Download Intermediate Accounting, Eighth Canadian Edition

Chapter 14A
Troubled Debt
Prepared by:
Patricia Zima, CA
Mohawk College of Applied Arts and Technology
Accounting Issues
• In troubled debt cases, two important
issues emerge:
• When should a loss be recognized?
• When it is likely a loss will occur, and
• When the loss can be measured
• What is the amount of loss to be
recognized?
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Troubled Debt: Key Terms
Troubled debt
Impairment
Restructuring
Probable loss:
Creditor unable
to collect principal
and interest.
Creditor grants a
concession to
debtor due to
debtor’s financial
difficulties.
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Troubled Debt: Key Terms
Restructuring
Creditor grants a concession to debtor
due to debtor’s financial difficulties.
Settlement
Debtor transfers equity
Interest/new debt or
assets to creditor
Modification of Terms
1. Reduction of principal
2. Reduction of interest rate
3. Extension of maturity date
4. Reduction of accrued interest
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Progression of Troubled Debt
Loan
Origination
Creditor
recognizes
loss
Loan
Impairment
Restructuring
Debtor may
recognize
gain/Creditor
refines estimate
of loss
Foreclosure
/Bankruptcy
If all else fails –
to ensure some
level of collection
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Impairment of Loans/Notes
Receivable
• Loss measured at estimated realizable value
– Expected future cash flows discounted at the
historical interest rate
• When future cash flows not determinable loss
measured at:
– FV of any security attached to loan, or
– Market price of loan (if any)
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Impairments—Example
Given:
December 31, 2008: $500,000 5-year note issued to
Community Bank
Effective interest rate: 10%
Entries to record the issuance of the note
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Impairments—Example
Cash
Notes Payable
Creditor
Notes Receivable
Cash
Debtor
310,460
310,460
310,460
310,460
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Impairments—Example
• Loan becomes impaired December 2010
• Future cash flows expected: $300,000
• Amount of loss to be recorded based on
expected future cash flows
• Loss equal to:
Carrying value of loan
less
PV of expected future cash flows
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Impairments—Example
PV of expected future cash flows:
Expected future cash flow: $300,000
Discounted at: 10%
Number of discount periods: 3
Present value = $225,396
Carrying value of loan
At December 31, 2008
Dec. 31/09 Accrued Interest (310,460 x 10%)
Dec. 31/10 Accrued Interest (341,506 x 10%)
Carrying Value
$310,460
31,046
341,506
34,151
$375,657
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Impairments—Example
Loss on Impairment:
Carrying value of loan less
$375,657
PV of expected future cash flows = 225,396
$150,261
Entry to record the loss:
Bad Debt Expense
Allowance for Doubtful Accounts
150,261
150,261
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Interest and Amortization
After Impairment
Date
Cash
Received 0%
Interest
Revenue
(10%)
Discount
Amortized
12/31/10
Carrying
Amount of
Note
$225,396
12/31/11
$0
$22,540
$22,540
247,936
12/31/12
0
24,794
24,794
272,730
12/31/13
0
27,273
27,273
300,000
$0
$74,607
$74,607
Total
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Interest and Amortization
After Impairment
December 31, 2010 entry:
Note Receivable
Interest Income
December 31, 2013 entry:
Allowance for Doubtful
Cash
Note Receivable
22,540
22,540
150,261
300,000
450,261
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Troubled Debt Restructurings
•
•
When a creditor grants a favorable
concession to a debtor
Two basic types of transactions
1. Settlement of debt at less than carrying
value
2. Continuation of debt with modification of
terms
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Gain or Loss: Debtor and Creditor
Settlement
Debtor
Creditor
• Gain = excess of
carrying amount of
payable over fair value of
assets transferred to
creditor
• The gain is not
extraordinary
• Recognize loss or gain
on disposition of noncash assets transferred
to creditor
• Loss = excess of loan
receivable over fair
value of assets
received from debtor
• The loss is not
extraordinary
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Modification of Terms
• No gain or loss recognized
• New effective interest rate must be found
– Carrying value of old debt equates to cash flows of
newly arranged debt
• First step required
– Determine if a settlement has occurred or a
modification of terms
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Modification of Terms—Example
Given:
Debt terms are modified
Carrying value of debt:
$10,500,000
Total future cash flows:
$11,880,000
Annual payments:
$ 720,000
The effective interest rate must be such that the PV of
$11,880,000 is $10,500,000
In this case (using a financial calculator and n = 4, interest
rate = 3.466%)
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