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

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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.

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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.

Creditor’s Books

Debit Credit

Land

Notes receivable

Interest receivable

Allow for bad debts

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).

Creditor’s Books

Debit Credit

Investments Portfolio

Notes receivable

Interest receivable

Allow for bad debts

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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 Cash Flows Interest

Revenue Difference Carrying Value 0 12% 27,481 0 4,000 23,481 1 2,500 2,818 318 23,799 2 2,500 2,856 356 24,155 3 2,500 2,899 399 24,554 4 2,500 2,946 446 25,000 25,000 0

Revenue recognition using effective interest method:

Creditor’s Books Debit Credit

At date of restructure:

Cash

Accrued Interest Receivable

Note Receivable (old)

Note Receivable (restructured)

Allowance for doubtful accounts

End of year 1

Cash

Interest revenue

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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 Cash Rec'd Revenue

Recognized Principal Received Carrying Value 27,481 0 4,000 23,481 1 2,500 0 2,500 20,981 2 2,500 0 2,500 18,481 3 2,500 0 2,500 15,981 4 27,500 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:

Cash 2,500

Note Recbl - Restructured 2,500

End of year 4

Cash 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?

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TROUBLED DEBT RESTRUCTURING - CREDITOR DEMONSTRATION PROBLEM #4

[Alternate terms, same as #3 except for item 2]

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?

Period Cash Flows Interest

Revenue Difference Carrying Value 0 11% 1 3,850 2 3,850 3 3,850 4 3,850 4 35,000 0

Revenue recogntion using effective interest method

At date of restructure:

Note Receivable (restructured)

Accrued Interest Receivable

Note Receivable (old)

Allowance for doubtful accounts

End of year 1

Cash

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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 Cash Rec'd Revenue

Recognized Principal Received Carrying Value 0 35,000 1 3,850 2 3,850 3 3,850 4 38,850

At date of restructure:

Note Receivable (restructured)

Accrued Interest Receivable

Note Receivable (old)

Allowance for doubtful accounts

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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.

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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.

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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

Troubled Debt Example #3

CREDITOR ACCOUNTING (FASB 114) Find PV of cash flows using original i = 12%: 2,500 * 3.037 + 25,000 * .636 + 4,000 immediately = approx. $27,481

Difference between carrying value $44,800 and PV calculated $27,481 = ordinary loss for creditor

Empire Airways (CREDITOR) Journal entries __________________________________________ At date of restructure

Cash 4,000

Accrued Interest Receivable 4,800

Notes Receivable (old) 40,000

Note Rec'bl - Restructured 23,481

At end of first year

Cash 2,500

Interest Revenue 2,818

Notes Rec'bl - Restructured 318

Period Cash Receive d Interest Revenue 12% Difference Carrying Value 0 4,000 23,481

FOR CREDITOR:

Accrued Interest Receivable $4,800 Note Receivable (old) 40,000 Note Receivable (restructured) $ 33,937

Allowance for doubtful accounts 10,863

Period Cash

Flows RevenueInterest Difference Carrying Value

0 12% 0 33,937 1 3,850 4,072 222 34,159 2 3,850 4,099 249 34,409 3 3,850 4,129 279 34,688 4 3,850 4,163 313 35,000

End of year 1 - effective

interest method Debit Credit

Cash $3,850

Interest revenue $ 4,072 Notes receivable (restructured) $ 222

End of year 1 - cost recovery

method

Cash $ 3,850

Notes receivable (restructured) $ 3,850

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

Cash 4,200

Interest Revenue 4,200

Example 5:

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 Cash $ 3,500

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Unit 6, No. 9

IFRS vs. US GAAP example (zero coupon loan) IFRS vs. US GAAP - Loan Impairment (creditor)

12/31/2006Initiation of loan

Note receivable $ 124,184

Sales $ 124,184

COGS xx

Inventory xx

[SAME UNDER IFRS & US GAAP]

12/31/2007Recognition of interest revenue

Interest revenue (from Table 1) $ 12,418

Notes receivable $ 12,418

12/31/2008Recognition of interest revenue

Interest revenue (from Table 1) 13,660

Notes receivable 13,660

12/31/2008Recognition 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)

12/31/2009Change in expectations

US GAAP No change - we don't recognize recoveries of

impairments previously recorded - continue to use Table 2

12/31/2009Note receivable 11,270

12/31/2010Note receivable 12,397

12/31/2011Assuming $160,000 is collected

Cash 160,000

Note receivable 136,364

Allowance for bad loans 10,000

or "recovery of impaired loan"

TRUE $ 521,758 $ 521,758

12/31/2009Change in expectations

Recovery of impairments ARE acceptable - use Table 3

IFRS Note receivable 11,270

12/31/2009Notes 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.

Note receivable 13,223

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.

Original schedule as of 12/31/2006 Creditor’s Original Amortization Table:

Table 1 Flows Cash Revenue Interest Differ-ence Carrying Value

12/31/2006 0 10% 124,184 12/31/2007 1 0 12,418 12,418 136,603 12/31/2008 2 0 13,660 13,660 150,263 12/31/2009 3 0 15,026 15,026 165,289 12/31/2010 4 0 16,529 16,529 181,818 12/31/2011 5 0 18,182 18,182 200,000 12/31/2012 6 IFRS&USGAAP

New schedule upon impairment 12/31/2008 Creditor’s NEW Amortization Table (after impairment): Table 2 Flows Cash Revenue Interest Differ-ence Carrying Value

12/31/2006 0 10% 12/31/2007 1 12/31/2008 2 112,697 12/31/2009 3 0 11,270 11,270 123,967 12/31/2010 4 0 12,397 12,397 136,364 12/31/2011 5 150,000 13,636 13,636 0

IFRS ONLY - new table 12/31/2009

IFRS ONLY - Creditor’s NEW Amortization Table after recovery: Table 3 Flows Cash Revenue Interest Differ-ence Carrying Value

12/31/2006 0 10% 12/31/2007 1 12/31/2008 2 12/31/2009 3 132,231 12/31/2010 4 0 13,223 13,223 145,455 12/31/2011 5 160,000 14,545 14,545 0