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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? 2 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. 3 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 4 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 5 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) 6 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 7 Impairments—Example Cash Notes Payable Creditor Notes Receivable Cash Debtor 310,460 310,460 310,460 310,460 8 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 9 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 10 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 11 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 12 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 13 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 14 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 15 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 16 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%) 17 COPYRIGHT Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. 18