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APPENDIX 7B

IMPAIRMENTS OF RECEIVABLES

11. Describe the accounting for a loan impairment. Companies continually evaluate their receivables to determine their ultimate collectibility. As discussed in the chapter, the FASB considers the collectibility of receivables a loss contingency. Thus, the allowance method is appropriate in situations where it is probable that an asset has been impaired and the amount of the loss can be reasonably estimated. Generally, companies start with historical loss rates and modify these rates for changes in economic conditions that could affect a borrower's ability to repay the loan. The discussion in the chapter assumed use of this approach to determine the amount of bad debts to be recorded for a period. However, for long-term receivables such as loans that are identified as impaired, companies perform an additional impairment evaluation. 18A loan is defined as a contractual right to receive money on demand or on fixed and determinable dates that is recognized as an asset in the creditor's statement of financial position. For example, accounts receivable with terms exceeding one year are considered loans. [11] GAAP has specific rules for measurement and reporting of these impairments. These rules relate to determining the value of these loans and how much loss to recognize if the holder of the loans plans to keep them in hope that the market will recover. More complex rules arise when these loans are sold as part of the securitization process, especially when the original terms of the notes are modified. 19Note that the impairment test shown in this Appendix only applies to specific loans. However, if the loans are bundled into a security (e.g., the mortgage-backed securities), the impairment test is different. Impairments of securities are measured based on fair value. We discuss this accounting in Chapter 17.

IMPAIRMENT MEASUREMENT AND REPORTING

A company considers a loan receivable impaired when it is probable, based on current information and events, that it will not collect all amounts due (both principal and interest). If a loan is determined to be individually impaired, the company should measure the loss due to the impairment . This impairment loss is calculated as the difference between the investment in the loan (generally the principal plus accrued interest) and the expected future cash flows discounted at the loan's historical effective-interest rate. 20The creditor may also, for the sake of expediency, use the market price of the loan (if such a price is available) or the fair value of the collateral if it is a collateralized loan. [12] Recognize that if the value of the investment is based on the historical rate, generally the resultant value will not be equal to the fair value of the loan in subsequent periods. We consider this accounting inconsistent with fair value principles as applied to other financial instruments. When using the historical effective loan rate, the value of the investment will change only if some of the legally contracted cash flows are reduced. A company recognizes a loss in this case because the expected future cash flows are now lower. The company ignores interest rate changes caused by current economic events that affect the fair value of the loan. In estimating future cash flows, the creditor should use reasonable and supportable assumptions and projections. [13]

Impairment Loss Example

At December 31, 2013, Ogden Bank recorded an investment of $100,000 in a loan to Carl King. The loan has an historical effective-interest rate of 10 percent, the principal is due in full at maturity in three years, and interest is due annually. Unfortunately, King is experiencing financial difficulty and thinks he will have a difficult time making full payment. The loan officer performs a review of the loan's expected future cash flows and utilizes the present value method for measuring the required impairment loss. Illustration 7B-1 shows the cash flow schedule prepared by the loan officer.

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ILLUSTRATION 7B-1 Impaired Loan Cash Flows

As indicated, this loan is impaired. The expected cash flows of $115,000 are less than the contractual cash flows, including principal and interest, of $130,000. The amount of the impairment to be recorded equals the difference between the recorded investment of $100,000 and the present value of the expected cash flows, as shown in Illustration 7B-2.

ILLUSTRATION 7B-2 Computation of Impairment Loss

The loss due to the impairment is $12,434. Why isn't it ? Because Ogden Bank must measure the loss at a present-value amount, not at an undiscounted amount, when it records the loss.

Recording Impairment Losses

Ogden Bank (the creditor) recognizes an impairment loss of $12,434 by debiting Bad Debt Expense for the expected loss. At the same time, it reduces the overall value of the receivable by crediting Allowance for Doubtful Accounts. The journal entry to record the loss is therefore as follows. 21In the event of a loan write-off, the company charges the loss against the allowance. In subsequent periods, if revising estimated expected cash flows based on new information, the company adjusts the allowance account and bad debt expense account (either increased or decreased depending on whether conditions improved or worsened) in the same fashion as the original impairment. We use the terms loss and bad debt expense interchangeably throughout this discussion. Companies should charge losses related to receivables transactions to Bad Debt Expense or the related Allowance for Doubtful Accounts because they use these accounts to recognize changes in values affecting receivables. Bad Debt Expense 12,434 Allowance for Doubtful Accounts 12,434 What entry does Carl King (the debtor) make? The debtor makes no entry because he still legally owes $100,000. In some cases, debtors like King negotiate a modification in the terms of the loan agreement. In such cases, the accounting entries from Ogden Bank are the same as the situation in which the loan officer must estimate the future cash flowsexcept that the calculation for the amount of the loss becomes more reliable (because the revised expected cash flow amounts are contractually specified in the loan agreement). 22Many alternatives are permitted to recognize income by Ogden Bank in subsequent periods. [14] The entries related to the debtor in this case often change; they are discussed in Appendix 14A.

What do the numbers mean?

LOST IN TRANSLATION

Floyd Norris, noted financial writer for the New York Times, recently wrote in his blog that he attended a conference to discuss the financial crisis in subprime lending. He highlighted, and provided translations of, some of the statements he heard at that conference:
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There is a problem of misaligned incentives. Translation: Many parties in the lending process were complicit in not performing due diligence on loans because there were lots of fees to be had if the loans were made, good loans or bad. It is pretty clear that there was a failure in some key assumptions that were supporting our analytics and our models. Translation: The rating agencies that evaluated the risk level of these securities made many miscalculations. Some structured finance products that were given superior ratings are no longer worth much. The plumbing of the U.S. economy has been deeply damaged. It is a long window of vulnerability. Translation: The U.S. has caused a financial crisis as a result of poor lending practices, and many financial institutions are fighting to survive. I'm glad that this time we did not cause it. Translation: Other countries realized they had caused financial crises in the past but were not to blame for the current U.S. financial situation. What you see is what you get. If you don't see it, it will get you. Translation: A large number of financial institutions have to take losses on assets that are not reported on their balance sheets. Their continuing interest in some of the loans that they supposedly sold is now coming back to them and they will have to report losses.
Source: Floyd Norris blog, http://www.norris.blogs.nytimes.com/ (acce sse d June 2008).

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 7B

11 Describe the accounting for a loan impairment. A creditor bases an impairment loan loss on the difference between the present value of the future cash flows (using the historical effective-interest rate) and the carrying amount of the note.

Copyright 2012 John Wiley & Sons, Inc. All rights reserved.

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