Corporation in financial

difficulty

Impairment of Loans

Impairment of loans
Requirements for impairment testing under IAS 39
Required for all financial instruments except those measured at fair value
through profit and Loss (FVTPL).
Only when there is objective evidence as a result of loss event(s)

Example of loss event(s) include:

Issuer encounters significant financial difficulties;

Default of payments
Lender has to grant special concession to the borrower
Borrower faces probable bankruptcy
Disappearance of an active market
Objective evidence on a decrease of estimated cash flows of the issuer

Edited by Taufik Hidayat

Impairment & Uncollectibility of F.A.

Loans and receivables & held-to-maturity investments

Two-Stage Assessment of Objective Evidence

Before an impairment loss is measured and recognised, an
entity is required to assess whether objective evidence of
impairment exists for loans and receivables and held-tomaturity investments using a two-stage assessment approach
as follows:
1. First stage (individual assessment) an entity is required to firstly assesses
whether objective evidence of impairment exists
individually for the financial assets that are individually significant, and
individually or collectively for the financial assets that are not individually
significant.
2. Second stage (collective assessment) If an entity determines that no
objective evidence of impairment exists for an individually assessed financial
asset, whether significant or not, it includes the asset in a group of financial
assets with similar credit risk characteristics and collectively assesses them for

Impairment & Uncollectibility of F.A.

Loans and receivables & held-to-maturity investments

If there is objective evidence that an impairment loss on

loans and receivables or held-to-maturity investments carried
at amortised cost has been incurred, the amount of the
impairment loss is measured as the difference between
the assets carrying amount and
the present value of estimated future cash flows (excluding future
credit losses that have not been incurred) discounted at the financial
assets original effective interest rate (i.e. the effective interest rate
computed at initial recognition).

Impairment & Uncollectibility of

LoansF.A.
and receivables & held-to-maturity investments
The amount of the impairment loss on loans and receivables
or held-to-maturity investments is recognised in profit or loss
while the carrying amount of the impaired asset is reduced
either:
directly in the asset or
through use of an allowance account.

5. Impairment & Uncollectibility of

LoansF.A.
and receivables & held-to-maturity investments
An entity is required to reverse the previously recognised
impairment loss on loans and receivables or held-tomaturity investments either directly or by adjusting an
allowance account if, in a subsequent period, the following
two conditions are met:
the amount of the impairment loss decreases and
the decrease can be related objectively to an event occurring after
the impairment was recognised (such as an improvement in the
debtors credit rating).

The amount of the reversal is recognised in profit or loss but

it must not result in a carrying amount of the financial asset
that exceeds what the amortised cost would have been had
the impairment not been recognised at the date the
impairment is reversed.

5. Impairment & Uncollectibility of

LoansF.A.
and receivables & held-to-maturity investments
Once a financial asset has been written down as a result
of an impairment loss, interest income is thereafter
recognised using the rate of interest used to discount
the future cash flows for the purpose of measuring the
impairment loss.

Illustration 1
Entity A has a loan asset whose initial carrying amount
is $100,000 and whose effective interest is 8%. On
January 1, X5, entity A determines that the borrower will
probably enter into bankruptcy, and expects to collect
only $20,000 of remaining principal and interest cash
flows. Entity A expects to recover this amount at the
end of X5
Determine the amount that entity A should records as
an impairment loss during X5 and the amount of
interest income that would be reported during X5, if any.

Illustration 1 (cont.)
Carrying value of loan= 100,000
PV of $20,000 one year from now discounted at 8%=
$18,519
Impairment loss = 100,000 18,519= 81,481
On Jan 1, X5, Entity A should recognize an impairment
loss:
Dr. Impairment loss 81,481
Cr. Loans and receivables 81,481

During X5, entity A should recognize interest income=

8% x 18,519
Dr. Loans and receivables 1,481

Impairment & Uncollectibility of

F.A.
Available-for-Sale Financial Assets
For available-for-sale financial asset carried at
fair value, an entity recognises the impairment
loss on it only when:
a decline in the fair value of an available-for-sale
financial asset has been recognised directly in equity
and
there is objective evidence that the asset is
impaired.

In recognising the impairment loss on an

available-for-sale financial asset, the entity
removes the cumulative loss that had been
recognised directly in equity from equity and

Impairment & Uncollectibility of

F.A.
Available-for-Sale Financial Assets

The amount of the cumulative loss that is

removed from equity and recognised in profit or
loss is the difference between:
the acquisition cost (net of any principal repayment
and amortisation) and
the current fair value, less any impairment loss on
that financial asset previously recognised in profit or
loss.

Impairment & Uncollectibility of

F.A. Financial Assets
Available-for-Sale
Impairment losses on available-for-sale equity
instruments
cannot be reversed through profit or loss (IAS 39.69),
i.e. any subsequent increase in fair value is
recognised in equity.

Reversal of the impairment loss on availablefor-sale debt instrument through profit or loss is
instead allowed.
After an impairment loss on available-for-sale debt
instrument is recognised in profit or loss, if (1) the
fair value of such instrument increases and (2) the
increase can be objectively related to an event

Illustration 2
Assume Entity A has an investment in a debt security
that it has classified as AFS and that it had initially
acquired for $100,000. Due to a decrease in fair value,
the current carrying amount of the investment is
$80,100 and entity A has an unrealized loss of $19,900
recognized as a separate component of equity.
Due to significant financial difficulties of the issuer, the
debt security has been downgraded by the rating
agency, and it appears likely that the issuer of the debt
will not be able to repay all principal and interest on the
bond.

Illustration 2 (cont.)
Entity A determines that there is objective evidence of
impairment equal to the unrealized holding loss
previously recorded in equity.
In this case, entity A will make the entry
Dr. Impairment loss 19,900
Cr. Equity
19,900

Debt impairment : debtor

A debtor may not reduce the carrying amount of its debt
due to the inability to pay, unless its contractual
obligations have been legally reduced.

Debt impairment : Creditor

A write-down is required for the difference between the
investment in the loan (principal and interest) and one
of the following:
The

expected future cash flows discounted at the

loans historical effective-interest rate.

The

market price of the loan. This can be the fair

value of the collateral, if secured.

 Once a financial asset or a group of similar financial

assets has been written down as a result of an
impairment loss, interest income is thereafter
recognised (by creditors) using the rate of interest used
to discount the future cash flows for the purpose of
measuring the impairment loss

Debt impairment : creditor

Upward revisions to the carrying value of the
investment in the loan are allowed after a write-down if
an improvement in credit quality occurs; however, the
revised carrying value cannot exceed the cost amount
prior to the write-down.

Example : debt impairment 1

On January 1, 2010, the Desert Bank of Arizona (DBA) extended a threeyear loan of $16 million to Royal Resorts Incorporated (RRI), a golf resort in
southern Arizona, at a 4% interest rate.
Interest is due quarterly with the final balance of the loan ($16 million), plus
interest, due on December 31, 2013. The note is secured by a golf resort in
southern Arizona with a fair value of $18 million as of January 1, 2010.
Interest was paid in 2010 and through March 31, 2012. In the second
quarter of 2012, RRI informed DBA that it had significant cash flow problems
and would not be able to make the remaining contractual interest payments
in 2012, and possibly 2013 or the principal due on December 31, 2013.

Example : debt impairment 1

At June 30, 2012, DBA determined that its loan was impaired
because the loan balance outstanding of $16 million, plus
accrued interest of $160,000 ($16,000,000 x 4% x 3/12), was
not collectible at the current time and the balance of the loan
exceeded the fair value of the loan, which was deemed to be
$14 million based on the underlying value of the secured
collateral.
how

should DBA and RRI reflect the asset and liability,

respectively, in their accounting records at June 30, 2012?

What

are the corresponding journal entries?

Example : debt impairment 1

DBA should determine what is the best determination of fair value.
In the above situation, fair value is deemed to be the collateral
value of the golf resort. DBA should write down the asset and use a
valuation allowance to allow for any possible future increase in
value (so as not to exceed the carrying amount at June30, 2012).
Reversing previously recognized interest income:
Interest income 160,000
Interest receivable
160,000
.

Example : debt impairment 1

Recognizing impairment loss:
The difference between the carrying value of loan ($16,000,000)
and the fair value of the property as the assessment date (June 30,
2012) ($14,000,000).
Loss on loan to RRI $2,000,000
Allowance for loan receivable from RRI
.

$2,000,000

Example : debt impairment 1

RRI
At June 30, 2012, RRI would not change the accounting
for the loan, but would recognize the quarterly interest
payable of $160,000 and maintain the loan balance
outstanding of $16 million because RRI has not
discharged its legal obligation on the note to DBA.
Interest expense $160,000
Interest payable
$160,000

Example : debt impairment 2

Use the same facts as part I but assume that on
December 31, 2012, RRI was able to obtain a significant
cash infusion and able to pay the interest due to DBA,
and thus bring the loan current. Also, assume the
prospects of its payment of the principal and interest
were not in doubt for 2013.
Show the journal entries to record the payment at
December31, 2012, for both DBA and RRI

Example : debt impairment 2

DBA
Cash
$ 480,000
Interest income
$ 480,000
To record the interest from April 1, 2012 through
December 31, 2012, (3 x $160,000)
To reverse the allowance established at June30, 2012.
Allowance for loan receivable from RRI
$2,000,000
Loss on loan to RRI
2,000,000

Example : debt impairment 2

RRI
RRI would pay off the accrued interest for the three
quarters in 2012.
Interest payable $480,000
Cash $480,000

Debt restructuring
Debt restructuring can take various legal forms including:
1.

An amendment to the terms of a debt instrument (e.g. the amounts and timing of
payments of interest and principal); or

2.

A notional repayment of existing debt with immediate re-lending of the same or a

different amount.

. The borrower will usually incur costs in a debt restructuring, and other fees might also
be paid or received.
. The accounting treatment of a debt restructuring depends on whether the modified
terms (or new debt instrument) are "substantially different" to the previous terms (or
debt instrument) based on a "10% test".
. This test requires a calculation of whether the present value of the revised cash flows
plus any costs/fees paid (less any fees received) differs by 10% or more from the
present value of the remaining cash flows of the existing debt using the original EIR.

A modification to the terms of a financial

liability should be accounted for as follows:
1. A substantial modification should be accounted for as
an extinguishment of the existing liability and the
recognition of a new liability ("extinguishment
accounting");
2. A non-substantial modification is accounted for as an
adjustment to the existing liability ("modification
accounting")

Extinguishment accounting
1. De-recognition of the existing liability;
2. Recognition of the new or modified liability at its fair value;
3. Recognition of a gain or loss equal to the difference between
the carrying value of the old liability and the fair value of the
new one.
4. Any incremental costs or fees incurred, and any consideration
paid or received, are also included in the calculation of the
gain or loss; and
5. Calculating a new EIR for the modified liability, this is then
used in future periods.

Modification accounting
1. Adjusting the carrying value of the existing liability for
fees paid or costs incurred;
2. Amending the EIR at the modification date. The EIR is
amended such that the adjusted carrying amount and
the revised estimate of future cash flows are
discounted over the revised estimated life of the
liability;
3. No gain or loss is recorded on modification.

Example : debt extinguishment

The Tempe Company (Tempe) is a viable entity. On January 1,
2011, Tempe intends to extinguish some long-term notes by
calling the long-term notes under the provisions of the note
agreement. These notes are for $10 million at 10% annual
interest due December 31, 2012. Tempe also has $50,000 in
unamortized discount on notes payable, but no other deferred
costs attributable to the borrowing or accrued interest.
Management issues new debt with a new lender for the same
amount and maturity date at 9% annual interest. Management
has incurred $100,000 in legal costs to negotiate the
extinguishment of the long-term notes payable.

Example : debt extinguishment

The carrying amount of the 10% bonds of $9,950,000 along with
the issuance costs on the 9% notes of $100,000 are both included
in the calculation of the gain or loss on extinguishment.
Long-term notes payable 10% $9,950,000
Loss on extinguishment of note 150,000
Cash
$
100,000
Long-term notes payable 9%
10,000,000
The effective-interest is the same as the stated interest at 9%,
resulting in recording the interest expense as follows:
Interest expense $900,000

Example : debt modifications

Assume the same debt
situation as in the
previous example
except that
management has been
able to modify the
interest rate to 9% with
the same lender to
reflect current market
rates. The same legal
costs of $100,000 are

Example : debt modifications

The legal costs of $100,000 would be directly charged against the
carrying amount of the note and thus would be amortized over the
remaining term of the modified debt.
Long-term notes payable 10% $9,950,000
Cash
$ 100,000
Long-term notes payable 9%
9,850,000
On the next slide is an amortization table showing the effectiveinterest rate on the note of 9.8627% and related interest expense.
Note that amounts are rounded to the nearest thousand.

Example : debt modifications

*Rounded up for presentation purposes.

Interest expense
$971,000
Cash
Long-term notes payable 9%

$900,000
71,000

Troubled debt restructuring: transfer

of assets
Mikes Industrial Company (MIC) has an unused factory
in one of the Midwest states that has a book value and
fair value of $8.0 million. MIC obtained a mortgage on
the factory five years ago from a New York-based bank
and the current balance due to the bank totals $10
million. Interest is being paid currently by MIC; however,
MIC currently does not have use for the factory or the
revenues to support the debt. After a lengthy
negotiation process, MIC will be transferring the
underlying property to the bank, along with a payment
of $1.5 million. This will discharge MIC from the debt.

Troubled debt restructuring: transfer

of assets
MIC
Under this scenario, MIC would have a gain on the
restructuring, calculated as follows:
Mortgage note payable

$ 10,000,000

Less:carrying value of the building

Less: cash to the bank

(8,000,000)

(1,500,000)

Gain on discharge of debt

$ 500,000

Troubled debt restructuring: transfer

of assets
The journal entry would be as follows:
Mortgage notes payable$10,000,000

Facility

$8,000,000

Cash

1,500,000

Gain on discharge of debt

500,000

To record the settlement of the mortgage note payable

to the New York bank and the accompanying transfer of
the property.

Troubled debt restructuring: transfer

of assets
Example 6 solution (continued):
Bank
The bank would record a loss on the
restructuring calculated as follows:

The journal entry to record the

restructuring and loss would be as follows:

Mortgage receivable $ 10,000,000

Less: fair value of the building
(8,000,000
Less: cash received
(1,500,000)
Loss on restructuring $ 500,000

Facility
$8,000,000
Cash
1,500,000
Loan loss
500,000
Mortgage loans receivable
$10,000,000
To record the payment and settlement of
the mortgage loan from MIC and the
transfer of the property.

Debt to equity swap

The entity is legally released from its obligation to pay
cash to the lenders. The lenders accept the swap
because they expect the capital gain in the future.
When equity instruments issued to a creditor to
extinguish all or part of a financial liability are
recognised initially, an entity shall measure them at the
fair value of the equity instruments issued
The difference between the carrying amount of the
financial liability extinguished, and the consideration
paid, shall be recognised in profit or loss

Debt to equity swap : example

For example, entity A issued a 10 year debt instrument
for its par amount of CU 100. Some years later, entity A
was in financial difficulty. Entity A and its lenders agreed
to the extinguishment of the financial liability in
exchange for issuing equity instruments to the lenders.
The fair value of the equity shares issued in exchange
was CU 60
Dr. Bonds payable 100
Cr. Equity 60
Cr. Gain on discharge of debt 40

Illustration 3: debt modification

On 1.1.X1 entity A issues 10 year bonds for $1,000,000,
bearing interest at 10% (payable annually on 31.12 each year).
The bonds are redeemable on 31.12.X10 for $1,000,000. No
costs or fees are incurred. The effective interest rate is
therefore 10%.
On 1.1.X6 (ie after 5 years) Entity A and the bondholders agree
to a modification in accordance with which:
1. No further interest payments are made;
2. The bonds are redeemed on the original due date (31.12.X10) for
$1,600,000; and
3. Legal and other fees of $50,000 are incurred

Illustration 3: debt modification

(contd.)
Expected future cash flows : $1,600,000 discounted by
10% for remaining 5 years: $993,474
Plus costs incurred $50,000 = $1,043,474
Carrying value = $1,000,000
Difference = (1,043,474 1,000,000)/1,000,000= 0.04
Not substantial modification accounting
Journal entry on 1.1.X6:
Dr bonds payable
50,000
Cr cash
50,000

Illustration 3: debt modification (contd.)

The debtor should calculate new effective

interest rate and prepare new amortization
table at the date of modification

Illustration 3: debt modification (cont.)

journal entries by debtor

Illustration 4: extinguishment of
debt
Assume the same facts as illustration 3 with respect to the
original bonds.
On 1.1.X6 (ie after 5 years) Entity A and the bondholders agree
to a modification in accordance with which:
1. The term is extended to 31.12.X12;
2. Interest payments are reduced to $50,000;
3. The bonds are redeemable on 31.12.X12 for $1,600,000; and
4. Legal and other fees of $50,000 are incurred.
.Entity A determines that the market interest rate at which it
could issue new bonds with similar terms is 11% (on 1.1X6).

Illustration 4 (cont.)
Determine whether the changes is substantial or not:
1.

Compare the carrying value (CV) with present value of expected

future cash flows

2.

Expected future cash flows:

Present value of 1,600,000

discounted by 10% for remaining
7 years
Present value of annual interest
of 50,000 (10 %, 7 yr)
3.

Difference calculated is more than 10% extinguishment of debt.

Record gain/loss

Illustration 4 (cont.)
Calculation of gain or loss on debt extinguishment:
1. Estimate the fair value of the modified liability as the PV
of the future cash flows (interest and principal), using
market interest rate at the date of extinguishment (the
market rate at which Entity A could issue new bonds with
similar terms). Not the original effective interest rate.
2. A gain or loss on modification is then determined as:
Gain (loss) = carrying value of existing liability - fair value of
modified liability - fees and costs incurred

Illustration 4 (cont.)
Fair value of new debt:
1. PV of 1,600,000 (7 years, 11%)
2. PV of annual interest payment 50,000 (7
years, 11%)

Journal entry:
.Dr. Bonds payable 1,000,000
.Dr. Loss on extinguishment 56,263
.Cr. bonds payable 1,006,263
.Cr. Cash 50,000

Illustration 4

The debtor should prepare

new amortization table at
(cont.) the date of extinguishment

Illustration 4
(cont.)