Jefferson Corporation has $20,000,000 of 10% bonds outstanding. Because of cash flow problems, the company is behind in interest payments and in contributions to its bonds retirement fund. The market value of the bonds has declined until it is currently only 50% of the face value of the bonds. After lengthy negotiations, the principal bondholders have agreed to exchange their bonds for preferred stock that has a current market value of $10,000,000. The accountant for Jefferson Corporation recorded the transaction by charging Bond Liability for the entire $20,000,000 and crediting Preferred Stock for the same amount. This entry thus transfers the amount received by the company from debt to equity.
The CPA firm performing the annual audit, however, does not agree with this treatment. The auditors argue that this transfer represents a troubled debt restructuring due to the significant concessions made by the bondholders, and under these conditions, the FASB requires Jefferson to use the market value of the preferred stock as its recorded value. The difference between the $20,000,000 face value of the bonds and the $10,000,000 market value of the preferred stock is a reportable gain.
The controller of Jefferson, L. Rogers, is flabbergasted. “Here we are, almost bankrupt, and you tell us we must report the $10,000,000 as a gain. I don’t care what the FASB says; that’s a ridiculous situation. You can’t be serious.”
The auditor in charge of the engagement is adamant. “We really have no choice. You have had a forgiveness of debt for $10,000,000. You had use of the money, and based on current conditions, you won’t have to pay it back. That situation looks like a gain to me.”
What position do you think should be taken? Consider the external users of the financial statements and their needs in your discussion.