Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology Chapter 14A Troubled Debt

2 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?

3 Troubled Debt: Key Terms Troubled debt Impairment Restructuring Probable loss: Creditor unable to collect principal and interest. Creditor grants a to concession to debtor due to debtor’s financial difficulties.

4 Troubled Debt: Key Terms Restructuring Creditor grants a to debtor Creditor grants a concession to debtor due to debtor’s financial difficulties. Settlement Modification of Terms Debtor transfers equity Interest/new debt or assets to creditor 1. Reduction of principal 2. Reduction of interest rate 3. Extension of maturity date 4. Reduction of accrued interest

5 Progression of Troubled Debt Loan Origination Loan Impairment Restructuring Foreclosure /Bankruptcy Creditor recognizes loss Debtor may recognize gain/Creditor refines estimate of loss If all else fails – to ensure some level of collection

6 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)

7 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

8 Impairments—Example Cash310,460 Notes Payable310,460 Debtor Creditor Notes Receivable310,460 Cash310,460

9 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 less PV of expected future cash flows

10 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 $310,460 Dec. 31/09 Accrued Interest (310,460 x 10%) 31, , ,506 Dec. 31/10 Accrued Interest (341,506 x 10%) 34,151 Carrying Value $375,657

11 Impairments—Example Entry to record the loss: Bad Debt Expense150,261 Allowance for Doubtful Accounts150,261 Allowance for Doubtful Accounts150,261 Loss on Impairment: Carrying value of loan less $375,657 PV of expected future cash flows = 225,396 $150,261 $150,261

12 Interest and Amortization After Impairment Date Cash Received 0% Interest Revenue (10%) Discount Amortized Carrying Amount of Note 12/31/10$225,396 12/31/11$0$22,540$22,540247,936 12/31/12024,79424,794272,730 12/31/13027,27327,273300,000 Total$0$74,607$74,607

13 Interest and Amortization After Impairment December 31, 2010 entry: Note Receivable22,540 Interest Income 22,540 December 31, 2013 entry: Allowance for Doubtful150,261 Cash300,000 Cash300,000 Note Receivable450,261 Note Receivable450,261

14 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

15 Gain or Loss: Debtor and Creditor Settlement Debtor Creditor Gain = excess of carrying amount of payable over fair value of assets transferred to creditorGain = excess of carrying amount of payable over fair value of assets transferred to creditor The gain isThe gain is not extraordinary Recognize loss or gain on transferred to creditorRecognize loss or gain on disposition of non- cash assets transferred to creditor Loss = excess of loan receivable over fair value of assets received from debtorLoss = excess of loan receivable over fair value of assets received from debtor The loss isThe loss is not extraordinary

16 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

17 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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