debt restructuring - Demonstration Problem #1Demonstration Problem #2DEMONSTRATION pROBLEM #3 - CREDITORtroubled debt restructuring - creditordEMONSTRATION prOBLEM #4troubled debt restructuring - creditordEMONSTRATION prOBLEM #4Acct 414 Spring 2010 Prof. Teresa Gordon Loan Impairment Examples S10c.docx as of 9/9/10 Page 1 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.Acct 414 Spring 2010 Prof. Teresa Gordon Loan Impairment Examples S10c.docx as of 9/9/10 Page 2 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 debtsAcct 414 Spring 2010 Prof. Teresa Gordon Loan Impairment Examples S10c.docx as of 9/9/10 Page 3 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 Revenue Difference Carrying Value 0 12% 27,481 0 4,000 23,481 1 2,500 2,818 318 23,799 2 2,500 2,856 356 24,155 3 2,500 2,899 399 24,554 4 2,500 2,946 446 25,000 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)Acct 414 Spring 2010 Prof. Teresa Gordon Loan