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    IA1 - Chapter 6

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    Layla Main

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    © All Rights Reserved
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    312 eR Chapter 6 Receivables — Additional Concept, Related standards: PERS 9 Financial Instruments PERS 15 Revenue from Contracts with Customers PAS 32 Financial Instruments: Presentation Learning Objectives 1. Explain the accounting for origination costs and fees, 2. Account for the impairment of receivables. 3. Identify the instances where derecognition of receivable is appropriate. Loans receivable Loan receivable is similar to note receivable in that it is also a claim supported by formal promise to pay a certain sum of money at specific future date(s) usually in the form of a promissory note However, the term “loans receivable” is more appropriately used by entities whose main operations involve lending of money, such as banks, financing companies, lending companies, insurance companies, pawnshops, non-bank intermediaries like savings an loans associations, credit cooperatives, and the like. The accounting for loans receivable is similar to the accounting for notes receivable, except that loan transactions usually involve transaction costs. Recall that receivables oe initially measured at fair value plus transaction costs. > Transaction costs are “incremental costs that ar° aes attributable to the acquisition, issue or disposal of a Firat asset or financial liability. An incremental cost #6 OM 4, would not have been incurred if the entity had not #7) y issued ot disposed of the financial instrument.” (PF#5°P Scanned with CamScanner receivables — Additional Concepts os Transaction costs include fees and commissions paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs. Origination costs and fees Lenders usually incur costs in originating loans. These costs are either direct origination costs (transaction costs) or indirect origination costs. The lenders recover these costs from borrowers by charging them origination fees. These fees include compensation for activities such as evaluating the borrower's financial condition, evaluating and recording guarantees, collateral securities and other arrangements, negotiating the terms of the instrument, preparing and processing documents and closing the transaction. Origination fees are usually expressed as a percentage of the Principal amount of the loan and are directly deducted from the loan proceeds released to the borrower. Accounting for origination costs and fees Direct origination costs and origination fees are included in the Measurement of loans receivables. > Direct origination costs are initially added to the carrying amount of the loan and are subsequently amortized using the effective: interest method. The subsequent amortization decreases both the carrying amount of the loan and interest Income, Origination fees are initially deducted from the carrying amount of the loan and subsequently amortized using the effective interest method. The subsequent amortization creases both the carrying amount of the loan and interest iNcome. Scanned with CamScanner a 3 iti > Indirect origination costs are not included in measurement of receivables. These are expensed immediate Direct origination costs and origination fees are inchudeg in the calculation of the effective interest rate. On transaction date direct origination costs and origination fees are treateq adjustments to the effective interest rate. Illustration: Origination costs and fees On January 1, 20x1, ABC Bank extended a 10%, P1,000,000 loan to XYZ, Inc. Principal is due on January 1, 20x4 but interests are due annually every January 1. ABC Bank incurred direct loan origination costs of P12,000 and indirect loan origination costs of P8,000. In addition, ABC Bank charged XYZ a 6-point nonrefundable loan origination fee. Requirements: Compute for the following: a. Initial carrying amount of the loan receivable. b. Interest income in 20x1. Solutions: Requirement (a): Initial carrying amount of the loan receivable Principal amount 1,000,000 Direct origination cost 12,000 Origination fee (1,000,000 x 6%) + (60,000) Initial carrying amount of loan receivable 952,00L, The indirect origination cost of P8,000 is chara immediately as expense and not included in the’ measurement the loan receivable. The entries on January 1, 20x1 are as follows: Scanned with CamScanner receivables — Additional Concepts 315 jon.1, | Loan receivable 1,000,000 20x1 Cash (1M - 60,000) 940,000 Unearned interest income 60,000 to record the release of loan, net of arigination fees jn.1, | Unearned interest income 12,000 20x1 Cash 12,000 to record the direct origination costs ja.1, | Administrative expense 8,000 20x1 Cash 8,000 to record the indirect origination costs| Requirement (b): Interest income in 20x1 As stated earlier, direct origination costs and origination fees are adjustments to the effective interest rate. Therefore, subsequent interests will not be computed using the stated interest rate of 10% but rather using an imputed interest rate. Also as discussed in the previous chapter, this rate can be computed using various methods, one of which is the “trial and error” approach. Trial and error Before we use again the trial and error approach, we need to understand the following additional concepts to limit the number of “tries” that we will be making: = When the initial carrying amount of a financial instrument is less than its face amount, the financial instrument is said to be at a discount. * When the initial carrying amount of a financial instrument is more than its face amount, the financial instrument is said to be ata premium. Carrying amount is less than Face amount Carrying amount is greater than Face amount When a financial instrument is at a discount, the effective rate is higher than the nominal rate. On the other hand, interest Scanned with CamScanner ’ : SMe Chapter when a financial instrument is at a premium, the effective interes, tate is lower than the nominal rate. Discount Effective interest rate is higher than Nominal Tate Premium Effective interest rate is lower than Nominal Tate There is no discount or premium when the initial carrying amount of the financial instrument is equal to the face amount Consequently, the effective interest rate is also equal to the nominal rate. Continuing the illustration, we know that the loan is issued at a discount because the initial carrying amount of 952,000 is Jess than the face amount of P1,000,000. Therefore, the effective interest rate that we will be estimating is higher than the nominal rate of 10%. Using the “trial and error” approach, let us first try 11%. Future cash flows x PV factor @ x% = Present value of note First trial (using 11%): > Principal of (1,000,000 x PV of 1 @11%, n=3) + Interest of (100,000 x PV of ordinary annuity @11%, n=3) = 952,300 > (1,000,000 x 0.731191381) + (100,000 x 2.443715) = 952,000 > (731,191 + 244,372) = 975,563 is not equal to 952,000, @ difference of 23,563. We need a lower amount; therefore, we need to increase the rate. Let us try 12%. Second trial (using 12%): > (1,000,000 X PV of 1 @12%, n=3) + (100,000 x PV of ordinasl annuity @12%, n=3) = 952,000 (1,000,000 x 0.711780248) + (100,000 x 2.401831268) = 952,000 > (711,780 + 240,183) = 951,963 approximates 952/00 difference of only 37. ‘ > a Scanned with CamScanner 7 eiontes — Additonal Concepts Re 317 If the difference of P37 is judged as immaterial, we can use 12% as the effective interest rate. In which case, no further 1 rpolation is performed. If other tools are used, the exact imputed interest rate is 11.985489449%. ‘Altemative ‘solution on a nonscientific calculator: rast rial at 11%. Press 1.11 [=] [=] [=] three times (equal to ‘n’ of 3). Multiply resulting factor by 1M. Save resulting amount in memory (e.9., or equverent Next, press 1.11 [+] [+] [=], then[=] three times (equal to'n' of 3) [= +|11% [=] Disregard negative sign [+/- | Multiply resultin, factor ee 00, 000. Add amount to memory. Press “memory recall” (eg., MRC or equivalent). You should come up with 975,563 which is not equal to e000. Second trial at 12%. Press 1.12[+] [+] [=] three times (equal to ‘n’ of 3). Multiply resulting factor by 1M. Save resulting amount in memory (e.g., M+, or equivalent), Next, press 1.12 [+] [+] [=], then [=]three times (equal to'n' of 3) [=] [4 12% [=] Disregard negative sign +f] Multiply resuling factor by 100,000. Add amount to memory. Press “memory recall” g., MRC approximates 952,000 (a difference of only 37). Amortization table — installment: or equivalent). You should come up with 951,963 which Collections Interest Present Date ofinterests income Amortization value Jon, 1, 20x1 952,000 Jon. 1, 2042 100,000 114,240 14,240 966,240 Jan, 1, 20x3 100,000 115,949 15,949 982,189 Jen, 1, 204 100,000 117,863 17,863 1,000,051 Te entry on December 31, 20x] is as follows: aa Interest receivable 100,000 Unearned interest 14,240 Interest income 114,240 \ to accrue interest income On the part of the XYZ, Inc., the borrower, the carrying Mount of i Scanned with CamScanner ts liability on January 1, 20x1 is determined as follows: Bi Chater — Principal amount 1,000,099 Discount on loan payable (1,000,000 x 6%) (60,099 Initial carrying amount of loan payable The entry in XYZ, Inc.’s books to record the loan payable is as follows: Jan. 1, | Cash 940,000 20x1 | Discount on loan payable 60,00 Loan payable 1,000,000 “Day 1” difference If the transaction price for a financial instrument differs from the fair value on initial recognition, the difference is recognized as gain or loss in profit or loss. This difference is sometimes referred to as “Day 1” difference. Illustration 1: “Day 1” difference On January 1, 20x1, ABC Co. extended a P 1,000,000, zero-interest loan to one of its directors. The loan matures in lump sum on January 1, 20x4. The prevailing interest rate for this type of loan is 10%. Case #1: Loan proceeds equal to present value Assume that the loan proceeds extended to the director is equal to the present value of the loan receivable. Requirement: Provide the journal entry on initial recognition. Solution: The present value of the loan receivable is determined as follows‘ Future cash flow 1,000,000 Multiply by PV of P1 @10%, n=3 0751315. Present value of loan receivable 751,315. Scanned with CamScanner r joables Additional Concepts 319 Rect Face amount 1,000,000 present value of loan receivable (751,315) Unearned interest income 248,685 The entry on January 1, 20x1 is as follows: yt. | Loan receivable 1,000,000 a Cash* 751,315 Unearned interest 248,685 2 There is no accounting problem in this case because the transaction price (price paid) is equal to the fair value at initial recognition (present value). Present value of loan receivable Transaction price (Cash paid) Difference Case #2: Loan proceeds equal to face amount 751,315 (751,315) Assume that the loan proceeds extended to the director is equal to the face amount of the loan receivable. Requirement: Provide the journal entry on initial Tecognition. Solution: (See computations for present value and unearned interest income above.) The ent on January 1, 20x1 is as follows: fm. Loan receivable Unrealized loss - “Day 1” difference Cash > Unearned interest 1,000,000 248,685 1,000,000 248,685 ’ An ac P cor gee sities Price unting problem arises in this case because the transaction PI Scanned with CamScanner ti ie Ce paid) is not equal to the Jair value at initial recognition ” 320 Chapter a a (present value). The difference (‘Day 1’ difference) is Tecognized jn profit or loss. Present value of loan receivable 751,315 Transaction price (Cash paid) (1,000,009) ‘ HH Difference - Unrealized loss (248,685) — ee) Case #2 is more common in practice. Impairment The ‘final version’ of PFRS 9 introduces a fundamental change in the accounting for impairment of financial assets, from the “incurred loss” model to a forward-looking expected credit loss model. This is following criticisms regarding delays in the recognition of credit losses under the old “incurred loss” model. Under the old model, an entity recognizes impairment only when there is objective evidence‘ of a loss event. Under the new model, an entity will always estimate expected credit losses using a ‘multi-factor and holistic’ analysis of credit risk that considers not only past events but also forward-looking information on current conditions and forecasts of future economic conditions. Thus, under the new model, the recognition of impairment does not necessarily depend on the identification of loss events. Scope The expected credit loss model shall be applied to all debt ineteements that are not measured at fair value through profit of loss. The expected credit loss model (ECL) The ECL model requires three approaches depending on the tyP* of asset or credit exposure. These are summarized below: Scanned with CamScanner — Additional Concepts peceonbles —_Approac e Simplified approac! Trade receivables, contract ssets and lease receivables 3 riginated or purchased credit-impaired financial « Changes in lifetime expected credit losses |___ approach e General approach (i.e., ‘three-stage’ or ‘three- bucket’ approach) assets _ 3, Other assets/exposures General approach The general approach is based on three stages which are intended to reflect the credit deterioration and improvement of a financial instrument. An overview of this ‘three-stage’ or ‘three-bucket’ approach is shown below: Stage 1 Stage 2 Stage 3 * Credit risk has e = Credit risk has ° = Credit risk has not increased increased increased significantly since significantly since significantly since initial recognition. initial recognition. initial recognition * ‘Low credit risk’ plus there is expediency objective evidence _ | of impairment. > Recognize > Recognize > Recognize a 12-month Lifetime expected Lifetime expected expected credit credit losses credit losses losses fee che te ae ef et > Interest revenues | > Interest revenue is | > Interest revenue is | computed on the computed on the computed on the 8ross carrying gross carrying net carrying amount of the amount of the amount (i.e., gross asset asset carrying amount ‘ less loss allowance) Change in credit risk since initial recognition 'MPROVEMENT S———_ DETERIORATION Scanned with CamScanner a? 322 q losses. > An entity recognizes a loss allowance for expecteq crea it 4s allowance — is the allowance for expected credit losses fi. ncial assets that are within the scope of the impairmen, requirements of PFRS 9. Expected credit losses - is “the weighted average of credit losses with the respective risks of a default Occurring as the weights.” (PFRS9.Appendix A) Credit loss — is “the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive (ie, all cash shortfalls), discounted at the original effective interest tate (or credit-adjusted effective interest rate for purchased or originated credit-impaired financial assets).” (PFRS 9.Appendix A) The amount of the loss allowance shall reflect the credit quality of the instrument. As shown on the table above: 1. If credit risk has not increased significantly since initial recognition or if the entity opts to apply the ‘low credit risk’ expediency, the entity shall recognize a loss allowance equal to 12-month expected credit losses. * - 12-month expected credit losses — “The portion of lifetime expected credit losses that tepresent the expected credit losses that result from default events on a financial instrument that are possible within 'the 12 months after the Teporting date.” (PFRS 9.Appendix A) * Credit risk - “The risk that one party to a financid instrument will cause a financial loss for the other party PY failing to discharge an obligation.” (PERS 7.Appendix A) the > ‘Low credit risk’ expediency: An entity may assume tha credit risk has not increased significantly since iN! Scanned with CamScanner Receivables = Additional Concepts 323 recognition if the financial instrument is determined to have low credit risk at the reporting date. This optional simplification is designed to relieve entities from tracking changes in the credit risk of high quality assets. This option can be applied on an instrument by instrument basis. 2, If credit risk has increased significantly since initial recognition but there is no objective evidence of impairment, the entity shall recognize a loss allowance equal to lifetime expected credit losses. ° Lifetime expected credit losses — "The expected credit losses that result from all possible default events over the expected life of a financial instrument.” (PFRS 9.Appendix A) 3. If credit risk has increased significantly since initial recognition and there is an objective evidence of impairment, the entity shall also recognize a loss allowance equal to lifetime expected credit losses. Notice that the measurement of loss allowance is the same in ‘Stages 2 and 3.’ However, the measurement of interest revenue varies. Under Stage 2, interest revenue is measured on the gross carrying amount of the instrument while under Stage 3, interest Tevenue is measured on the net carrying amount of the instrument (ie, gross carrying amount less loss allowance). If the credit quality of an instrument improves, an entity May revert to measuring the loss allowance from the lifetime expected credit losses to the 12-month expected credit losses. A decrease in the loss allowance is tecognized as a gain. lustration: 12-month vs. Lifetime expected credit losses BC Co, issues 3-year, interest-bearing loan of P1,000,000 on August 1, 20x1. ABC Co. makes the following estimates of risks and default losses: Scanned with CamScanner 324 Risk of default Loss from ~ ___ Date Next 12 months Remaining mos. default Aug. 1, 20x1 2.00% 5.00% 400,000 Dec, 31, 20x1 3.00% 12.00% 350,000 Dec. 31, 20x2 1.00% 3.00% 250,000 Requirements: Compute for the amount of loss allowance on the following dates: a. August 1, 20x1 b. December 31, 20x1 c. December 31, 20x2 Solutions: Requirement (a): Initial recognition On initial recognition, ABC Co. shall recognize 12-month expected credit losses of P8,000 (2% x 400,000). Notice that under the expected credit loss model, losses are recognized even on initial recognition. This treatment differs from the old incurred loss model wherein losses are recognized only after initial recognition when a loss event has been identified. The entry to recognize the loss allowance is as follows: Aug. 1, | Impairment loss 8,000 20x1 Loss allowance 8,000 Requirement (b): Dec. 31, 20x1 At each reporting date, ABC Co, shall determine whether there has been a significant increase in credit risk since initia recognition. The assessment is made as'follows: Scanned with CamScanner eceinables ~ Additional Concepts Baa ee gg Risk of default in: Date Next 12 months Remaining mos. Total (a) (b) () = (a) + (b) ‘Aug. 1, 20x1 2.00% 5.00% 7.00% Dec. 31, 20x1 3.00% 12.00% 15.00% The total risk increased from 7% to 15%. Although PFRS 9 does not quantify what constitutes ‘low risk’ or ‘significant increase,’ the increase in the risk in the illustration above may be deemed significant (as it has more than doubled!). Accordingly, ABC Co. shall measure the loss allowance equal to the lifetime expected credit losses of P52,500 (15% x 350,000). The entry to adjust the loss allowance is as follows: Dec.31, | Impairment loss 44,500 | 20x1 Loss allowance (52,500 - 8,000) 44,500 | Requirement (c): Dec. 31, 20x2 ABC Co. shall again determine whether the credit risk has increased significantly since August 1, 20x1. Risk of default in: Date Next 12 months Remainingmos. _ Total (a) (b) (c) = (a) + (b) Aug. 1, 20x1 2.00% 5.00% 7.00% Dec. 31, 20x1 3.00% 12.00% 15.00% Dec. 31, 20x2 1.00% 3.00% 4.00% The total risk on December 31, 20x2 has decreased to 4%, which is lower than the 7% total risk on initial recognition. Therefore, ABC Co. shall revert to measuring the loss allowance pa the lifetime expected credit losses to the 12-month expected credit Osses, Scanned with CamScanner aN 326 — chapter, ABC Co. shall measure the loss allowance equal to month expected credit losses of P2,500 (1% x 250,000). 2. The entry to adjust the loss allowance is as follows: Dec. 31, | Loss allowance (52,500 - 2,500) 50,000 20x2 Impairment gain 50,009 | Determining significant increases in credit risk Determining significant increases in credit risk is essential in applying the impairment requirements of PFRS 9 because whether the loss allowance is measured equal to 12-month expected credit losses or lifetime expected credit losses depends on this assessment. PERS 9 requires an entity to assess, at each reporting date, whether credit risk has increased significantly since initial recognition by comparing the risk of default at the reporting date with the risk of default at initial recognition. When making the assessment, the entity shall use reasonable and supportable information that is available without undue cost or effort. PERS 9 states that there is a rebuttable presumption that credit risk has increased significantly since initial recognition when contractual payments are more than 30 days past due. Depending on the nature of the financial asset, the assessment may be made either on an individual basis (€-8: each financial asset) or collective basis (e.g., group of financial assets): 3 For purposes of determining the change in credit risk vst collective basis, an entity can group financial instruments 07° basis of shared credit risk characteristics. Examples of shared risk characteristics include the following: instrument type; credit risk ratings; collateral type; date of initial recognition; remaining term to maturity; epaoop Scanned with CamScanner ditional Concepts receivables -A t industry; geographical location of the borrower; and the value of collateral relative to the financial asset if it has an impact on the probability of a default occurring. woe e Measurement of expected credit losses Expected credit losses shall be measured in a manner that reflects: a. an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes; b._ the time value of money; and c. reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions. Probability-weighted outcome The measurement is unbiased in that it neither reflects a worst- case scenario nor a best-case scenario. Rather, it considers both the possibilities that a loss will occur and a loss will not occur, even if the most likely outcome is that no loss will occur. Time value of money The expected credit losses shall be discounted to the reporting date using the original effective interest rate, except for financial instruments with variable interest rate for which the current rate is used and purchased or originated credit-impaired financial assets for which a credit-adjusted effective interest rate is used. Reasonable and supportable information Reasonable and supportable information is one that is reasonably available at the reporting date without undue cost or effort. This includes: 2. past events; ~ Current conditions; and GQ forecasts of future economic conditions. Scanned with CamScanner ) Summary of measurement principles Stage Nature of Measurement of credit losses instrument Stages 1 & 2 Financial asset | Present value of the difference that is not between: credit- a. the contractual cash flows impaired due under the contract, and b. the cash flows expected to be received Stage 3 Financial asset | The difference between: that is credit- | a. the asset’s gross carrying impaired (but amount, and not purchased | b. the present value of estimated or originated cash flows discounted at the credit- original effective interest rate impaired) Credit-impaired financial assets A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred. Evidence that a financial asset is credit-impaired includes observable data about the following events: a) Significant financial difficulty of the issuer or obligor; b) Breach of contract, such as a default or delinquency in interest or principal payments; . c) The lender, for economic or legal reasons relating to th? borrower's financial difficulty, granting to the borrower # concession that the lender would not otherwise consider; d) It becoming probable that the borrower will enter bankrupt o other financial reorganization; e) The disappearance of an active market for that financial because of financial difficulties; or f) The purchase or origination of a financial asset at 4 discount that reflects the incurred credit losses. 1 asset deep Scanned with CamScanner 4 peceivables — Additional Concepts 329 The impairment loss is computed as the difference between: a. the asset’s gross carrying amount, and p. the present value of estimated cash flows discounted at the original effective interest rate The carrying amount of a loan or note receivable before impairment includes any interest receivable accrued up to the date the loss event has been determined. The original effective interest rate is the effective interest rate on the date the receivable was initially recognized. Impairment loss is deducted from the carrying amount of the impaired loan or note receivable either directly or through an allowance account. After impairment, interest income is computed by multiplying the original effective interest rate by the net carrying amount of the impaired receivable. Illustration 1: Stage 3 - Credit-impaired financial asset On January 1, 20x1, ABC Bank extended a P1,000,000 loan to XYZ, Inc. Principal is due on December 31, 20x5 but 10% interest is due annually starting December 31, 20x1. On December 31, 20x3, XYZ, Inc. was delinquent and it was ascertained that the loan is credit-impaired. ABC Bank assessed that interests accruing on the loan will not be collected; however, the Principal is expected to be received in two equal annual installments starting on December 31, 20x4. The carrying amount of the loan, together with the accrued interest, as of December 31, 20x3 is shown below: Loan receivable , : 1,000,000 ‘terest receivable 100,000 otal carrying amount of receivables before impairment 1,100,000 The current market rate on December 31, 20x3 is 14%. Scanned with CamScanner 330 Chapter 6 Requirement: Compute for the impairment loss on the loan receivable. Solution: The present value of estimated future cash flows is computed ag follows: Estimated future cash flows (1M +2 equal annual installments) 500,000 Multiplied by: PV of ordinary annuity at 10%, n= 2 ___1.735537_ Present value of estimated future cash flows 867,769 — Notice that the current market rate on December 31, 20x3 of 14% is ignored. The rate used is the original effective interest rate of 10%, equal to the nominal rate of 10% because the loan was initially recorded at face amount. The “n” of 2 pertains to the remaining years to maturity as of date of impairment (ie, December 31, 20x3 to December 31, 20x5). The impairment loss is ‘computed as follows: Present value of estimated future cash flows 867,769 Carrying amount before impairment _(1,100,000)_ Impairment loss (232,232) The impairment loss is recorded under each of the allowed methods as follows: Direct Allowance Dec. 31, 20x3 Dec. 31, 20x3 Impairmentloss 232, 231 Impairment loss 232,231 Interest receivable 100,000 Interest receivable 100, “at Loan receivable 132,231* | Loss allowance* 1 , i “ in liew Alternatively, the “Allowance for impairment loss” account may be used it Mi of this account. Scanned with CamScanner ee: ~ Additional Concepts receivables The net carrying amount of the loan is equal to the present of future cash flows. yalue Direct Allowance Toan receivable (before) 1,000,000 | Loan receivable 1,000,000 Impairment loss on loan* (132,231) | Loss allowance (132,231) Loan receivable (after) 867,769 | Loan receivable — net 867,769 “Cfotal impairment loss 232,231 less Interest receivable 100,000 ~ 132,231 impairment Joss pertaining to the loan receivable) A new amortization table is prepared after the impairment - Amortization table — installment: Date Collections Interest income Amortization Present value Dec. 31, 20x3 867,769 Dec.31,20x4 500,000 86,777 413,223 454,545 Dec.31,20x5 500,000 45,455 454,545 0 The entries on December 31, 20x4 are as follows: Direct Allowance Dec. 31, 2033 Dec. 31, 20x3 Cash 500,000 Cash 500,000 Interest income 86,777 Loss allowance 86,777 Loan receivable 413,223 Interest income 86,777 Loan receivable 500,000 Illustration 2: Interest not accrued because of loss event On January 1, 20x1, ABC Co. received a P10,000,000 note fee from XYZ, Inc. Principal payments of P2,000,000 and rest at 12% are due annually at the end of each year for 5 Years, The first payment starts on December 31, 20x1. Shan made the required payments during 20x1 and 20x2. difficult, during 20x3, XYZ, Inc. began to experience financial ‘€s, requiring ABC Co. to reassess the collectability of the Scanned with CamScanner 382g note. Because of the loss event, ABC Co. did not accrue te interest on December 31, 20x3. ABC Co. made the following cash flow projections on Decembey 31, 20x3: Date of expected receipt Amount of cash flow January 1, 20x4 1,000,000 January 1, 20x5 2,000,000 January 1, 20x6 3,000,000 Requirement: Compute for the impairment loss on the note receivable. Solution: The present value of estimated future cash flows is computed as follows: Date _ Future cash flows PVof1 Present value Jan.1, 20x4 1,000,000 1,000000000* 1,000,000 dant, 20s 2,000,000 0.892857143, 1,785,714 Jan.1, 20x6 3,000,000 0.797193878 2,391,582 __5,177,296_ * The first cash flow is receivable immediately, i.e., one day after impairment testing. The carrying amount of the receivable is computed as follows: Principal amount - Jan. 1, 20x1 10,000, Payment in 20x1 (2,000,000) Payment in 20x2 2,000,000). Outstanding balance - Dec. 31, 20x3 : 6,000,000 Interest receivable — Dec. 31, 20x3 a Carrying amount before impairment — Dec. 31, 20x3 — 6000 Scanned with CamScanner eccnables Additional Concepts The impairment loss is computed as follows: present value of estimated future cash flows 5,177,296 Carrying amount before impairment Impairment loss ‘Amortization table — installment: Interest Date Collections income __ Amortization _ Present value ‘Dec. 31, 20x3 5,177,296 Jan.1, 20x4 1,000,000 0 1,000,000 4,177,296 Jan.1, 20x5 2,000,000 501,276 1,498,724 2,678,572. Jan.1, 20%6 3,000,000 321,429 2,678,571 0 The pertinent entries under the ‘allowance method’ are as follows: Dec. 31, | Impairment loss 822,704 203 | _Allowance for impairment loss* 822,704 Jon. | Cash 1,000,000 2 |__Note receivable 1,000,000 eae Allowance for impairment loss 501,276 Interest income 501,276 mt | Cash 2,000,000 Note receivable 2,000,000 ay Allowance for impairment loss 321,429 Interest income 321,429 kmh | Cash 3,000,000 Note receivable 3,000,000 "Notice that when there is no accrued interest included in the carrying amount of an impaired receivable, the allowance for Impairment is equal to the impairment loss recognized. Changes in lifetime expected credit losses approach . $ approach is applicable to originated or purchased credit-impaired et assets, Originated or purchased credit-impaired financial Sets aré those that are credit-impaired on initial recognition. Scanned with CamScanner Cha; For this type of financial asset, the loss allowance recognized at the reporting date is equal to the curulative changes in lifetime expected credit losses since initial recognition. "When discounting cash flows for purposes of measurin, expected credit losses, the entity shall use a credit-adjusted effecting interest rate. Credit-adjusted effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts through the expected life of the financial asset to the amortized cost of a financial asset that is a purchased or originated credit-impaired financial asset. Simplified approach Under the simplified approach, an entity always measures the loss allowance equal to lifetime expected credit losses for trade receivables or contract assets that do not contain a significant financing component. An entity may also choose to apply this simplified approach to trade receivable or contract assets that contain a significant financing component or to lease receivables. This accounting policy choice may be applied independently to each of these assets. An advantage of this simplified approach is that the entity is not required to determine whether credit risk has increased significantly since initial recognition, unlike under the ‘general approach’. Applying the simplified approach PERS 9 does not require specific procedures in estimating lifetim? expected credit losses under the simplified approach. Instead PERS 9 allows practical expedients and refers to the example of # “provision matrix” (e.g, the ‘aging method’ discussed in Chapt 4). Another possible practical expedient is the use of a “single 105 rate” approach (eg, the ‘percentage of credit sales’ method a ‘percentage of ending receivables’ method, also discussed Chapter 4). Scanned with CamScanner peccioables ~ Additional Concepts Derecognition of receivables A financial asset is derecognized when: a. the contractual rights to the cash flows from the financial asset expire; or b. the financial asset is transferred and the transfer qualifies for derecognition. » Derecognition is the opposite of recognition. Derecognition refers to the removal of a previously recognized asset or liability from the entity’s statement of financial position. Expiration of contractual rights to cash flows Contractual rights to cash flows from a financial asset expire when the cash flows are collected, cancelled, or when they become uncollectible because of loss events. Transfer A financial asset is transferred if the entity either: a, transfers the contractual rights to receive the cash flows of the financial asset; or b. retains the contractual rights to receive the cash flows of the financial asset, but assumes an obligation to remit the collections to a recipient in an arrangement that meets all of the conditions listed below: i. The entity is not obligated to pay the recipient unless it collects an equivalent amount from the original asset. ii, The entity is prohibited from selling or pledging the original asset except as security in favor of the recipient. iii. The entity is obligated to remit collections to the eventual Tecipients without material delay. In addition, the entity is prohibited from reinvesting the collections, except in cash or cash equivalents during the short period from the collection date to the required remittance date, and any interest earned on the investment is also remitted to the recipient. Scanned with CamScanner a | 336 ———— Chapter 5 Example for (a) above: Transfer of contractual right ABC Co. has a P10,000 receivable from Alpha Co. and a Payable of P8,000 to Beta Co. In settlement of the P8,000 payable to Beta, ape Co. transfers its receivable from Alpha to Beta. Beta will in tur jy the one to collect from Alpha. > In here, the contractual right of ABC Co. over the TeCeivable from Alpha is transferred to Beta. ABC Co. will the, derecognize the receivable. Example for (b) above: Retention of contractual right ABC Co. is an insurance broker acting as agent in selling insurance for XYZ Insurance Corporation. ABC Co. is entitled toa 10% commission on insurance sold and also acts as collector for XYZ. ABC sells insurance to Mr. Letters at 10,000. Question: How should ABC Co. record the sale? (Entry #1 or Entry #2 below?) Entry #1 Date | Accounts receivable — Mr. Letters 10,000 Commission income (10% x10K) 1,000 Accounts payable - XYZ 9,000 OR ! Entry #2 : Z Date] Accounts receivable ~ XYZ 1,000 a Commission income (10% x10K) 1,000 To answer the question, let’s go back to paragraph ) eg transfers above. If ABC Co, retains the right to collect from Mr. Letters and assumes an obligation to remit the collections to * (which is the case in the problem) and all of the other condition listed above (i to iti) are met, the entry would be Entry #2. Co transfer qualifies for derecognition. Consequently, ABC recognizes receivable pertaining only to its commission (ie P1,000). Scanned with CamScanner Yr Additional Concepts 337 eceioal However, if not all of the conditions listed above (i to iii) are met, the entry would be Entry #1. The transfer does not qualify for derecognition. In such case, ABC Co. recognizes the total ivable of P10,000. Disregarding the previous answers, assume that ABC Co. retains the right to collect from Mr. Letters but assumes an obligation to remit the collections to XYZ and that: a) ABC Co. has no obligation to remit payment to XYZ if no collection is made from Mr. Letters, b) ABC Co. is prohibited from selling or pledging the receivable from Mr. Letters, c) ABC Co. is required to remit collections from Mr. Letters within 45 days upon collection and is prohibited from investing the collections other than for 30-day time deposits. rece! From the conditions above, it seems that the definition of a transfer is met and that Entry #2 should be made. But what if the interest on the 30-day time deposits is not remitted to XYZ? If that’s the case, not all of the conditions are met. The transfer does not qualify for derecognition. Therefore, Entry #1 will be made. ABC Co. recognizes the total receivables together with the related liability for amounts to be remitted to XYZ. In practice, it has been debated over the years as to whether the broker is entitled to recognize receivables that are Tequired to be remitted to eventual recipients when the broker also acts as the collector. This has been quite a delicate matter because if the broker is permitted to recognize the receivables, his Teported total assets will be increased, and even with increased liabilities, a balance sheet that shows large amounts of assets is 8enerally held to be more favorable to financial statement users than a balance sheet that shows small amounts of assets. With the 8uidance provided by current standards, instances can now be identified when the broker is permitted to recognize such Teceivables or not. Example b’ above might seem exaggerated; however, this was a common case when I Wasan auditor.4@) Scanned with CamScanner ON Evaluation of transfers > If the entity transfers substantially all the risks and Tewards of o\ nership of the financial asset, the entity derecognizes the financial asset and recognizes separately as assets or liabilities an tights and obligations created or retained in the transfer, » If the entity retains substantially all the risks and rewards of ownership of the financial asset, the entity continues to recognize the financial asset. > If the entity neither transfers nor retains substantially all the risks and rewards (e.g.,, when there is partial transfer and partial retention), the entity determines whether it has retained control of the financial asset: a. If the entity has not retained control, it derecognizes the financial asset and recognizes separately as assets or liabilities any rights and obligations created or retained in the transfer. b. If the entity has retained control, it continues to recognize the financial asset to the extent of its continuing involvement in the financial asset. 7 Illustration: Evaluation of transfers ABC Co. transferred loans receivable with carrying amount and fair value of P100,000 to XYZ, Inc. in exchange for cash of P100,000. Scenario 1: ABC Co. transfers substantially all the risks and rewards of ownership of the loans receivable. > Analysis: The transfer. qualifies for derecognition. ABC Co derecognizes the receivable as follows: Date | Cash 100,000 wo Loans receivable 1005 Scanned with CamScanner eevenles~ Additional Concepts 339 scenario 2: ‘ABC Co. is obligated to repurchase the transferred loans at a future date at fair value plus 10% interest. » Analysis: The transfer does not qualify for derecognition because ABC Co. is obligated to repurchase the transferred loans and therefore, retains substantially all the risks and rewards of ownership of the financial asset. Accordingly, ABC Co. continues to recognize the receivable, but recognizes a liability for the cash received. Date | Cash 100,000 Liability on repurchase agreement 100,000 Scenario 3: ABC Co. is obligated under the terms of the transfer to repurchase any individual loan but the aggregate amount of loans that could be repurchased could not exceed P10,000. > Analysis: ABC Co. neither transfers nor retains substantially all the risks and rewards of ownership of the financial asset. Accordingly, ABC Co. continues to recognize the receivable to the extent of its continuing involvement in the financial asset, i.e., the minimum amount ABC Co. is obligated to repurchase. Date T Cash 100,000 Loans receivable 90,000 Liability on repurchase agreement 10,000 Scenario 4: ABC Co. has only an option to repurchase the transferred asset at its fair value at the time of repurchase. > Analysis: The transfer qualifies for derecognition because the Tepurchase is only optional. Scanned with CamScanner Bog Tale sal ch 100,000 Loans receivable 100,009 Transfers that qualify for derecognition If a financial asset is transferred in its entirety but the transferring entity retains the right to service the financial asset for a fee, . financial asset or financial liability is recognized for the Servicing contract. If the fee is considered inadequate to compensate for the services, a servicing liability is recognized at fair value. If the fee is considered more than adequate, a service asset is recognized. The amount of asset to be recognized is determined by allocating the previous carrying amount of a larger financial asset to the part that is derecognized and the part that continues to be recognized, based on the relative fair values of those parts on the date of the transfer. If the transfer results to obtaining a new financial asset or assuming a new financial liability, or a servicing liability, the entity recognizes these items at fair value. On derecognition of a financial asset in its entirety, the difference between (a) and (b) below is recognized as gain or loss in profit or loss: a. the consideration received (including any new asset obtained less any new liability assumed); and b. the carrying amount (measured at the date of derecognition). Illustration 1: Transfer of financial asset ABC Co. transfers loans receivable with a fair value of 300,000 and carrying amount of P280,000. ABC Co. obtains an option f° purchase similar loans and assumes a recourse obligation repurchase similar loans. ABC Co. also agrees to provide * floating rate of interest to the transferee company. The assets and liabilities received as consideration for the transfer are Ji below: Scanned with CamScanner on peceioables ~ Additional Concepts 341 Assets received & liabilities assumed Fair values Cash proceeds 200,000 Interest rate swap 150,000 Call option 50,000 100,000 Recourse obligation Requirement: Compute for the gain or loss on the derecognition of the financial asset. Solution: The entry to record the transfer is as follows: Date | Cash 200,000 Interest rate swap 150,000 Call option 50,000 Loans receivable (carrying amount) 280,000 Recourse obligation 100,000 Gain on transfer of loans (squeeze) 20,000 The gain or loss on derecognition may also be computed as follows: Cash proceeds 200,000 Interest rate swap 150,000 Call option 50,000 Less: Recourse obligation , (100,000) Fair value of net assets received : 300,000 Carrying amount of loans transferred (280,000) Gain on transfer of loans 20,000 * Notes; * The new financial assets and financial liability obtained from the transfer are recorded at fair values. The interest rate swap and call option are debited because these are assets received (derivative assets). Scanned with CamScanner @ The difference between (a) the net consideration receiy (assets less liability) and (b) the carrying amount of the lo transferred is recognized as gain on the transfer. ans @ The fair value of the transferred receivables of P300,009 is ignored. Illustration 2: Servicing of a financial asset Use the information in Illustration 1 except that ABC Co, agreed to service the loans without explicitly stating the compensation, The fair value of the service is P15,000. Requirement: Compute for the gain or loss on the derecognition of the financial asset. Solution: The servicing fee is considered inadequate because it is not explicitly stated. Accordingly, a service liability will be recognized at fair value. The entry to record the transfer is as follows: | Date | Cash 200,000 Interest rate swap 150,000 Call option 50,000 Loans receivable 20,000 Recourse obligation 100,00 Liability on service obligation 15m Gain on transfer of loans (squeeze) 5m Notice that the gain is reduced by the fair value of “ service liability. This is because the recognition of the cai liability decreases the net consideration received. (The on Ilustration 1 is P20,000 while the gain in Illustration 2 is P5,000, the deere due to the service obligation of P15,000.) If the compensation for the servicing of loat wil stated and it is more than adequate, a service asset recognized. jcith loans is explidly Scanned with CamScanner aviv = Aalditional Concepts 343 transfers that do not qualify for derecognition jf a transter does not resull in derecognition because the entity has retained substantially all the risks and rewards of ownership of the transterred asset, the entity shall continue to. recognize. the tin its er consideration received, In subsequent periods, the transferred as rely and shall recognize a_ financial Hiability for the entity shall recognize any income on the transferred asset and any expense incurred on the financial liability. tat 1 asset continues to be recognized, the asset ated liability shall not be offset. Similarly, the entity set any income arising from the transferred asset with any expense incurred on the associated liability. Offsetting a financial asset and a financial liability A financial asset and a financial liability are offset and only the net amount is presented in the statement of financial position when the entity has both: a. a legal right of setoff; and b, an intention to settle the amounts on a net basis or simultaneously However, when a transfer of financial asset does not qualify for derecognition, the retained asset shall not be offset to the associated liability. Mlustration: Transfer and subsequent offsetting ABC Co. sold a loan receivable with a carrying amount of P25,000 to XYZ, Inc. for P25,000. The transaction requires ABC Co. to Tepurchase the financial asset at a future date for P25,000 plus 10% interest, to be computed annually starting on the date of transfer. © The transfer does not qualify for derecognition because ABC Co. is required to repurchase the transferred loan. The cash Teceived is recorded as follows: | Date Kies: 25,000 Liability on repurchase agreement 25,000 Scanned with CamScanner ees The retained loan receivable and the associated liabitit, repurchase agreement, and the interest income and interest on On that will be recognized on these items, are not offset but af presented separately in the financial statements. i Simpler guide on transfers The following guide in determining whether a transfer of financial asset qualifies for derecognition is adopted from the US GAap- A transfer. of financial asset is considered a sale, and therefore derecognized in its entirety, when all of the following conditions are met. 1. The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors); 2. The transferee has obtained the right to pledge or exchange either the transferred asset or beneficial interest in the transferred asset; and 3. The transferor does not maintain effective control over the transferred asset through an agreement to repurchase or redeem them before their maturity. If any of the foregoing conditions is not met, the financial asset is not derecognized in its entirety. If a partial transfer occurs the transferred asset is recognized to the extent of the transferor S continuing involvement. Only the portion for which control is transferred is derecognized. Sale or secured borrowing Under US GAAP, transfers of receivables are treated either @ or secured borrowing. tion (ie a. A transfer of receivable that qualifies for derecognition 1) i when all of the three conditions listed above are mel treated as a sale. The receivable is derecognized in its ent the The difference between the consideration receiv s sale Scanned with CamScanner |

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