Acct 414 Spring 2010
Prof. Teresa Gordon
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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Acct 414 Spring 2010
Prof. Teresa Gordon
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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Acct 414 Spring 2010
Prof. Teresa Gordon
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
Difference
Revenue
0
12%
0
4,000
1
2,500
2,818
318
2
2,500
2,856
356
3
2,500
2,899
399
4
2,500
2,946
446
25,000
Carrying
Value
27,481
23,481
23,799
24,155
24,554
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
Notes receivable (restructured)
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Acct 414 Spring 2010
Cost Recovery Method (FAS 118 Amendment to FAS 114)
Prof. Teresa Gordon
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
Note Recbl - Restructured
2,500
End of year 4
Cash
27,500
Note Recbl - Restructured
Income Realized on Impaired Loans
2,500
15,981
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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Acct 414 Spring 2010
Prof. Teresa Gordon
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?
Creditor’s New Amortization Table:
Period Cash Flows
Interest
Difference
Revenue
0
11%
1
3,850
2
3,850
3
3,850
4
3,850
4
35,000
Revenue recogntion using effective interest method
Creditor’s Books
Carrying
Value
0
Debit
Credit
At date of restructure:
Note Receivable (restructured)
Accrued Interest Receivable
Note Receivable (old)
Allowance for doubtful accounts
End of year 1
Cash
Interest revenue
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Acct 414 Spring 2010
Prof. Teresa Gordon
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
0
1
3,850
2
3,850
3
3,850
4
38,850
Creditor’s Books
Carrying
Value
35,000
Debit
Credit
At date of restructure:
Note Receivable (restructured)
Accrued Interest Receivable
Note Receivable (old)
Allowance for doubtful accounts
End of year 1
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Acct 414 Spring 2010
Prof. Teresa Gordon
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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Acct 414 Spring 2010
Prof. Teresa Gordon
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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Acct 414 Spring 2010
Prof. Teresa Gordon
Troubled Debt Example #4
SOLUTIONS - Troubled Debt
Restructuring Examples
FOR CREDITOR:
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 * 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
Troubled Debt Example #3
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
Allow for doubtful accts
17,319
At end of first year
Cash
Interest Revenue
Notes Rec'bl - Restructured
Period
0
1
2
3
4
Cash
Receive
d
4,000
2,500
2,500
2,500
2,500
25,000
Interest
Revenue
12%
2,818
2,856
2,899
2,946
2,818
318
318
356
399
446
$ 33,937
10,863
Creditor’s New Amortization Table:
Cash
Interest Difference Carrying
Flows
Revenue
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
Debit
Credit
interest method
Cash
$3,850
Interest revenue
$ 4,072
Notes receivable (restructured)
$ 222
Period
End of year 1 - cost recovery
method
Cash
Notes receivable (restructured)
$ 3,850
$ 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
Cash
Interest Revenue
4,200
4,200
Carrying
Value
23,481
23,799
24,155
24,554
25,000
0
Creditor’s Books
8/1/2006 Alllowance for bad debts
Restructured note receivable
Note Receivable
Interest receivable
$
$
Using effective interest method, accrue
interest at year end
5 = number of months
12/31/2006 Interest receivable
Interest revenue
8/1/2007 Cash
Notes receivable
Interest receivable
Interest revenue
7/12 of line
Debit
48,704
61,296
$
2,554
$
$
3,500
2,630
$
118,684
$
3,500
Credit
$
$
100,000
10,000
$
2,554
$
$
$
2,554
3,576
118,684
$
3,500
12/31/2006 COST RECOVERY METHOD
no entry because we never accrue principal
8/1/2007 cash
Notes receivable
Document1 as of 3/14/16
$4,800
40,000
Example 5:
2,500
Difference
Accrued Interest Receivable
Note Receivable (old)
Note Receivable (restructured)
Allowance for doubtful accounts
Page 1
Acct 414 Spring 2010
Unit 6, No. 9
IFRS vs. US GAAP example (zero coupon loan)
Prof. Teresa Gordon
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. 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 they will probably collect $160,000 on the
manufacturing equipment. 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.
Creditor’s Books
12/31/2006
12/31/2007
12/31/2008
12/31/2008
US GAAP
IFRS
Debit
Initiation of loan
Note receivable
Sales
COGS
Inventory
[SAME UNDER IFRS & US GAAP]
$
Credit
124,184
$
xx
Recognition of interest revenue
Interest revenue (from Table 1)
Notes receivable
$
$
Recognition of interest revenue
Interest revenue (from Table 1)
Notes receivable
Recognition of impairment
Allowance for bad loans
Notes receivable (new)
Notes receivable (old)
Provision for bad and doubtful debts
Notes receivable
12/31/2009
12/31/2009
13,660
$
37,566
112,697
$
150,263
$
37,566
37,566
Change in expectations
No change - we don't recognize recoveries of
impairments previously recorded - continue to use Table 2
Note receivable
11,270
Interest revenue (from Table 2)
12/31/2010
12/31/2011
Note receivable
Interest revenue (from Table 2)
12,397
12,397
Assuming $160,000 is collected
160,000
13,636
136,364
10,000
TRUE $
521,758
$
521,758
Change in expectations
Recovery of impairments ARE acceptable - use Table 3
IFRS
12/31/2009
Note receivable
Interest revenue (from Table 2)
11,270
Notes receivable
Provision for bad and doubtful debts
8,264
11,270
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.
12/31/2010
Note receivable
IFRS ONLY - new table 12/31/2009
IFRS ONLY - Creditor’s NEW Amortization Table after recovery:
Cash
Interest
DifferCarrying
Table 3
Flows
Revenue
ence
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
13,223
Interest revenue (Table 3)
13,223
To recognize interest revenue
12/31/2011
IFRS&USGAAP
New schedule upon impairment 12/31/2008
Creditor’s NEW Amortization Table (after impairment):
Cash
Interest
DifferCarrying
Table 2
Flows
Revenue
ence
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
11,270
Cash
Interest revenue (from Table 2)
Note receivable
Allowance for bad loans
or "recovery of impaired loan"
12/31/2009
12,418
13,660
$
$
Carrying
Value
124,184
136,603
150,263
165,289
181,818
200,000
12,418
(or used old and new accts)
US GAAP
124,184
xx
Table 1
12/31/2006
12/31/2007
12/31/2008
12/31/2009
12/31/2010
12/31/2011
12/31/2012
Original schedule as of 12/31/2006
Creditor’s Original Amortization Table:
Cash
Interest
DifferFlows
Revenue
ence
0
10%
1
0
12,418
12,418
2
0
13,660
13,660
3
0
15,026
15,026
4
0
16,529
16,529
5
0
18,182
18,182
6
Assuming $160,000 is collected
Cash
Interest revenue (Table 3)
Note receivable
160,000
14,545
145,455
TRUE
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192,757
192,757
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