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Intermediate Accounting November 4 th , 2010. General Course Questions Chapter 7 Cash and Receivables (using assigned homework) A. Recording Bad Debt Expense Problems 2,4, and 6 B. Using Receivables to Raise Cash ?17 & 19 BE 8 , 9, & 10

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Intermediate AccountingNovember 4th, 2010

  • General Course Questions

  • Chapter 7 Cash and Receivables(using assigned homework)

    A. Recording Bad Debt Expense Problems 2,4, and 6

    B. Using Receivables to Raise Cash ?17 & 19 BE 8, 9, & 10

    C. A/R journal entries, turnover and liquidity Ex 20

    D. Long-term Notes Receivable ?16, BE 17, ex 6, 7 & 18

    3. Chapter 7 Assignments for Tuesday, November 9th:

    A. Using Receivables to Raise Cash (Ex 14, 16, 17, Pr 7 & 11)

    B. Loan Impairments (Ex 27 and problem 15)

    4. Review Project 1 Columbia Sportswear 10-K

    5. Additional Questions and Review of Midterm Exam


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Estimating Uncollectible Receivables

Methods of Accounting for Uncollectible Accounts

  • Direct Write-Off

  • Theoretically undesirable:

    • A/R are written off when determined uncollectible

    • No matching (Expense and Revenue not likely recorded in the same period)

    • Receivables not stated at net realizable value (no Balance Sheet account for “allowance for bad debts”)

    • Not GAAP, unless bad debt expense in immaterial

Allowance Method

Losses are Estimated using an contra account (Allowance for Bad Debts):

  • Percentage-of-sales

  • Meets GAAP Matching requirement - Bad Debt expense estimated in same period as Sale.

  • Percentage-of-receivables

  • Meets GAAP - Receivables are carried at net realizable value


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Uncollectible Accounts Receivable

Income Statement Approach (ignore Balance Sheet Accounts – A/R & Allowance Account) Use “Sales” to estimate the “Bad debt expense” for the period.

Balance Sheet Approach (ignore Income Statement accounts – Sales and Bad Debt Expense) Use A/R to determine what the ending Balance in the Allowance Account should be (adjust it).

Entry: Debit: Bad Debt Expense (temporary account, 0 before adj.)

Credit: Allowance for Doubtful Accounts (permanent account)


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AR Allowance Methods: Determining the Amount of the Adjustment

Percent of Receivables Allowance method

  • Balance-sheet oriented

  • Uses one B/S account (AR) to estimate another B/S account (Allowance)

  • Estimates the ENDING balance in the allowance account

  • Bad debt expense is the “plug”

    Percent of Sales Allowance method

  • Income-statement oriented

  • Uses one I/S account (revenue) to estimate another I/S account (bad debt expense)

  • Estimates the TOTAL bad debt expense

  • The allowance is the “running total”

Entry: Debit: Bad Debt Expense (temporary account, 0 before adj.)

Credit: Allowance for Doubtful Accounts (permanent account)


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Balance Sheet Representation Adjustment

Short-term accounts receivable are shown at their net realizable value as follows:

Accounts Receivable (gross): $ XXX

less: Allowance: ($ XX)

Net Realizable Value: $ XX

Or present in line item as:

“AR net of $xxx allowance for doubtful accounts”


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Disposition of Accounts and Notes Receivable Adjustment

Owner may transfer accounts or notes receivables to another company for cash.

Reasons:

  • Competition.

  • Sell receivables because money is tight.

  • Billing / collection are time-consuming and costly.

Transfer accomplished by:

  • Secured borrowing (Holder retains ownership of receivables in a secured borrowing transaction)

  • Sale of receivables (Holder transfers ownership of receivables in a sale)


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Secured Borrowing Adjustment

Sale

With Recourse

Without Recourse

Accounting for Transfers of Receivables

Transfers

  • Seller guarantees payment if debtor does not pay

  • Factored receivables are written off, loss on sale recognized and includes estimate of a recourse liability of future payment firm will have to make for uncollectible receivables sold

  • Seller has no future obligation

  • Write-off factored receivables (and recognize any gain / loss)


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Secured Borrowing – the Basics Adjustment

  • Overall - Receivables remain on the books of the company borrowing money (i.e. – no sale) (and continue to treat A/R as usual (collections, write-off, etc.)

  • Also called “pledged” receivables

  • Transferor:

    • Records liability

    • Records a finance charge.

    • Collects accounts receivable.

    • Records sales returns and sales discounts.

    • Absorbs bad debts expense.

    • Records interest expense on notes payable.

    • Pays on the note periodically from collections.


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Sale Adjustment of Receivables – the Basics

  • Factor records the (transferred) accounts as assets in its books.

  • Transferor:

    • Transfers ownership of receivables to factor.

    • Records any amount retained by transferee as “due from factor.”

      • This is an amount held back to allow customer adjustments for sales returns and allowances

    • Records loss on sale of receivables.

    • Records any component liability IF with recourse

      • i.e., any estimated future liability that the transferor will need to pay if customers do not pay


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Secured Borrowing Example Adjustment

To help overcome a cash shortage, H Software took out a $1,000 loan with T Bank. H Software used $3,000 of A/R as collateral for the loan. T Bank withheld $30 as a finance charge, and forwarded $970 to H Software on July 1. H Software collected the on the accounts on July 31 ($120 were written off), and repaid T Bank on August 2nd with interest of $50.

July 1:

July 31:

August 2:


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Secured Borrowing Example Adjustment

To help overcome a cash shortage, H Software took out a $1,000 loan with T Bank. H Software used $3,000 of A/R as collateral for the loan. T Bank withheld $30 as a finance charge, and forwarded $970 to H Software on July 1. H Software collected the on the accounts on July 31 ($120 were written off), and repaid T Bank on August 2nd with interest of $50.

July 1:

Dr. Cash 970

Dr. Finance charge 30

Cr. Note Payable 1,000

July 31:

Dr. Cash 2,880

Dr. Allowance for doubtful accounts 120

Cr. A/R 3,000

August 2:

Dr. Interest Expense 50

Dr. Note Payable 1,000

Cr. Cash 1,050


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Sales of Receivables Adjustment

Factorsare finance companies or banks that buy receivables from businesses for a fee.


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Sales of Receivables Adjustment

Sale Without Recourse

  • Purchaser assumes risk of collection

  • Transfer is outright sale of receivable

  • Seller records loss on sale

  • Seller use Due from Factor (receivable) account to cover discounts, returns, and allowances

Sale With Recourse

  • Seller guarantees payment to purchaser

  • Financial components approach used to record transfer


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Sales of Receivables Adjustment

Illustration:Crest Textiles, Inc. factors $500,000 of accounts receivable with Commercial Factors, Inc., on a without recourse basis. Commercial Factors assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments).

Journal entry by Crest Textiles:

Journal entry by Commercial Factors:


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Sales of Receivables Adjustment

Illustration:Crest Textiles, Inc. factors $500,000 of accounts receivable with Commercial Factors, Inc., on a without recourse basis. Commercial Factors assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments).

Journal entry by Crest Textiles:

Cash $ 460,000

Due from Factor 25,000

Loss on Sale of Receivables 15,000

Accounts Receivable $500,000

Journal entry by Commercial Factors:

Accounts Receivable $500,000

Due to Crest Textiles $25,000

Financing Revenues 15,000

Cash 460,000


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Sales of Receivables Adjustment

Illustration: Assume Crest Textiles sold the receivables on a with recourse basis. Crest Textiles determines that this recourse obligation has a fair value of $6,000.

Journal entry by Crest Textiles:

Journal entry by Commercial Factors:


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Sales of Receivables Adjustment

Illustration: Assume Crest Textiles sold the receivables on a with recourse basis. Crest Textiles determines that this recourse obligation has a fair value of $6,000.

Journal entry by Crest Textiles: (recourse Liab. increases loss)

Cash $ 460,000

Due from Factor 25,000

Loss on Sale of Receivables 21,000

Accounts Receivable $500,000

Recourse Liability 6,000

Journal entry by Commercial Factors: (no change)

Accounts Receivable $500,000

Due to Crest Textiles $25,000

Financing Revenues 15,000

Cash 460,000


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Presentation & Disclosure of Receivables Adjustment

Rules:

  • Segregate different types of receivables if material

  • Offset valuation accounts against gross balance

  • Ensure all current receivables will really be converted to cash within a year or operating cycle, whichever is longer

  • Disclose any loss contingencies on the receivables

  • Disclose amounts pledged as collateral

  • Disclose significant concentrations of credit risk


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Analysis of Receivables Adjustment

What is purpose of analysis?

Ratios used

AR Turnover = Net Sales/Average net Trade AR

Days AR or Average Collection Period = 365 days/AR turnover

Exercise 20


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Recognition of Notes Receivable Adjustment

  • Supported by a formal promissory note (negotiable instrument)

  • Maker signs in favor of a Payee

  • Interest-bearing (has a stated rate of interest) OR

  • Zero-interest-bearing (interest included in face amount)

Generally originate from:

  • Customers who need to extend payment period of an outstanding receivable

  • High-risk or new customers

  • Loans to employees and subsidiaries

  • Sales of property, plant, and equipment

  • Lending transactions (the majority of notes)


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Recognition of Notes Receivable Adjustment

Short-Term

Long-Term

Record at Face Value,

less allowance

Record at Present Value

of cash expected to be collected

Note Issued at

Interest Rates

Stated rate = Market rate

Stated rate > Market rate

Stated rate < Market rate

Face Value

Premium

Discount


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Notes Issued at Face Value AdjustmentStated Rate = Market Rate

On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 6%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%.

How much should the Note Receivable be recorded for?

What is the fair value of the transaction?

  • PV of cash interest payments

  • PV of principle payment


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Notes Issued at Face Value AdjustmentStated Rate = Market Rate

On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 6%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%.

How much should the Note Receivable be recorded for?

i = 6%

$600,000 Principal

$36,000

36,000

36,000 Interest

0

1

2

3

4

n = 3

  • What is the fair value of the transaction?

    • PV of cash interest payments 3 n 6% I/Y 36,000 pmt; cpt PV_______

    • PV of principle payment


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Notes Issued at Face Value AdjustmentStated Rate = Market Rate

On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 6%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%.

How much should the Note Receivable be recorded for?

i = 6%

$600,000 Principal

$36,000

36,000

36,000 Interest

0

1

2

3

4

n = 3

  • What is the fair value of the transaction?

    • PV of cash interest payments 3 n 6% I/Y 36,000 pmt; cpt PV $ 96,228,43

    • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57


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Notes Receivable: AdjustmentStated Rate = Market Rate


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Notes Issued at Face Value AdjustmentStated Rate = Market Rate

Summary

  • Present value of interest $ 96,228,43

  • Present value of principal $503,771.57

  • Note current market value $600,000.00

  • Notes receivable 600,000

    Consulting Revenue 600,000

    Cash 36,000

    Interest revenue 36,000


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    Notes Issued at Face Value AdjustmentStated Rate < Market Rate

    On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 3%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%.

    How much should the Note Receivable be recorded for?

    i = 3%

    $600,000 Principal

    $18,000

    18,000

    18,000 Interest

    0

    1

    2

    3

    4

    n = 3

    • What is the fair value of the transaction?

      • PV of cash interest payments 3 n 6% I/Y 18,000 pmt; cpt PV _________

      • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57


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    Notes Issued at Face Value AdjustmentStated Rate < Market Rate

    On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 3%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%.

    How much should the Note Receivable be recorded for?

    i = 3%

    $600,000 Principal

    $18,000

    18,000

    18,000 Interest

    0

    1

    2

    3

    4

    n = 3

    • What is the fair value of the transaction?

      • PV of cash interest payments 3 n 6% I/Y 18,000 pmt; cpt PV $ 48,114.22

      • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57


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    Notes Receivable: AdjustmentStated Rate < Market Rate

    On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 3%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%.

    Is this a discount or a premium?

    How much should the Note Receivable be recorded for?


    Notes receivable stated rate market rate30 l.jpg
    Notes Receivable: AdjustmentStated Rate < Market Rate

    Fair value of transaction:

    Interest: $ 48,114.22

    Principle:` $503,771.57

    $551,885.79

    Journal entry at 12/31/07:

    Note Receivable $600,0000

    Discount on Note Rec. $48,114.21

    Consulting Revenue 551,885.79


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    N/R: Stated Rate < Market Rate AdjustmentEffective Interest Amortization


    N r stated rate market rate effective interest amortization32 l.jpg
    N/R: Stated Rate < Market Rate AdjustmentEffective Interest Amortization


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    Notes Receivable: AdjustmentStated Rate < Market Rate

    Journal Entries:


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    Notes Receivable: AdjustmentStated Rate < Market Rate

    Journal Entries:

    Cash $18,000

    Discount on Note Receivable $15,113

    Interest Revenue $ 33,113

    Cash $18,000

    Discount on Note Receivable $16,020

    Interest Revenue $ 34,020

    Cash $18,000

    Discount on Note Receivable $16,981

    Interest Revenue $ 34,981


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    Notes Issued at Face Value AdjustmentStated Rate > Market Rate

    On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 9%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%.

    How much should the Note Receivable be recorded for?

    i =9%

    $600,000 Principal

    $54,000

    54,000

    54,000 Interest

    0

    1

    2

    3

    4

    n = 3

    • What is the fair value of the transaction?

      • PV of cash interest payments 3 n 6% I/Y 54,000 pmt; cpt PV $

      • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57


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    Notes Issued at Face Value AdjustmentStated Rate > Market Rate

    On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 9%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%.

    How much should the Note Receivable be recorded for?

    i =9%

    $600,000 Principal

    $54,000

    54,000

    54,000 Interest

    0

    1

    2

    3

    4

    n = 3

    • What is the fair value of the transaction?

      • PV of cash interest payments 3 n 6% I/Y 54,000 pmt; cpt PV $144,342.65

      • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57


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    Notes Receivable: AdjustmentStated Rate > Market Rate

    On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 9%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%.

    Is this a discount or a premium?

    How much should the Note Receivable be recorded for?


    Notes receivable stated rate market rate38 l.jpg
    Notes Receivable: AdjustmentStated Rate > Market Rate

    Fair value of transaction:

    Interest: $144,342.65

    Principle:` $503,771.57

    $648,114.22

    Journal entry at 12/31/07:

    Note Receivable $600,0000

    Premium on Note Rec $48,114.21

    Consulting Revenue 648,114.21


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    N/R: Stated Rate > Market Rate AdjustmentEffective Interest Amortization


    N r stated rate market rate effective interest amortization40 l.jpg
    N/R: Stated Rate > Market Rate AdjustmentEffective Interest Amortization


    Notes receivable stated rate market rate41 l.jpg
    Notes Receivable: AdjustmentStated Rate > Market Rate

    Journal Entries


    Notes receivable stated rate market rate42 l.jpg
    Notes Receivable: AdjustmentStated Rate < Market Rate

    Journal Entries:

    Cash $54,000

    Premium on Note Receivable $15,113

    Interest Revenue $ 38,887

    Cash $54,000

    Premium on Note Receivable $16,020

    Interest Revenue $ 37,980

    Cash $54,000

    Premium on Note Receivable $16,981

    Interest Revenue $ 37,019


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    Non-interest Bearing Notes Adjustment

    This is a special case of a discount.

    Steps:

    1. Determine issue price on notes receivable at implicit rate of interest

    2. The discount is amortized to interest revenue by the effective interest method


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    Notes Receivable – Non-Interest Bearing Adjustment

    On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with a list price of $10,000. Mickey signs a non-interest bearing note promising to pay Mouse Co. $10,000 on December 31, 2007. The fair value of the machine on 1/1/06 is $7,972.

    Implicitly, how much interest revenue will Mouse receive over the 2 year period of the note?

    What is the implicit interest rate on this note receivable?

    • It is the rate that equates the fair value of the machine today $7972 to the $10,000 that will be received in two years

      $7,972 PV, 2 N, 10,000 FV CPT I/Y = ___________%


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    Notes Receivable – Non-Interest Bearing Adjustment

    On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with a list price of $10,000. Mickey signs a non-interest bearing note promising to pay Mouse Co. $10,000 on December 31, 2007. The fair value of the machine on 1/1/06 is $7,972.

    Implicitly, how much interest revenue will Mouse receive over the 2 year period of the note?

    What is the implicit interest rate on this note receivable?

    • It is the rate that equates the fair value of the machine today $7972 to the $10,000 that will be received in two years

      $7,972 PV, 2 N, 10,000 FV CPT I/Y = 11.99995 or 12%


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    Notes Receivable – Non-Interest Bearing Adjustment

    On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with a list price of $10,000. Mickey signs a non-interest bearing note promising to pay Mouse Co. $10,000 on December 31, 2007. The fair value of the machine on 1/1/06 is $7,972.

    Implicitly, how much interest revenue will Mouse receive over the 2 year period of the note?

    What is the implicit interest rate on this note receivable?

    • It is the rate that equates $7972 at t=0 to $10,000 at t=2

    • 7,972F = 10,000; or F=10,000/7,972 = 1.2544

    • In table 6.1, Future Value of 1 (p. 303), the rate is 12% (F=1.2544, n = 2)-


    Note rec non interest bearing effective interest amortization l.jpg
    Note Rec.: Non-Interest Bearing AdjustmentEffective Interest Amortization


    Note rec non interest bearing effective interest amortization48 l.jpg
    Note Rec.: Non-Interest Bearing AdjustmentEffective Interest Amortization


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    Notes Receivable – Non-Interest Bearing Adjustment

    January 1, 2006:

    December 31, 2006:

    December 31, 2007:


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    Notes Receivable – Non-Interest Bearing Adjustment

    January 1, 2006:

    Notes Receivable $7,972

    Sales $7,972

    December 31, 2006:

    Notes Receivable $956.64

    Interest Income $956.64

    December 31, 2007:

    Notes Receivable $1071.44

    Interest Income $1071.44

    Cash $10,000

    Notes Receivable $10,000


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    Impairment of Long-Term Receivables Adjustment

    • When does impairment occur?

    • Companies evaluate their receivables to determine their ultimate collectibility.

    • Allowance method is appropriate when:

      • probable that an asset has been impaired and

      • amount of the loss can be reasonably estimated.

    Long-term receivables such as loans that are identified as impaired, companies perform an additional impairment evaluation.


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    Impairment of Long-Term Receivables Adjustment

    Impairment Measurement and Reporting

    Impairment loss is calculated as the difference between

    • BOOK VALUE: the investment in the loan (generally the principal plus accrued interest) and

    • PV of FUTURE CASH FLOWS: the expected future cash flows discounted at the loan’s historical effective interest rate.

  • How


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    Impairment of Long-Term Receivables Adjustment

    Example: Brillard Properties owes First Prudent Bank $30million under a 10% note with two years remaining until maturity. Due to financial difficulties of the developer, the previous year’s interest of $3million was not paid. First Prudent agrees to

    1. Suspend the interest payment from last year until the following year

    2. Reduce the remaining two interest payments to $2 million each

    3. Reduce the principal to $25 million

    4. Later decides to forgive the interest payment from last year.

    How much impairment loss should be recorded?


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    Impairment of Long-Term Receivables Adjustment

    Book value of asset:

    Accrued interest (10% x $30million) $ 3,000,000

    Principal 30,000,000

    Carrying amount of the receivable $33,000,000

    New Value:

    PV of future interest ($2million x 1.73554) $3,471,080

    PV of principal ($25million x .82645) 20,661,250

    PV of receivable (24,132,330)

    Loss $8,867,670

    Journal Entry

    Loss on troubled debt restructuring 8,867,670

    Accrued interest receivable 3,000,000

    Note receivable ($30,000,000-24,132,330) 5,867,670


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    Impairment of Long-Term Receivables Adjustment

    Illustration: At December 31, 2009, 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. The loan officer performs a review of the loan’s expected future cash flow and utilizes the present value method for measuring the required impairment loss.


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    Impairment of Long-Term Receivables Adjustment

    Illustration: Computation of Impairment Loss

    Recording Impairment Losses

    Bad Debt Expense 12,437

    Allowance for Doubtful Accounts 12,437


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