Cr. Sales revenue 500,000 (5,000*100)
2022. Record payment for warranties incurred.
Dr. Warranty expense 4,000
Cr. Cash, inventory, accrued payroll 4,000
12/31/2022. Record the adjusting entry to record estimated warranty expense and warranty
liability for expected warranty claims in 2023.
Dr. Warranty expense 16,000
Cr. Warranty liability 16,000 (200*100-4,000)
2023. Record payment for warranty costs incurred in 2023 related to 2022 machinery sales.
Dr. Warranty liability 16,000
Cr. Cash, inventory, accrued payroll 16,000
At the end of 2023, no warranty liability is reported for the machinery sold in 2012.ç

Example. Leppard AG sells DVD players. The company also offers its customers a 4-year
warranty contract. Early in 2022, Leppard sold 20,000 warranty contracts at €99 each. The
company spent €180,000 servicing warranties during 2022. Prepare Leppard’s journal entries
for (a) the sale of contracts, (b) the cost of servicing the warranties, and (c) the recognition of
warranty revenue. Assume the service costs are inventory costs.
During 2022
Dr. Cash 1,980,000
Cr. Unearned service revenue 1,980,000 (22,000*99)
Dr. Warranty expense 180,000
Cr. Inventory 180,000
Adjusting entry
Dr. Unearned warranty revenue 495,000
1,980,000 1
Cr. Warranty revenue 495,000 ( )
4
2) Service-type warranty.

Companies record a service-type warranty as a separate performance obligation. For instance,

in the case of the television, the seller recognizes the sale of the television with the assurance-
type warranty separately from the sale of the service-type warranty. The sale of the service-
type warranty is usually recorded in an Unearned Warranty Revenue account.

Companies then recognize revenue on a straight-line basis over the period the service-type
warranty is in effect.

Contingences

Contingent for liabilities and assets that are not recognized in the financial statement.

1) Contingent liabilities

Contingent liabilities are not recognized in the financial statements because they are a possible
obligation (not yet confirmed as a present obligation) (5-50%), a present obligation for which it
is not probable that payment will be made, or a present obligation for which a reliable estimate
of the obligation cannot be made.
Unless the possibility of any outflow in settlement is remote, companies should disclose the
contingent liability at the end of the reporting period.
2) Contingent assets

A contingent asset is a possible that arises from past events (>50%) and whose existence will be
confirmed by the occurrence or non-occurrence of uncertain future events not wholly within
the control of the company.
Contingent assets are disclosed when an inflow of economic benefits is considered more likely
that not to occur (greater that 50%).

1
divided 4 due to years of the warranty contract
Non-current liabilities

Non-current liabilities consist of an expected outflow of resources arising from present

obligations that are not payable within a year or the operating cycle of the company, whichever
is longer.

1. Bonds 2. Lease liabilities

3. Notes 4. Pension liabilities
5. Mortgages payable 6. Other…

Initial assessment: Present value of effective cash flows (effective, yield, market value), if it’s
not possible FV less debt issue costs which reduce the cash received (capitalized the PV).

Subsequent valuation is done at each reporting date according to the amortized cost method.

1. Bonds.

Represent a promise to pay, a sim of money at designated maturity date, or a periodic interest
at a specified rate on the maturity amount. Common types of bonds found in practice: secured
and unsecured bond; term, serial and callable bonds; convertible, commodity-backed and
deep-discount bonds; and registered and bearer (coupon) bonds.

Issuance of bonds usually takes weeks or months. The issuing company must arrange for
underwriters, obtain regulatory approval of bond issue, undergo audits and issue a prospectus;
and finally, the prospectus will include the terms in advance of the sale (face value, stated
interest(explicit)…).

Valuation of Bonds payable:

Bonds issued at par.

Example. Santos Company issues R$100,000 in bonds dated January 1, 2022, due in five years
with 9 percent interest payable annually on January 1. At the time of issue, the market rate for
such bonds is 9 percent.
Present value of the principal ¿ 100,000∗.64993=64,993
Present value of the interest payments ¿ 9,000∗3.88965=35,007
Present value of the bonds ¿ 64,993+35,007=100,000
The present value is equal to the carrying amount (Face Value).
01/01/2022
Dr. Cash 100,000
Cr. Bonds 100,000
12/31/2022
Dr. Interest expense 9,000
Cr. Interest payable 9,000
01/01/2023
Dr. Interest payable 9,000
Cr. Cash 9,000

Bonds issued at a discount. EXPLICIT<EFFECTIVE The amount paid at maturity is more than the
issue amount. When bonds sell at less than face value:
-Investors demand a rate of interest higher than stated rate.
-Usually occurs because investors can earn a higher rate on alternative investments of equal
risk.
-Cannot change stated rate so investors refuse to pay face value for the bonds.
-Investors receive interest at the stated rate computed on the face value, but they actually earn
at an effective rate because they paid less than face value for the bonds.
Example. Santos issues R$100,000 in bonds, due in five years with 9 percent interest payable
annually at year-end. At the time of issue, the market rate for such bonds is 11 percent.
Present value of the principal ¿ 100,000∗.59345=59,345
Present value of the interest payments ¿ 9,000∗3.69590=33,263
Present value of the bonds ¿ 59,345+33,263=92,608
01/01/2022
Dr. Cash 92,608
Cr. Bonds 92,608
12/31/2022
Dr. Interest expense 10,187 (92,608*0.11)
Cr. Interest payable 9,000
Cr. Bonds 1,187
01/01/2023
Dr. Interest payable 9,000
Cr. Cash 9,000

How do you calculate the amount of interest that is actually recorded as interest expense by
the issuer of the bonds?
Accrued interest* = Effective rate x Carrying Value of the bond

Bonds issued at premium. EXPLICIT>EFFECTIVE The amount paid at maturity is less than the
issue amount.
Example. Evermaster Corporation issued €100,000 of 8% term bonds on January 1, 2022, due
on January 1, 2027, with interest payable each July 1 and January 1. Investors require an
effective-interest rate of 6%. Calculate the bond proceeds.
Present value of the principal ¿ 100,000∗.74409=74,409
Present value of the interest payments ¿ 4,000∗8.53020=34,121
Present value of the bonds ¿ 74,409+34,121=108,530
01/01/2022
Dr. Cash 108,530
Cr. Bonds 34,121
07/01/2022
Dr. Interest expense 3,256
Dr. Bonds 744
Cr. Cash 4,000
12/31/2022
Dr. Interest ´expense 3,234
Dr. Bonds 766
Cr. Interest payable 4,000
01/01/2023
Dr. Interest payable 4,000
Cr. Cash 4,000

Debt Issue costs

With sold debt, the issuing company will incur costs in connection with issuing bonds or notes,
such as legal and accounting fees and printing costs, in addition to registration and
underwriting fees. Under IFRS, these debt issue costs reduce the net cash the issuing company
receives from the sale of the financial instrument, reduce the initial valuation of the bonds
payable, increase the effective interest rate to be applied to accrue interest expense.

2. Notes

A note is valued at the present value of its future cash outflows (both interest and principal).
Companies amortize any discount or premium over the life of the note. Notes don’t trade as
readily as bonds in organized securities markets.

Notes i rate is appropriate i rate is not considered

appropriate
Interest-bearing PV=FV PV<FV
Zero-interest bearing Ø PV<FV
Example. Interest bearing. Coldwell, Inc. issued a $100,000, 4-year, 10% note at face value to
Flint Hills Bank on January 1, 2022, and received $100,000 cash. The note requires annual
interest payments each December 31. Prepare Coldwell’s journal entries to record (a) the
issuance of the note and (b) the December 31 interest payment.
Dr. Cash 100,000
Cr. Notes payable 100,000
Dr. Interest expense 10,000
Cr. Cash 10,000 (100,000*0.1)

Zero-Interest-Bearing Notes

Issuing company records the difference between the face amount and the present value (cash
received) as a discount and amortizes that discount to interest over the life of the note.
Example. Samson Corporation issued a 4-year, $75,000, zero-interest-bearing note to Brown
Company on January 1, 2022, and received cash of $47,663. The implicit interest rate is 12%.
Prepare Samson’s journal entries for (a) the Jan. 1 issuance and (b) the Dec. 31 recognition of
interest.
Dr. Cash 47,663
Cr. Notes 47,663
Dr. Interest expense 5,720
Cr. Notes 5,720 (47,663*0.12)

Example. Interest-bearing notes. McCormick Corporation issued a 4-year, $40,000, 5% note to

Greenbush Company on Jan. 1, 2022, and received a computer that normally sells for $31,495.
The note requires annual interest payments each Dec. 31. The market rate of interest is 12%.
Prepare McCormick’s journal entries for (a) the Jan. 1, 2022 issuance and (b) the Dec. 31, 2022
interest.

Dr. Cash 31,495

Cr. Notes 31,495
Dr. Interest expense 3,779
Cr. Notes payable 1,779
Cr. Cash 2,000

3. Mortgage notes payable

A mortgage notes payable is a promissory note secured by a document called mortgagee that
pledges title to property (real estate usually) as security for the loan. Its most common form is
a long-term note payable. The call for payment is usually in monthly installments rather than by
a single amount at maturity. Typically, installments payments are equal amounts each period.
Each payment includes both an amount that represents interest and an amount that
represents a reduction of the outstanding balance (principal reduction). The accounting
treatment is similar to lease liabilities or serial bonds.

Example. (semesters instead of months to simplify) Amount of loan = $ 666,633 (01/01/11).

Term = 6 semesters. Installment payment (end of each semester) = $ 139,857. Effective interest
rate = 7%
 Date Cash Payment Effective interest Decrease in debt Outstanding balance
01/01/11 666,633
06/30/11 139,857 46,664 93,193 573,440
12/31/11 139,857 40,141 99,716 473,724
06/30/12 139,857 33,161 106,696 367,028
12/31/12 139,857 25,692 114,165 252,863
06/30/13 139,857 17,700 122,157 130,706
12/31/13 139,857 9,151 130,706 0,000

For instalment notes, the outstanding balance of the note does not eventually become its
face amount as it does for notes with designated maturity amounts. Instead, at the maturity
date the balance is zero.

01/01/2011
Dr. Cash 666,633
Cr. Notes (mortgage payable) 666,633
6/30/2011
Dr. Interest expense 46,664
Dr. Notes (mortgage payable) 93,193
Cr. Cash 139,857

Extinguishment of Non-current liabilities

The extinguishment of a non-current liability is the payment of it. If a company holds the bonds
to maturity, the answer is straightforward: the company doesn’t compute any gains or losses. It
will have a fully amortized any premium or discount at that date the bonds mature. As a result,
the carrying amount, the maturity value, and the fair value of the bond are the same.
Therefore, no gain or loss exists.

Common situation of extinguishment of debt:

1. Extinguishment with cash before maturity.

A company extinguishes debt before its maturity date. The amount on extinguishment is called
the reacquisition price. On any specific date, the carrying amount of the bonds is the amount
payable at maturity, adjusted for unamortized premium or discount. Any excess of net carrying
amount over the acquisition price is a gain from extinguishment. The excess over the carrying
amount is a loss from extinguishment. At the time of reacquisition, the unamortized premium
or discount must be amortized up to the reacquisition date.

Example. Chen Ltd. issued its 9%, 25-year mortgage bonds in the principal amount of
¥30,000,000 on January 2, 2008, at a discount of ¥2,722,992 (effective rate of 10%). The
indenture securing the issue provided that the bonds could be called for redemption in total,
but not in part, at any time before maturity at 104% of the principal amount. However, the
indenture did not provide for any sinking fund. On December 18, 2022, the company issued its
11%, 20-year debenture bonds in the principal amount of ¥40,000,000 at 102, and the
proceeds were used to redeem the 9%, 25-year mortgage bonds on January 2, 2023. The
indenture securing the new issue did not provide for any sinking fund or for retirement before
maturity. The unamortized discount at retirement was ¥1,842,888.
12/18/2022 Issuance of the 11% bonds.
Dr. Cash 40,800,000
Cr. Bonds 40,800,000 (40,000,000*1.02)
01/02/2023
Dr. Bonds 28,157,112 (30,000,000-1,842,888)
Dr. Loss on retirement 3,042,888 (31,200,000 -28,157,122)
Cr. Cash 31,200,000 (30,000,000*1.04)
The loss on retirement represents the excess of the cash paid over the carrying amount of the
bonds. The loss will be recorded as another income and expense item, in the income statement.

2. Extinguishment with modification of terms.

The creditor offers these concessions to ensure the highest possible collection of the loan. For
instance, the creditor might offer one or a combination of the following modifications:
reduction of the stated interest rate, extension of the maturity date of the face amount of the
debt, reduction of the face amount of the debt, and reduction or deferral of any accrued
interest.

As with extinguishments, when a creditor grants favorable concessions on the term of a loan,
the debtor has an economic gain. Thus, the accounting for modifications is similar to that for
other extinguishments. That is, the original obligation is extinguished, the new payable is
recorded at fair value, and a gain is recognized for the difference in the fair value of the new
obligation and the carrying value of the old obligation.

Example. On December 31, 2022, Morgan National Bank enters into a debt modification
agreement with Resorts Development Group, which is experiencing financial difficulties. The
bank restructures a ¥10,500,000 loan receivable issued at par (interest paid to date) by:
Reducing the principal obligation from ¥10,500,000 to ¥9,000,000; Extending the maturity date
from December 31, 2022, to December 31, 2026; and reducing the interest rate from the
historical effective rate of 12 percent to 8 percent. Given Resorts Development’s financial
distress, its market-based borrowing rate is 15 percent.
New fair value= 9,000,000*0.8= 7,201,336
The gain on the modification is ¥3,298,664, which is the difference between the prior carrying
value (¥10,500,000) and the fair value of the restructured note, as computed in Illustration
14.23 (¥7,201,336). Given this information, Resorts Development makes the following entry to
record the modification.
Dr. Notes (old) 10,500,000
Cr. Gain on extinguishment 3,298,664(10,500,0007,201,336)
Cr. Notes (new) 7,201,336
Resorts Development recognizes interest expense on this note using the effective rate of 15
percent. Thus, on December 31, 2023 (date of first interest payment after restructure), Resorts
Development makes the following entry:
12/31/2023
Dr. Interest expense 1,080,200 (7,201,336*0.15)
Cr. Notes 360,000 (1,080,200 – 720,00)
Cr. Cash 720,000 (9,000,000*0.08)
Resorts Development makes a similar entry (except for different amounts for credits to Notes
Payable and debits to Interest Expense) each year until maturity. At maturity, Resorts
Development makes the following entry.
12/31/2026
Dr. Notes 9,000,000
Cr. Cash 9,000,000
In summary, following the modification, Resorts Development has extinguished the old note
with an effective rate of 12 percent and now has a new loan with a much higher effective rate
of 15 percent.