Loan Impairment Examples S10c.docx as of 9/9/10 Page 1

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1 Impairment of Notes Receivables US GAAP requires entities to assess whether financial assets are impaired and recognize the impairment. If a note receivable is impaired, the loss is measured by the creditor as the difference between the investment in the loan (usually the principal plus accrued interest) and the expected future cash flows discounted at the loan s historical effective interest rate. US GAAP recognizes the uncollectible amount through an allowance account. Unlike IFRS, US GAAP prohibits the reversal of impairment losses. In the U.S., creditors sometimes work with customers and change the terms of the original agreement giving customer more time to make the payments, reducing the interest rate, or even reducing the balance owed. This situation is often referred to as restructuring or troubled debt restructuring. This semester, we will look only at the rules for creditors but you should be aware that there are even more complicated standards to guide accounting by debtors in troubled debt restructuring situations. If you use old exams to study, you should skip all problems that ask for the debtor s accounting procedures. With respect to IFRS, review Unit 6 on receivables in the VirginiaTech material. In short, IAS 39 also specifies that entities should assess whether their financial assets are impaired. If a portion of accounts receivable is impaired, the loss is measured as the difference between the asset s carrying value and the present value of expected future cash flows discounted at the asset s original effective interest rate. Entities can choose to recognize the uncollectible amount either directly or through an allowance account. IFRS refers to the allowance account as a provision. The amount of the loss is recognized in profit or loss. IFRS allows entities to subsequently reverse impairment losses provided there is objective evidence to warrant reversing the original impairment. Reversal of impairment is recognized in profit and loss. Note that neither FASB nor IASB are measuring the fair value of the problem receivables and these standards could change as SFAS No. 157 becomes more familiar. The current reasoning is that these troubled debt situations are not NEW loans (which would be recognized at fair value). Therefore, it makes sense to use the original interest rate the creditor is just trying to collect the highest possible amount from the existing loan. The problem with getting a fair value would be the interest rate since this is a problem customer, there is considerable risk involved and it is probably difficult to find an orderly market where such troubled receivables are actively traded. There is also a notes file available with a flowchart on the schedule page. Note: Excel versions of these problems are available but the only real benefit of using Excel instead of this paper copy is the ease of doing amortization tables when needed. Loan Impairment Examples S10c.docx as of 9/9/10 Page 1

2 DEBT RESTRUCTURING - DEMONSTRATION PROBLEM #1 1. Viola Vacations signed a note to Empire Airways in the amount of $50,000. The terms specified annual 10% interest payments on the unpaid balance. The note is due today. Viola Vacations has not paid the interest for the last year and is unable to pay anything on the principal due. 2. Empire has agreed to a concession which involves the transfer of noncash items with a market value of less than the $55,000 amount of the past-due debt ($50,000 principal, $5,000 accrued interest already debited to interest expense and credited to interest payable). 3. Viola Vacations will transfer a parcel of real estate to Empire. The fair market value of the land (per the appraisal) is $30,000. Viola Vacations had purchased the land several years ago for $10,000. Land Notes receivable Interest receivable Allow for bad debts Creditor s Books Debit Credit DEMONSTRATION PROBLEM #2 Same as #1 except that instead of transferring land: 3. Viola Vacations will issue to Empire Airways 4,000 shares (a 10% ownership interest) of its common stock which has a par value of $10 and has been estimated to be worth $12 per share. In return, Empire Airways will accept the stock in full settlement of the debt principal and accrued interest (i.e., $55,000). Investments Portfolio Notes receivable Interest receivable Allow for bad debts Creditor s Books Debit Credit Loan Impairment Examples S10c.docx as of 9/9/10 Page 2

3 DEMONSTRATION PROBLEM #3 - CREDITOR 1. Farview Farms had signed a $40,000 note to Idaho First Bank and Trust. The note specified annual payments of $10,000 per year plus 12% interest on the unpaid balance. Unseasonable weather two years in a row has ruined the crops which Farview intended to sell to make its loan payments. The bank has agreed to restructure the terms of the loan. [Assume that Farview has already recorded as interest expense the $4,800 unpaid accrued interest.] 2. The new loan agreement specifies an immediate payment of $4,000 which represents 10% interest on the balance which was outstanding during the year. Farview will then pay interest only for three years at a 10% rate on a reduced principal amount of $25,000. Four years from now, the balloon payment of $27,500 will come due. Find present value of new cash flows using original effective interest rate: Creditor s New Amortization Table: Period Flows Interest 0 12% 27, ,000 23, ,500 2, , ,500 2, , ,500 2, , ,500 2, ,000 25,000 0 recognition using effective interest method: Creditor s Books Debit Credit At date of restructure: Accrued Interest Receivable Note Receivable (old) Note Receivable (restructured) Allowance for doubtful accounts End of year 1 Interest revenue Notes receivable (restructured) Loan Impairment Examples S10c.docx as of 9/9/10 Page 3

4 Cost Recovery Method (FAS 118 Amendment to FAS 114) Under FAS 114 troubled debt accounting required creditors to use the interest method to recognize interest income on the restructured debt. Many financial institutions objected to this procedure because it caused them to recognize revenue that would later have to be written off as a loss if the debtor was unable to meet the terms of the restructured debt. Under the amendment, creditors are permitted to use other revenue recognition methods such as the cost recovery method. This method assumes that all cash collected goes toward principle until the entire amount has been recovered. If the creditors in the demonstration problems used cost recovery method instead, they would recognize revenue as shown below -- no interest income would ever be recorded. Troubled Debt Demonstration Problem #3 Period Rec'd Recognized Principal Received 27, ,000 23, , ,500 20, , ,500 18, , ,500 15, ,500 11,519 15,981 0 Totals 39,000 11,519 23,481 The entry at the date of restructure would be the same as under the effective interest method of revenue recognition. End of year 1, 2 and 3: 2,500 Note Recbl - Restructured 2,500 End of year 4 27,500 Note Recbl - Restructured 15,981 Income Realized on Impaired Loans 11,519 Compare this table and journal entries to the original solution - Is the issue a matter of amount or timing? Loan Impairment Examples S10c.docx as of 9/9/10 Page 4

5 TROUBLED DEBT RESTRUCTURING - CREDITOR [Alternate terms, same as #3 except for item 2] DEMONSTRATION PROBLEM #4 1. Farview Farms had signed a $40,000 note to Idaho First Bank and Trust. The note specified annual payments of $10,000 per year plus 12% interest on the unpaid balance. Unseasonable weather two years in a row has ruined the crops upon which Farview intended to sell to makes it loan payments. The bank has agreed to restructure the terms of the loan. [Assume that Farview has already recorded as interest expense the $4,800 unpaid accrued interest.] 2. The new loan agreement specifies no immediate payments. Farview will pay interest only for three years at a 11% rate on a reduced principal amount of $35,000. Four years from now, the balloon payment will come due, i.e., $38,850 principal plus interest. What is the present value of the cash flows using the original effective interest rate? Do we need to make an amortization table? Creditor s New Amortization Table: Period Flows Interest 0 11% 1 3, , , , ,000 0 recogntion using effective interest method Creditor s Books Debit Credit At date of restructure: Note Receivable (restructured) Accrued Interest Receivable Note Receivable (old) Allowance for doubtful accounts End of year 1 Interest revenue Loan Impairment Examples S10c.docx as of 9/9/10 Page 5

6 TROUBLED DEBT RESTRUCTURING - CREDITOR DEMONSTRATION PROBLEM #4 Assume that the creditor uses the cost recovery method of revenue recognition for impaired debt. Prepare the following schedule using the cost recovery method and make the journal entries. Troubled Debt Demonstration Problem #4 Period Rec'd Recognized Principal Received 0 35, , , , ,850 Creditor s Books Debit Credit At date of restructure: Note Receivable (restructured) Accrued Interest Receivable Note Receivable (old) Allowance for doubtful accounts End of year 1 Loan Impairment Examples S10c.docx as of 9/9/10 Page 6

7 Demonstration Problem #5 Troubled Debt (Question from F06 Exam 1). Bobs Brakes Inc. is a major creditor of Adam s Auto Repair Inc. Adam s Auto Repair Inc. is experiencing substantial financial difficulties. Its original note with Bobs Brakes Inc. was dated August 1, 2005 and has a face value of $100,000 and specified a 10% interest rate. The interest for the year ending August 1, 2006 has not been paid. On August 1, 2006, the debtor persuaded Bobs Brakes to reduce the principal from $100,000 to $70,000 and to reduce interest payments to $3,500 per year for the remaining 3-year life of the debt. The modified terms also waive payment of the accrued interest currently due. Both debtor and creditor have fiscal years that coincide with the calendar year. Loan Impairment Examples S10c.docx as of 9/9/10 Page 7

8 Demonstration Problem #6 Comparing US GAAP and IFRS for a Loan Impairment From VirginiaTech Unit 6, problem 9 (modified slightly) On December 31, 2006, Jones Company sold manufacturing equipment to Steel Corporation. Steel Corporation gave Jones Company a 5 year $200,000, zero interest note. The market rate of interest for a note with similar risks is 10%. At December 31, 2008 Jones Company reviews its financial assets for impairment. Jones Company concludes that the value of the note is impaired and it only expects to collect $150,000 of the principal at maturity. By December 31, 2009 Jones Company has determined that it is probable that $160,000 will be collected at maturity. Prepare the appropriate journal entries for December 31, 2008 and December 31, 2009 according to a) IFRS b) US GAAP. Explain why the journal entries differ under the two sets of standards. Loan Impairment Examples S10c.docx as of 9/9/10 Page 8

9 SOLUTIONS - Troubled Debt Restructuring Examples Example #1 - Empire Airways (Creditor) Land 30,000 Notes Receivable 50,000 Interest Receivable 5,000 Allow for doubtful accts 25,000 Example #2 - Empire Airways (CREDITOR) Investments 48,000 Notes Receivable 50,000 Interest Receivable 5,000 Allow for doubtful accts 7,000 Troubled Debt Example #3 CREDITOR ACCOUNTING (FASB 114) Find PV of cash flows using original i = 12%: 2,500 * ,000 * ,000 immediately = approx. $27,481 between carrying value $44,800 and PV calculated $27,481 = ordinary loss for creditor Troubled Debt Example #3 Empire Airways (CREDITOR) Journal entries At date of restructure 4,000 Accrued Interest Receivable 4,800 Notes Receivable (old) 40,000 Note Rec'bl - Restructured 23,481 Allow for doubtful accts 17,319 At end of first year 2,500 Interest 2,818 Notes Rec'bl - Restructured 318 Period Receive d Interest 12% 0 4,000 23, ,500 2, , ,500 2, , ,500 2, , ,500 2, ,000 25,000 0 Troubled Debt Example #4 FOR CREDITOR: Accrued Interest Receivable $4,800 Note Receivable (old) 40,000 Note Receivable (restructured) $ 33,937 Allowance for doubtful accounts 10,863 Creditor s New Amortization Table: Period Flows Interest 0 12% 0 33, ,850 4, , ,850 4, , ,850 4, , ,850 4, ,000 End of year 1 - effective Debit Credit interest method $3,850 Interest revenue $ 4,072 Notes receivable (restructured) $ 222 End of year 1 - cost recovery method $ 3,850 Notes receivable (restructured) $ 3,850 Troubled Debt Example #4 Empire Airways (CREDITOR) journal entries At date of restructure Notes Rec'bl - Restructured 35,000 Allowance for bad debts 9,800 Notes Recbl (old) 40,000 Accrued Interest Rec'bl 4,800 End of year 1 4,200 Interest 4,200 Example 5: Creditor s Books Debit Credit 8/1/2006 Alllowance for bad debts $ 48,704 Restructured note receivable $ 61,296 Note Receivable $ 100,000 Interest receivable $ 10,000 Using effective interest method, accrue interest at year end 5 = number of months 12/31/2006 Interest receivable $ 2,554 Interest revenue $ 2,554 8/1/2007 $ 3,500 Notes receivable $ 2,630 Interest receivable $ 2,554 Interest revenue $ 3,576 7/12 of line $ 118,684 $ 118,684 12/31/2006 COST RECOVERY METHOD no entry because we never accrue principal 8/1/2007 cash $ 3,500 Notes receivable $ 3,500 Loan Impairment Examples S10c.docx as of 9/9/10 Page 1

10 Unit 6, No. 9 IFRS vs. US GAAP example (zero coupon loan) IFRS vs. US GAAP - Loan Impairment (creditor) 6-9. On December 31, 2006, Jones Company sold manufacturing equipment to Steel Corporation. Steel Corporation gave Jones Company a 5 year $200,000, zero interest note. market rate of interest for a note with similar risks is 10%. At December 31, 2008 Jones Company reviews its financial assets for impairment. Jones Company concludes that the va the note is impaired and it only expects to collect $150,000 of the principal at maturity. By December 31, 2009 Jones Company has determined they will probably collect $160,000 on manufacturing equipment. Prepare the appropriate journal entries for December 31, 2008 a December 31, 2009 according to a) IFRS b) US GAAP. Explain why the journal entries dif under the two sets of standards. Creditor s Books Debit Credit 12/31/2006 Initiation of loan Note receivable $ 124,184 Sales $ 124,184 COGS xx Inventory xx [SAME UNDER IFRS & US GAAP] 12/31/2007 Recognition of interest revenue Interest revenue (from Table 1) $ 12,418 Notes receivable $ 12,418 12/31/2008 Recognition of interest revenue Interest revenue (from Table 1) 13,660 Notes receivable 13,660 12/31/2008 Recognition of impairment US GAAP Allowance for bad loans $ 37,566 Notes receivable (new) $ 112,697 Notes receivable (old) $ 150,263 IFRS Provision for bad and doubtful debts $ 37,566 Notes receivable $ 37,566 (or used old and new accts) 12/31/2009 Change in expectations US GAAP No change - we don't recognize recoveries of impairments previously recorded - continue to use Table 2 12/31/2009 Note receivable 11,270 Interest revenue (from Table 2) 11,270 12/31/2010 Note receivable 12,397 Interest revenue (from Table 2) 12,397 12/31/2011 Assuming $160,000 is collected 160,000 Interest revenue (from Table 2) 13,636 Note receivable 136,364 Allowance for bad loans 10,000 or "recovery of impaired loan" TRUE $ 521,758 $ 521,758 12/31/2009 Change in expectations Recovery of impairments ARE acceptable - use Table 3 IFRS Note receivable 11,270 Interest revenue (from Table 2) 11,270 12/31/2009 Notes receivable 8,264 Provision for bad and doubtful debts 8,264 To adjust N/R for improved expectations At this point, the carrying value = new present value of expected cash flows at original interest rate. Original schedule as of 12/31/2006 Creditor s Original Amortization Table: Table 1 Flows Interest 12/31/ % 124,184 12/31/ ,418 12, ,603 12/31/ ,660 13, ,263 12/31/ ,026 15, ,289 12/31/ ,529 16, ,818 12/31/ ,182 18, ,000 12/31/ IFRS&USGAAP New schedule upon impairment 12/31/2008 Creditor s NEW Amortization Table (after impairment): Table 2 Flows Interest 12/31/ % 12/31/ /31/ ,697 12/31/ ,270 11, ,967 12/31/ ,397 12, ,364 12/31/ ,000 13,636 13,636 0 IFRS ONLY - new table 12/31/2009 IFRS ONLY - Creditor s NEW Amortization Table after recovery: Table 3 Flows Interest 12/31/ % 12/31/ /31/ /31/ ,231 12/31/ ,223 13, ,455 12/31/ ,000 14,545 14, /31/2010 Note receivable 13,223 Interest revenue (Table 3) 13,223 To recognize interest revenue 12/31/2011 Assuming $160,000 is collected 160,000 Interest revenue (Table 3) 14,545 Note receivable 145,455 TRUE 192, ,757 Loan Impairment Examples S10c.docx as of 9/9/10 Page 2