Chapter 12 Set-off and extinguishment of debt

12.1 12.2 A set-off is the reduction of an asset by a liability or a liability by an asset in the presentation of a statement of financial position so that only the net amount is presented. AASB 132 allows assets and liabilities to be set-off for statement of financial position purposes when a legally recognised right of set-off exists, and the entities expect to settle the debts on a net basis. Specifically, paragraph 42 of AASB 132 states: A financial asset and a financial liability shall be offset and the net amount presented in the statement of financial position when, and only when, an entity: (a) currently has a legally enforceable right to set off the recognised amounts; and (b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. 12.3 By performing a set-off of assets and liabilities a companys reported gearing ratios would show improvement. This may be particularly beneficial for companies that are subject to debt constraints, or where debt levels look unfavourable relative to competitors/industry norms. A legal defeasance is not defined in AASB 132. It was formerly defined in AASB 1014. A defeasance occurs when there is a release of a debtor from the primary obligation of a debt. A legal defeasance is considered to occur when the release of the debtor from the primary obligation for a debt is either acknowledged formally by the creditor or by a duly appointed trustee of the creditor, or established by legal judgement. An example would be where a debt is formally forgiven. The Accounting Standards do not explicitly require disclosures relating to the set-off. To the extent that the right of set-off exists and is exercised, then there would be no further obligation in relation to the debt and therefore such debt, and the related receivable, would not require disclosure. There could be a perception that by showing lower amounts of debt on the statement of financial position, and by providing information which would lead to the calculation of lower leverage indicators, the readers of the financial statements will assess that the reporting entity is of lower risk that might otherwise be the case. This in turn might enable the organisation to attract funds at a lower cost. Implicit in this answer is an assumption that the capital market may not be fully efficient, and as result, the act of offsetting an asset against a liability (a reasonably inexpensive exercise) will lead to material benefits.

12.4

12.5

12.6

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12.7

Firstly, we need to determine the original issue price so that we may determine the balance of the debenture liability at the date the debt was forgiven. Present value of debenture principaldiscounted for 8 years at 16% $5 000 000 x 0.3050 Present value of debenture interestannuity for 8 years discounted at 16% $600 000 x 4.3436 Original issue price $1 525 000 $2 606 160 $4 131 160

To determine the interest expense and liability increase in each year we can use the following table. Opening liability 4 131 160 4 192 146 4 262 889 4 344 951 4 440 143 4 550 566 4 678 657 4 827 242 Interest Expense @ 16% 660 986 670 743 682 062 695 192 710 423 728 091 748 585 772 359 Cash payment 600 000 600 000 600 000 600 000 600 000 600 000 600 000 600 000 Closing liability 4 192 146 4 262 889 4 344 951 4 440 143 4 550 566 4 678 657 4 827 242 4 999 601*

Period 1 2 3 4 5 6 7 8
*rounding error of $399

Increase in Liability 60 986 70 743 82 062 95 192 110 423 128 091 148 585 172 359

The journal entries to record the forgiveness of the debt after 3 years would therefore be: Dr Cr 12.8 Debentures Gain on forgiveness of debt 4 344 951 4 344 951

An entity may wish to perform a set-off to reduce gearing ratios such as debt to assets, or debt to shareholders funds. If Arthur was to perform a set-off, the post set-off statement of financial position would be: Statement of financial position Post set-off Loans payable Shareholders equity 700 000 Loans receivable 1 000 000 Fixed assets $1 700 000 900 000 800 000 $1 700 000

As we can see, as a result of the set-off, the debt-to-asset ratio has moved from 50% to 41.2%, whilst the debt to shareholders funds has moved from 100% to 70%.

12.9

Yes, the two amounts can be set-off. If one entity in an economic entity (for example, Parent Ltd) owes an outside entity (for example, Outsider Ltd) a determinable amount and that same outside entity (Outsider Ltd) owes another entity in the economic entity (for example, A Ltd) a determinable amount, then a set-off may be performed for the purposes of the consolidated 122

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statement of financial position. Consequently, the consolidated statement of financial position would show an amount of $100 000 payable to Outsider Ltd. Paragraph 45 of AASB 132 states: A right of set-off is a debtors legal right, by contract or otherwise, to settle or otherwise eliminate all or a portion of an amount due to a creditor by applying against that amount an amount due from the creditor. In unusual circumstances, a debtor may have a legal right to apply an amount due from a third party against the amount due to a creditor provided that there is an agreement between the three parties that clearly establishes the debtors right of set-off. Because the right of set-off is a legal right, the conditions supporting the right may vary from one legal jurisdiction to another and the laws applicable to the relationships between the parties need to be considered. 12.10 An insubstance debt defeasance was defined in AASB 1014 (now replaced by AASB 132) as a defeasance, other than a legal defeasance, in which the debtor effectively achieved release from the primary obligation for a debt, either by placing in trust assets which are adequate to meet the servicing requirements (both interest and principal) of the debt, or by having a suitable entity assume responsibility for those servicing requirements. It was referred to as an insubstance defeasance as the creditor had not actually been repaid, but the substance of the transaction was that no further amount was likely to be paid, so in substance, the debt was effectively paid. Since the firm would have to pay nothing further in relation to the debt, they had, in substance, paid off the debt. From 2005, AASB 132 prohibits the removal of debt from the statement of financial position as a result of an insubstance debt defeasance. Specifically, paragraph 49 of AASB 132 notes that the conditions set out in paragraph 42 (pertaining to the removal of debt from the statement of financial position) are generally not satisfied and offsetting is inappropriate when financial assets are set aside in trust by a debtor for the purpose of discharging an obligation without those assets having been accepted by the creditor in settlement of the debt. That is, the involvement of the creditor in the action is now required. The above prohibition now contained in AASB 132 is interesting. AASB 132 seems to take a much more form over substance approach than the previous Australian position under AASB 1014. If the probability that further payments will be necessary is remote because the assets irrevocably transferred to the trust are sufficient to meet the debt servicing requirements then it makes sense that debt should be removed from the statement of financial position. That is, the former treatment provided by AASB 1014 appears logical. It is not clear that the AASB 132 is as logical. 12.11 5 May 2014 Books of Snapper Ltd Dr Cr Loan payableKirra Ltd Gain on release from debt (a revenue item) 500 000 500 000

Books of Kirra Ltd Dr Loss on release of debtorSnapper Ltd (an expense item) 500 000

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Cr

Loan receivableSnapper Ltd

500 000

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