Prepared by:Gabriela H. Schneider, CMA

Northern Alberta Institute of Technology

INTERMEDIATEACCOUNTINGSeventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

INTERMEDIATEACCOUNTINGSeventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

Appendix 15AAppendix 15A

Troubled DebtTroubled Debt

Appendix 15AAppendix 15A

Troubled DebtTroubled Debt

9.9. Account for impairments on notes and loans Account for impairments on notes and loans receivablereceivable

10.10. Distinguish between and account for debt Distinguish between and account for debt restructurings resulting in extinguishment restructurings resulting in extinguishment versus debt continuationversus debt continuation

Learning ObjectivesLearning Objectives

Accounting IssuesAccounting Issues

• In troubled debt cases, two important In troubled debt cases, two important issues emerge:issues emerge:• When should a loss be recognized?When should a loss be recognized?

• When it is likely a loss will occur, andWhen it is likely a loss will occur, and• When the loss can be measuredWhen the loss can be measured

• What is the amount of loss to be What is the amount of loss to be recognized?recognized?

Troubled Debt: Key TermsTroubled Debt: Key Terms

Troubled debtTroubled debt

ImpairmentImpairment RestructuringRestructuring

Probable loss:Probable loss:Creditor unableCreditor unable

to collect principalto collect principaland interest.and interest.

Creditor grants aCreditor grants aconcessionconcession to todebtor due todebtor due to

debtor’s financialdebtor’s financialdifficulties.difficulties.

Troubled Debt: Key TermsTroubled Debt: Key Terms

RestructuringRestructuring

Creditor grants a Creditor grants a concessionconcession to debtor to debtor due to debtor’s financial difficulties.due to debtor’s financial difficulties.

SettlementSettlement Modification of TermsModification of Terms

Debtor transfers equityDebtor transfers equityinterest orinterest or

assets to creditorassets to creditor

1. Reduction of principal1. Reduction of principal2. Reduction of interest rate2. Reduction of interest rate3. Extension of maturity date3. Extension of maturity date4. Reduction of accrued interest4. Reduction of accrued interest

Progression of Troubled DebtProgression of Troubled Debt

Loan Loan OriginationOrigination

Loan Loan ImpairmentImpairment

RestructuringRestructuring ForeclosureForeclosure/Bankruptcy/Bankruptcy

Creditor Creditor recognizes recognizes

lossloss

Debtor may Debtor may recognize recognize

gain/Creditor gain/Creditor refines estimate refines estimate

of lossof loss

If all else fails – If all else fails – to ensure some to ensure some level of collectionlevel of collection

Impairment of Loans/Notes Impairment of Loans/Notes ReceivableReceivable

• Loss measured at Loss measured at estimated realizable estimated realizable valuevalue– Expected future cash flows discounted at Expected future cash flows discounted at

the the historical interest ratehistorical interest rate

• When future cash flows When future cash flows not not determinabledeterminable loss measured at: loss measured at:– FV of any security attached to loan, orFV of any security attached to loan, or– Market price of loan (if any)Market price of loan (if any)

ImpairmentsImpairments——ExampleExample

Given:Given:December 31, 2004: $500,000 5-year note issued December 31, 2004: $500,000 5-year note issued to Community Bankto Community Bank

Effective interest rate: 10%Effective interest rate: 10%

Entries to record the issuance of the noteEntries to record the issuance of the note

ImpairmentsImpairments——ExampleExample

CashCash 310,460310,460

Discount on Notes PayableDiscount on Notes Payable 189,540189,540

Notes PayableNotes Payable 500,000500,000

DebtorDebtor

CreditorCreditor

Notes ReceivableNotes Receivable 500,000500,000

Discount on Notes ReceivableDiscount on Notes Receivable189,540189,540

CashCash 310,460310,460

ImpairmentsImpairments——ExampleExample

• Loan becomes impaired December 2006Loan becomes impaired December 2006

• Future cash flows expected: $300,000Future cash flows expected: $300,000

• Amount of loss to be recorded based on Amount of loss to be recorded based on expected future cash flowsexpected future cash flows

• Loss equal to:Loss equal to:

Carrying value of loanCarrying value of loan lessless

PV of expected future cash flowsPV of expected future cash flows

ImpairmentsImpairments——ExampleExample

PV of expected future cash flows:PV of expected future cash flows:Expected future cash flow:Expected future cash flow: $300,000 $300,000Discounted at: 10% Discounted at: 10% Number of discount periods: 3Number of discount periods: 3Present value = $225,396Present value = $225,396

Carrying value of loanCarrying value of loanAt December 31, 2004At December 31, 2004 $310,460 $310,460Dec. 31/05 Accrued Interest (310,460 x 10%) Dec. 31/05 Accrued Interest (310,460 x 10%) 31,046 31,046

341,506341,506Dec. 31/06 Accrued Interest (341,506 x 10%) Dec. 31/06 Accrued Interest (341,506 x 10%) 34,151 34,151

Carrying Value Carrying Value $375,657$375,657

ImpairmentsImpairments——ExampleExample

Entry to record the loss:Entry to record the loss:Bad Debt ExpenseBad Debt Expense 150,261150,261 Allowance for Doubtful AccountsAllowance for Doubtful Accounts 150,261150,261

Loss on Impairment:Loss on Impairment:Carrying value of loan Carrying value of loan lessless $375,657 $375,657PV of expected future cash flows = PV of expected future cash flows = 225,396 225,396

$150,261$150,261

Interest and AmortizationInterest and AmortizationAfter ImpairmentAfter Impairment

DateDate Cash Cash Received Received

0%0%

Interest Interest Revenue Revenue

(10%)(10%)

Discount Discount AmortizedAmortized

Carrying Carrying Amount of Amount of

NoteNote

12/31/0612/31/06 $225,396$225,396

12/31/0712/31/07 $0$0 $22,540$22,540 $22,540$22,540 247,936247,936

12/31/0812/31/08 00 24,79424,794 24,79424,794 272,730272,730

12/31/0912/31/09 00 27,27327,273 27,27327,273 300,000300,000

TotalTotal $0$0 $74,607$74,607 $74,607$74,607

Interest and AmortizationInterest and AmortizationAfter ImpairmentAfter Impairment

December 31, 2007 entry:December 31, 2007 entry:Discount on NoteDiscount on Note 22,54022,540 Interest Income Interest Income 22,540 22,540

December 31, 2009 entry:December 31, 2009 entry:Allowance for DoubtfulAllowance for Doubtful 150,261150,261

CashCash 300,000300,000

Discount on NoteDiscount on Note 49,739 49,739

Note ReceivableNote Receivable 500,000500,000

Troubled Debt Troubled Debt RestructuringsRestructurings

• When a creditor grants a favorable When a creditor grants a favorable concession to a debtorconcession to a debtor

• Two basic types of transactionsTwo basic types of transactions1.1. Settlement Settlement of debt at less than carrying of debt at less than carrying

valuevalue

2.2. Continuation Continuation of debt with of debt with modification modification of of termsterms

Gain or Loss: Debtor and Gain or Loss: Debtor and Creditor SettlementCreditor SettlementDebtorDebtor CreditorCreditor

• Gain = excess of Gain = excess of carrying amount of carrying amount of payable payable overover fair value fair value of assets transferred to of assets transferred to creditorcreditor

• The gain is The gain is notnot extraordinaryextraordinary

• Recognize loss or gain Recognize loss or gain on on disposition of non-disposition of non-cash assetscash assets transferred transferred to creditor to creditor

• Loss = excess of Loss = excess of loan receivable loan receivable overover fair value of assets fair value of assets received from received from debtordebtor

• The loss is The loss is ordinaryordinary and is charged to and is charged to Allowance for Allowance for Doubtful AccountsDoubtful Accounts

Modification of TermsModification of Terms

• No gain or loss recognizedNo gain or loss recognized

• New effective interest rate must be New effective interest rate must be foundfound– Carrying value of old debt equates to cash Carrying value of old debt equates to cash

flows of newly arranged debtflows of newly arranged debt

• First step requiredFirst step required– Determine if a settlement has occurred or a Determine if a settlement has occurred or a

modification of termsmodification of terms

Modification of TermsModification of Terms——ExampleExample

GivenGiven::Debt terms are modifiedDebt terms are modifiedCarrying value of debt:Carrying value of debt: $10,500,000$10,500,000Total future cash flows:Total future cash flows: $11,880,000$11,880,000Annual payments:Annual payments: $ 720,000$ 720,000The effective interest rate must be such that the PV of The effective interest rate must be such that the PV of $11,880,000 is $10,500,000$11,880,000 is $10,500,000In this case (using a financial calculator and n = 4, In this case (using a financial calculator and n = 4, interest rate = 3.466%)interest rate = 3.466%)

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